Over on the Bogleheads forum, for a short while, a number of posters were wondering why they didn’t see a dividend posted from certain Fidelity funds. Fidelity Spartan Total Market Index Fund, for example, typically pays dividend twice a year in April and in December. It paid a dividend on April 11, 2014 and again on April 10, 2015. As of April 14, 2016, it hadn’t paid a dividend in April 2016. People were worried when they thought their funds skipped a dividend, until the funds finally declared a dividend on April 15th.
Meanwhile Vanguard’s Total Market Index Fund paid dividend quarterly on schedule. Its latest dividend was paid in late March.
Is it a problem that the Fidelity fund pays dividend only twice a year when the Vanguard fund pays four times a year? Do you get more compounding when you get dividends more frequently? Moreover, is it a problem if a fund skips a dividend? If that happens, where did the money go? Into the fund manager’s pockets?
From an investment returns point of view, how frequently a fund pays dividends does not matter. A fund buys stocks. Some of those stocks pay dividends. The fund gets them. The money goes into a cash pool. If some fund investors sell fund shares, the fund may just pay out of the cash pool instead of selling stocks. If the fund has enough cash, the dividends get reinvested into more stocks.
The fund pays out dividends only because they are required by law to pass all dividends received to the fund investors, so that the fund investors are taxed on those dividends (unless you hold the shares in a tax-advantaged account). The fund does not have to pass the dividends right away. It’s only required to pass them within the same year. A fund may choose to pay a dividend in April, but it doesn’t have to. Skipping one in April and waiting till December is not really a problem. Think of it as being automatically reinvested. When the fund holds the dividends received in the fund, the money isn’t stolen or misappropriated by the fund manager.
Before the dividends are paid out, the fund invests them in the same way as any other money received by the fund. The value of the dividends received is reflected in the fund’s daily price. If you automatically reinvest dividends, you are not missing anything no matter how often the fund pays dividends. A fund’s performance is calculated assuming dividends are automatically reinvested. In fact if all fund investors automatically reinvest dividends, declaring a dividend is merely a bookkeeping exercise for the fund — no cash leaves the fund. You don’t get more compounding if a fund pays dividends more often.
Some funds offered exclusively in 401k-type plans don’t pay dividends at all, because they are not required to do so when the fund has no taxable investors. Not paying dividends by itself doesn’t affect a fund’s performance.
Why are people concerned about a missing dividend then? Other than a possible misunderstanding of the significance of a dividend from a mutual fund or ETF, some investors may be spending the dividend or using the dividend for rebalancing. If a fund doesn’t pay a dividend when you need some money from it, you can always sell some shares yourself. A dividend is 100% taxable. Selling shares is taxable only on the capital gain, which is less than 100% of what you sell.
Don’t worry about how often a fund pays dividends or when it skips a dividend. If you need money from the fund, just sell some shares on your own.
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Smart Money MD says
Great overview. For those people who pay attention closely at the frequency of dividend payments, I think it becomes somewhat psychologically advantageous to “see” more payments even if mathematically it makes no difference.
“Some of those stocks pay dividends. The fund gets them. The money goes into a cash pool. If some fund investors sell fund shares, the fund may just pay out of the cash pool instead of selling stocks.”
When the fund uses this “dividend” money to pay an investor who sells shares, does the investor know/care the cash came from dividends? In other words, the tax on a sale will be on capital gains regardless, and not ever in the form of dividends tax, right?
Also, say investors happen to sell enough shares in a given year that they exhaust all dividends that would otherwise needed to have been distributed that year. Does that mean the fund has no dividend left to distribute then?
In both cases, it seems like the government is missing out on taxes (not that I’m complaining, just want to understand this is how it really works). For the seller, the tax would only be on capital gains amount, instead of dividend tax on entire amount. For other investors, there could be less dividend left over to distribute (or even be no dividend at all) so less dividend tax that year overall.
Harry Sit says
The customer doesn’t know or care where the money comes from. If the fund used up the dividend money for something else, it’s still obligated to declare the same amount of dividend in the year.
Mark Caspary says
I think for someone who is retired and trying to budget themselves it’s important to have a predictable flow of dividend payments. As you say in the article you could just sell some shares if you need the money and get taxed at your capital gains level, but if your level is higher than 15% in effect you would be getting taxed twice for the dividends when they are finally paid and for the capital gains on the shares you sold, if in a taxable account. I suppose you cold sell some shares at a loss later in the year to off set gains, but this just adds a bit more complexity to the situation and possibly you would not have any or enough losses to write off.
Harry Sit says
Unless you live 100% on dividends, you have to sell some anyway. If you sold more in April because the anticipated dividend didn’t come, you just sell less in December. If someone truly lives 100% on dividends it’s also easier to live on last year’s dividends, instead of month-to-month on dividends in the current year. After a year, see how much you got from dividends, and that becomes your next year’s spending money.
John Sarnow says
As a result of compounding, assets grow faster. Assuming “average” stock market growth, a dividend reinvested in March has 9 months to “grow” as compared to the fund that holds all dividends for an end-of-year payment.
Harry Sit says
The fund already automatically reinvested the dividend money received. It’s not holding it in cash separately waiting until December.