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By Michael Rawson, CFA

The total return from any investment can be broken down into two sources, dividends and capital gains. While it is important not to lose sight of the fact that we are ultimately most concerned about total return, it can be informative to track the source of returns between dividend yields and capital gains, particularly for income investors. If you are counting on a specific level of dividend per share from your exchange-traded fund, there is good reason to dig a little deeper into the details of fund operations.

An ETF that owns stocks will collect the dividends based on the number of shares of the underlying companies it owns over the course of time. Periodically, it will pay out these collected dividends to its shareholders. But what happens when new ETF shares are created? For example, the WisdomTree Equity Income (NYSEARCA:DHS) had about 3.1 million shares outstanding last June. It paid a dividend of $0.44 per share to shareholders of record on June 30. This amounted to a non-annualized yield of about 1.4%. Over the course of the next quarter, it collected dividends based on the number of shares in the fund, which averaged about 3.2 million. But in the days before the next dividend in mid-September, the shares outstanding in the fund nearly doubled to 6.1 million. Because the total dividend was now spread out among more shareholders, the dividend per share dropped to $0.20 for a yield of about 0.5%. So, the new ETF shareholders diluted the dividend received by the existing ETF shareholders, but does this mean that the existing shareholders were robbed? Not quite. First, some preliminaries on dividends.

Dividend Yields Quoted Net of Fees
When you type in the ticker of an ETF into the Quote page of Morningstar.com, the price shows up on the left-hand side along with a number of statistics on the right-hand side, including one called yield. This represents the sum of all dividends paid by the fund over the past 12 months' divided by the previous month-end net asset value. For example, SPDR S&P Dividend (NYSEARCA:SDY) has a dividend yield of about 3.3%. However, when you click on the portfolio tab to view statistics on the stocks within the ETF, it lists the average dividend yield of the stocks within the portfolio as 3.8%. What accounts for the 0.5% discrepancy? The bulk of the difference between the fund's dividend yield and the weighted average dividend yield on the underlying stocks in the portfolio is a result of the 0.38% expense ratio, which is deducted from dividends before they are paid out to shareholders. Although the top tax rate on long-term capital gains and qualified dividends is the same under current law, historically the top rate on dividends was higher, so it made sense to take expenses out of dividends rather than the NAV.

Dividend Deadline
In order to receive a dividend, you must be the registered owner of the fund by the record date. Because ETF trades take three days to settle, you need to buy the fund in advance of the record date in order to receive the next dividend. The first day that a fund trades without its dividend is known as the ex-date. On the ex-date, a fund's NAV should drop by the amount of the dividend, as anyone who buys on this date is not entitled to receive the dividend. SDY's most recent record date was Dec. 21, 2010, and the last day to buy the fund and still receive that dividend was Dec. 16. On the ex-date of Dec. 17, the fund NAV dropped by 40 basis points, even though the S&P 500 was up 11 basis points that day. The difference of about 50 basis points was paid to anyone who owned the ETF on Dec.16 in the form of a dividend. So, while owners of the ETF saw their NAV decline, their total return was about the same as it was for the index.

This explains why existing shareholders of DHS were no worse off after new shareholders stepped in front of the dividend. While it is true that if the share count had not doubled, their dividend would have been twice as large, on the positive side, the NAV declined by only half as much as it would have had those new shares not been created. So, while the dividend yield is lower after the new shares are created, the total return is the same. Over the next quarter, DHS collected dividends from its underlying stocks based on its new, higher share count. But over the course of the quarter, DHS saw net redemptions of shares, so those higher dividends collected were spread out over fewer shares, resulting in a dividend of $0.57 per share. Capital gains distributions can also affect NAV, as outlined in this article by Christine Benz.

The change in the dividend amount as a result of fund flows is an artifact of the way funds are designed. The current NAV of a fund will reflect the value of all of the underlying stocks, plus the cash component that has accumulated from dividends. So it will be a combination of securities and cash. Since new shares are always created at NAV, new shareholders pay the same price as existing shareholders, but the composition of that basket may differ depending on the procedures of the fund provider. Some providers, such as Rydex, require a component of the creation basket be set aside as cash to "pre-fund" the dividend. Thus, when shares outstanding in Rydex S&P 500 Equal Weight (NYSEARCA:RSP) increased by 20% in December, the cash component of the fund kept pace, preventing any dilution in the dividend. Most providers, including WisdomTree, iShares, and Vanguard do not require this prefunding, and thus the creation basket will be closer to the actual index, which doesn't carry any cash.

Buying the Dividend
While it may seem like a good idea to buy a fund right before the ex-date, so as to earn an extra dividend, this is actually not true. As we just discussed above, the NAV of the fund will adjust downward, so any gain you get from receiving an extra dividend will be offset by a decline in the NAV, at least in an efficient market. If the investment is held in a taxable account, you will incur a tax on the dividend. To add insult to injury, in our scenario the dividend will be non-qualified, meaning that it will be taxed at higher ordinary income tax rates. In order to qualify for the lower 5% or 15% tax rate, the investment needs to be held more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. This is probably not a major concern for any ETF with an average dividend yield, but it might make sense to review a fund's distribution schedule before buying a high-dividend fund.

The dilution of a dividend is less likely to occur in funds with large assets under management, in which flows are likely to be a smaller percentage of assets. Investors who are counting on a certain level of dividend can always offset a lower-dividend distribution by selling shares. Since this will result in a transaction cost, investors might consider switching to a brokerage platform that allows low- or no-cost trading of some ETFs.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Why Does My ETF Dividend Fluctuate So Much?