The winner of the Charles Brandes Prize, awarded by the Brandes Institute, has been announced and is an excellent effort by Samuel M. Hartzmark and David H. Solomon titled The Dividend Disconnect:
We show that many individual investors, mutual funds and institutions trade as if dividends and capital gains are separate disconnected attributes, not fully appreciating that dividends come at the expense of price decreases. Behavioral trading patterns (e.g. the disposition effect) are driven by price changes excluding dividends. Investors treat dividends as a separate stable income stream, holding high dividend-yield stocks longer and displaying less sensitivity to their price changes. We term this mistake the free dividends fallacy. Demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to high valuations and lower future returns for dividend-paying stocks. Investors rarely reinvest dividends into the stocks from which they came, instead purchasing other stocks. This creates predictable marketwide price increases on days of large aggregate dividend payouts, concentrated in stocks not paying dividends.
…
If investors are subject to the free dividends fallacy, viewing dividends as a distinct source of income, they should place a higher value on that perceived income stream when other options for income are less attractive. For an investor exhibiting the free dividends fallacy, perhaps the closest substitute for dividend income is from bonds. We nd that dividend demand is higher when the interest rate is low, consistent with the periodic payments from bonds appearing less attractive. In
the cross-section, demand is higher for stocks whose dividends are more stable, and whose dividends have increased in the recent past. In addition, the demand for dividends is lower when recent past market returns have been higher. In these times, the smaller predictable stream of payments from dividends is apt to appear less attractive compared with the large recent capital gains, if the two components are evaluated as separate alternative ways to make money on a stock.
I don’t agree with this bit:
Finally, if investors view dividend payments as being separate from the value of their position, they may not reinvest dividends into the stocks from which they came. This has been shown before for the case of individuals in Baker et al. (2007), who argued that dividends were financing consumption. We show that dividend reinvestment is also rare among mutual funds and institutions (similar to Kaustia and Rantapuska (2012) using Finnish data). As well as being more sophisticated than retail investors, most mutual funds and institutions lack the consumption motive of individuals, meaning that there must be other motives for their behavior. Using quarterly holdings, we examine how often dividend-paying holdings increase by approximately the number of shares that could be purchased with the dividend on the payment date (when reinvestment requires a non-trivial number of shares). We compare this to another benchmark for passive investing – holding exactly the same number of shares in the subsequent quarter, and leaving the dividend in cash or investing it elsewhere. We show that dividend reinvestment is only about 2.3% as common as zero holdings changes for the case of mutual funds, and 9.6% as common for institutional investors. If revealed preference is to be believed, the low level of dividend reinvestment implies that these investors have a desire to marginally reduce their portfolio weights by the exact amount of the dividend starting on the ex-dividend date. It seems more likely that these sophisticated investors are either not directly tracking which dividends correspond to which stocks for reinvestment purposes, or do not
care enough to maintain particular portfolio weights.
Portfolio cash flows are an excellent means to slowly rebalance portfolios. Any portfolio manager, good or bad, will have three categories of stocks: buy, hold, sell. When one of the ‘hold’ stocks pays a dividend, there is not necessarily any rational reason to reinvest the dividends in that issue; there will be at least some rationale to reinvest the dividend in one of the ‘buy’ stocks.
I’m also skeptical of this bit:
The disconnect between price changes and dividends also helps to unify a number of results that are puzzling under normal assumptions about returns. Baker et al. (2007) present evidence that individuals like to consume out of their dividends, consistent with the mental accounting distinctions between dividends and capital gains. Baker andWurgler (2004b) argue for a catering theory whereby investors have a general demand for dividends due to psychological or institutional reasons, though the psychology behind this is not discussed at length. The free dividends fallacy not only explains psychologically why dividends may be desirable, but also why the shifting attractiveness of capital gains and dividends can generate time-varying demand for dividends which rms respond to (Baker and Wurgler 2004a). Valuing dividends purely as an income stream can also help to explain the observed preference that older investors have for dividends documented in Graham and Kumar (2006) and Becker et al. (2011), and the fact that investors do not perceive the risk-reward tradeoff inherent in the change in leverage associated with a dividend, as shown in Welch (2016). An overall demand for dividends is consistent with Hartzmark and Solomon (2013), who document abnormally positive returns during dividend months linked to price pressure from dividend-demanding investors. Harris et al. (2015) show that mutual funds have a tendency to juice their dividend yield by trading in and out of dividend-paying stocks to increase the fund’s dividend yield at the expense of overall returns. These results all point to a generalized time-varying demand for dividends, but do not explain why dividends are desirable.
