Dividend Mutual Funds & ETF's - The surprising impact of share dilution resulting from open ended fund structure
I just learned something new that surprised me, but isn't surprising in retrospect. I thought I'd pass it along to share it with those who might be interested and to spur on some conversation. TLDR: while the companies held by an ETF or mutual fund might pay out X% cash as dividends, and while the the SEC might require the fund to pay out all cash dividends to shareholders on record, fund share issuance in a given quarter owing to fund popularity can significantly dilute the cash paid to existing shareholders.
The quandry I explored: VHYAX and VYM (Vanguard's High Dividend Yield Index) had a disappointing year over year dividend increase of 0.8% despite its largest holding (Broadcom with an 8% weighting) increasing its dividend payout by over 10% in December last year. So why such a meager fund year over year increase in its distribution? The answer turns out to be the popularity of the fund! Q1 fund inflows were somewhere between $3.5-4 billion. This resulted in fresh share issuance, a feature of all open ended funds. With total net assets of about $90 billion, this represents a share dilution of about 4%. In other words, the combined VHYAX/VYM share class issued roughly 4% new shares. During this period the fund was continuously receiving dividends from its existing underlying companies; however, new share purchases would only increase the amount of cash available to pay shareholders if the new purchases were made prior to the ex date. The simple math: if the fund's underlying components increased their payments by 4.8% year over year and the fund increased its share count by 4% in Q1 then the year over year increase in the fund payout would only be 0.8%. Mystery solved.
So what does this mean for us (often maligned) dividend investors? It means that we're not 100% entitled to the cash distributed by the companies held by funds we own. If a fund becomes popular and there is a significant capital inflow then the cash accumulated in a given quarter will also be distributed to new shareholders on record. It can be a problem for a couple of reasons: 1) When relying upon the income stream of the fund the mutual fund share issuance can significantly F*** the quarterly distribution (sucks), and 2) When evaluating a dividend oriented fund it's important to bear in mind that the historic track record of dividend growth may have been suppressed. I think open ended funds are still a great way to gain exposure to a diversified slate of dividend paying companies, but this is one land mine I wan't aware of until now.