Dividend Drag

Dividend drag is a negative effect of the dividend structure of a unit investment trust (UIT), a type of unmanaged exchange-traded fund (ETF), in a rising market. SEC rules stipulate that unit investment trusts, which require no board of directors, must pay out profits as cash dividends to investors instead of reinvesting in the portfolio. In a rising market, this means the ETF will underperform similar funds with the ability to reinvest.

Dividend drag affects shareholders even if they choose to reinvest the dividend themselves. The structure of ETFs delays dividend payments for days, and in a rising market the cost to reinvest is constantly increasing. Without an automatic dividend reinvestment option for shareholders, it may take a week for the money to be reinvested. In the meantime, the price of the shares will have increased, and the same amount of money will buy fewer shares than it would if it had been immediately reinvested.

In a declining market, dividend drag is not an issue per se. In fact, because stock prices are falling, a dollar in cash is worth more than a dollar in investment assets.

Dividend drag is a feature specific to UITs. Today, most ETFs are open-end management investment companies. Like UITs, management investment companies take several days to get dividends into the pockets of shareholders. Unlike UITs, management investment companies can elect to reinvest profits as opposed to issuing a cash dividend, thus eliminating dividend drag.

Management investment companies’ operating costs are higher than those of UITs, but their mutual fund-like structure allows for more flexibility. Investors should assess the quality of an investment in the context of their personal investment philosophy and unique life situation.

While dividend drag is enough for some investors to swear off UITs completely, they remain a popular investment product. In fact, some of the largest ETFs trading today are UITs. For many investors, dividend drag doesn’t count for much. Some find the net effect of dividend drag, while valid and measurable, still too small to matter, particularly considering all the other factors in evaluating a fund, such as index tracking, exposure, operating costs and tax efficiency. Others prefer dividend payments to reinvestment no matter what the charts say, because their goal is not to maximize the value of their investment assets over the long term but rather to use dividend payments to maintain a certain standard of living in the short term.