Prices are more volatile than dividends; it is therefore desirable, in a consumption situation such as retirement, to arrange one’s portfolio so that income is spent while the capital is untouched – this forms a part of ‘Sequence of Returns Risk’.
However, this bit is sobering:
Our results suggest that the free dividends fallacy is costly to investors because of the systematic nature of time-varying dividend demand. In addition to the direct costs and bene fits associated with dividend paying stocks (such as taxes, trading costs and reinvestments), if investors buy dividend paying stocks when they are relatively over-priced due to a general demand for dividends, they will earn predictably lower returns. We estimate that investors buying dividend-paying stocks during times of high demand earn roughly 2-4% less per year in expectation. Thus an investor whose preferences for dividends cause him to shift into and out of dividend-paying stocks at the same time as other investors would lose a signifi cant portion of the equity premium by doing so.
| HIMIPref™ Preferred Indices These values reflect the December 2008 revision of the HIMIPref™ Indices Values are provisional and are finalized monthly |
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| Index | Mean Current Yield (at bid) |
Median YTW |
Median Average Trading Value |
Median Mod Dur (YTW) |
Issues | Day’s Perf. | Index Value |
| Ratchet | 0.00 % | 0.00 % | 0 | 0.00 | 0 | -0.0169 % | 2,424.1 |
| FixedFloater | 0.00 % | 0.00 % | 0 | 0.00 | 0 | -0.0169 % | 4,448.1 |
| Floater | 3.78 % | 3.94 % | 33,794 | 17.55 | 4 | -0.0169 % | 2,563.5 |
| OpRet | 0.00 % | 0.00 % | 0 | 0.00 | 0 | -0.0132 % | 3,078.7 |
| SplitShare | 4.74 % | 4.70 % | 67,888 | 4.35 | 6 | -0.0132 % | 3,676.6 |
| Interest-Bearing | 0.00 % | 0.00 % | 0 | 0.00 | 0 | -0.0132 % | 2,868.6 |
| Perpetual-Premium | 5.36 % | -0.32 % | 66,293 | 0.18 | 17 | -0.0370 % | 2,827.7 |
| Perpetual-Discount | 5.29 % | 5.24 % | 67,546 | 15.00 | 19 | 0.0693 % | 2,977.5 |
| FixedReset | 4.24 % | 4.24 % | 146,536 | 4.52 | 99 | -0.1374 % | 2,480.1 |
| Deemed-Retractible | 5.06 % | 5.48 % | 99,735 | 5.98 | 30 | 0.0717 % | 2,913.1 |
| FloatingReset | 2.74 % | 2.78 % | 45,576 | 4.03 | 8 | 0.2177 % | 2,677.7 |
| Performance Highlights | |||
| Issue | Index | Change | Notes |
| MFC.PR.L | FixedReset | -2.09 % | YTW SCENARIO Maturity Type : Hard Maturity Maturity Date : 2025-01-31 Maturity Price : 25.00 Evaluated at bid price : 22.48 Bid-YTW : 5.67 % |
| SLF.PR.I | FixedReset | -1.18 % | YTW SCENARIO Maturity Type : Hard Maturity Maturity Date : 2025-01-31 Maturity Price : 25.00 Evaluated at bid price : 24.36 Bid-YTW : 4.52 % |
| TRP.PR.A | FixedReset | -1.14 % | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2047-10-26 Maturity Price : 20.03 Evaluated at bid price : 20.03 Bid-YTW : 4.49 % |
| CM.PR.Q | FixedReset | -1.02 % | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2047-10-26 Maturity Price : 23.15 Evaluated at bid price : 24.30 Bid-YTW : 4.41 % |
| IAG.PR.A | Deemed-Retractible | 1.39 % | YTW SCENARIO Maturity Type : Hard Maturity Maturity Date : 2025-01-31 Maturity Price : 25.00 Evaluated at bid price : 23.32 Bid-YTW : 5.84 % |
| PWF.PR.Z | Perpetual-Discount | 1.40 % | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2047-10-26 Maturity Price : 24.22 Evaluated at bid price : 24.60 Bid-YTW : 5.24 % |
| Volume Highlights | |||
| Issue | Index | Shares Traded |
Notes |
| RY.PR.Q | FixedReset | 81,229 | YTW SCENARIO Maturity Type : Call Maturity Date : 2021-05-24 Maturity Price : 25.00 Evaluated at bid price : 26.63 Bid-YTW : 3.44 % |
