Quantifying & Visualizing the "Dividend Premium"
How to Separate Accrued Income From the Security's Actual Value
About five years ago, I discovered that when an investor buys a security and then receives their first distributions, they will actually lose money after tax. That is only possible if their tax rate exceeds 100%.
I was doing extensive research to determine why this was happening. But my research yielded no fruit.
Then, one day, I was crunching some numbers by comparing the price of the S&P 500 Index with the price of an S&P 500 Index Fund. To perform this analysis, I calculated the percent change of each dataset, anchored to a specific date, and then subtracted the percent change calculations of the S&P 500 Index from the S&P 500 Index fund.
To my astonishment, a repeating pattern emerged in the data. I am a quant with over 20+ years of experience, and I know that whenever you find a repeating pattern in a generally random dataset, you must dive deeper because repeating patterns are not supposed to show up in random data.
When I looked closer, I saw this pattern starting and stopping on certain days. I looked up the historical ex-dividend days of this fund, and sure enough - the pattern started and stopped on the ex-dividend days. Furthermore, the percent change of the S&P 500 Index Fund was deviating away from the percent change of its index by an amount equal to the quarterly dividend the fund paid.
Then, it hit me. These funds added their accrued dividends earned by the fund to its net asset value. This pushed the fund’s value above the value of its underlying holdings (the index). Furthermore, the sharp drops on the ex-dividend days represent the fund correcting its accounting by recognizing those accrued dividends for what they actually are — liabilities — causing a drop in the fund’s value on the ex-dividend day and resetting it back to the value of its index or underlying holdings.
From this model, I created the equations needed to quantify investor losses.
Here is a graph of the “dividend premium” in an S&P 500 Index fund.
Anytime you see a dividend premium over 0%, you are “buying dividends,” and you will lose money. Notice that it is virtually impossible to avoid buying dividends because they accrue daily.
The other way to visualize the dividend premium is to create a running ratio of the price of the S&P 500 index fund divided by the price of the S&P 500 Index. While this method won’t express the premium as a percentage, it will show you the fluctuations of the two data series and the resetting of the ratio on ex-dividend days.
I hope that visualizing the problem will help you understand it and clear up any concerns that this problem is a theory. On the contrary, the problem is very real and quantifiable.
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