| SLF.PR.E | Deemed-Retractible | 51,200 | YTW SCENARIO Maturity Type : Hard Maturity Maturity Date : 2025-01-31 Maturity Price : 25.00 Evaluated at bid price : 21.79 Bid-YTW : 6.87 % |
| RY.PR.A | Deemed-Retractible | 51,002 | YTW SCENARIO Maturity Type : Call Maturity Date : 2017-11-25 Maturity Price : 25.00 Evaluated at bid price : 25.31 Bid-YTW : -14.32 % |
| RY.PR.O | Perpetual-Premium | 42,123 | YTW SCENARIO Maturity Type : Call Maturity Date : 2024-11-24 Maturity Price : 25.00 Evaluated at bid price : 25.22 Bid-YTW : 4.72 % |
| TRP.PR.C | FixedReset | 35,750 | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2047-10-26 Maturity Price : 17.23 Evaluated at bid price : 17.23 Bid-YTW : 4.47 % |
| TRP.PR.E | FixedReset | 33,282 | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2047-10-26 Maturity Price : 22.73 Evaluated at bid price : 23.06 Bid-YTW : 4.40 % |
| There were 20 other index-included issues trading in excess of 10,000 shares. | |||
| Wide Spread Highlights | ||
| Issue | Index | Quote Data and Yield Notes |
| TD.PF.I | FixedReset | Quote: 25.50 – 26.00 Spot Rate : 0.5000 Average : 0.3583 YTW SCENARIO |
| MFC.PR.L | FixedReset | Quote: 22.48 – 22.86 Spot Rate : 0.3800 Average : 0.2495 YTW SCENARIO |
| MFC.PR.C | Deemed-Retractible | Quote: 21.99 – 22.44 Spot Rate : 0.4500 Average : 0.3412 YTW SCENARIO |
| GWO.PR.M | Deemed-Retractible | Quote: 26.05 – 26.28 Spot Rate : 0.2300 Average : 0.1426 YTW SCENARIO |
| SLF.PR.I | FixedReset | Quote: 24.36 – 24.72 Spot Rate : 0.3600 Average : 0.2742 YTW SCENARIO |
| CU.PR.I | FixedReset | Quote: 26.15 – 26.65 Spot Rate : 0.5000 Average : 0.4152 YTW SCENARIO |
I’m not sure I understand any of this. Why should it be surprising that investors are less sensitive to price changes in a stock they bought for the dividend stream?
When I buy a stock (mostly prefs and bank shares) for the dividend stream, I have zero interest in price changes, unless the price change reflects a fundamental change in risk profile of the company. As Benjamin Graham said – in the short term the market is a voting machine in the long term a weighing machine. Changes in price are only of interest to me when they the change is downward and the companies risk profile hasn’t changed.
I don’t understand this at all – “dividends come at the expense of price decreases”. Are they referring to the day after a dividend has been paid out and, everything else being equal, the stock drops to compensate?
I agree that it doesn’t mean anything that investors frequently don’t reinvest dividends in the stock that produced the dividend. As you say, I view this as an opportunity to re-balance my portfolio.
I reread this post several times. I am a simple person and this resonates in a few small parts.
I think all depends on market conditions and life stages and time horizons and risk profiles and personal sentiment and general view one’s station in life.
Save a bit of REITS, I dont reinvest pref dividends in same source. By my design, the dividend stream from a group of prefs is meant to fund a fixed income stream (with albeit lower income production from GICs and bonds) and that this will evolve to income/consumption at some point. These both should, hopefully, fund some sort of comfortable income over time. I dont really mind the market price changes for the basket of prefs, yet the immediate past has meant more attention to buying prefs and accepting any cap. gains/loss (to be realized at some point in the future).
Re-balancing this at some later life stage in inevitable as is moving to a more tax efficient approach.