This is a guest contribution by Josh Arnold for Sure Dividend. Sure Dividend helps investors find the best income securities for their retirement and financial freedom portfolios.
There are many strategies that help investors capture higher levels of income from their capital. This can be critical for investors that are relying upon investment income for living expenses – such as retirees – or those that are simply trying to compound wealth in the most efficient way possible before reaching retirement.
Some of these strategies work better than others – we like buying high-quality dividend stocks such as the Dividend Aristocrats and holding for the long-term. This article will discuss an alternative strategy called dividend capture.
The Benefits Of The Dividend Capture Strategy
This is a guest contribution by Josh Arnold for Sure Dividend. Sure Dividend helps investors find the best income securities for their retirement and financial freedom portfolios.
There are many strategies that help investors capture higher levels of income from their capital. This can be critical for investors that are relying upon investment income for living expenses – such as retirees – or those that are simply trying to compound wealth in the most efficient way possible before reaching retirement.
Some of these strategies work better than others – we like buying high-quality dividend stocks such as the Dividend Aristocrats and holding for the long-term. This article will discuss an alternative strategy called dividend capture.
What is Dividend Capture?
The idea behind dividend capture is simple: the income investor simply trades more often and attempts to capture the cash payouts of more stocks than would otherwise be possible by simply buying and holding. The strategy is an income-focused trading strategy that differs greatly from simply buying and holding, in that instead of receiving typical quarterly dividends from a few stocks, the trader attempts to receive a steady stream of dividends from a wide variety of stocks that are held for very short periods of time.
Dividend capture requires very frequent buying and selling in order to capture as many dividends as possible, which opens up the trader to higher risks, potentially higher taxes, and unfavorable capital returns.
The strategy relies upon the trader buying a dividend stock just before its ex-dividend date, and then selling right after. In this way, the trader owns the stock just long enough to be eligible for the dividend, and then sells the stock essentially immediately afterwards. Holding periods, therefore, can be as short as one day.
Dividends are usually paid out quarterly, but some are paid monthly, and a few stocks even pay one dividend annually. The dividend capture strategy is generally easier to make work with larger payouts, so monthly dividends would be inefficient, and annual payouts would be more advantageous to capture.
The way the strategy works is that the investor must know when a dividend is going to be paid, and when they are eligible to receive that payment. The ex-dividend date is crucial in that this is the date that the stock begins to trade without the dividend payment, hence “ex-dividend”, and therefore the trader must buy the stock before this date to be eligible to receive the payment.
The date of record is when the company records the shareholders that are eligible to receive the dividend, and is generally the day after the ex-dividend date. Thus, the dividend capture strategy requires the trader owning the stock on the record date. Shares can be sold the following day, meaning the holding period can be as little as one or two days in the dividend capture strategy.
This strategy has obvious appeal on the surface because it looks like the trader simply collects many dividend payments over the course of the year. However, as we’ll see below, it is highly debatable whether investors are better off with a dividend capture strategy.
Is Dividend Capture Advantageous?
On one hand, income investors could receive many more dividend payments utilizing the dividend capture strategy than a different investor who simply holds throughout the year. But this does not mean that investors will generate superior total returns using a dividend capture strategy.
The reason is because ex-dividend dates are telegraphed well in advance by the companies that are paying dividends, meaning any market participant knows the exact date the stock will trade ex-dividend, and the price tends to reflect that. In other words, if a stock is about to go ex-dividend with a payment of $1.00 per share, the share price will move $1.00 higher (or something close to it) as the ex-dividend date gets closer. When the stock goes ex-dividend, the share price will then decline by the amount of the payment.
By way of example, if a stock is trading for $100 and has a $1.00 dividend that is going ex-dividend in two weeks, the share price will, all else equal, rise to $101 just before the ex-dividend date, and then trade back to $100 right after. The net of all of this is that the dividend capture strategy requires the stock to stay at $100 before the ex-dividend date to work, but that may not happen. Market participants know the payment is coming, and therefore bid the stock up in sympathy just before the ex-dividend date.
In practice, this means that the dividend capture strategy is almost certainly paying $101 per share for our theoretical stock, then receiving the $1 dividend payment, then selling for $100. The net of this is essentially nothing, apart from whatever market volatility occurs during the short holding period.
There are other considerations as well, not the least of which is taxes. Because the trader is holding stocks for a matter of days, any gains and losses are classified as short-term, which carry higher tax rates than long-term capital gains. In addition, the dividends received with dividend capture don’t meet the necessary holding conditions to receive favorable tax treatment from the IRS, and therefore are taxed at the trader’s ordinary income rate. The IRS dictates investors must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date to receive this preferential tax treatment; dividend capture cannot meet that threshold by definition. Of course, there are ways to mitigate the tax impact, such as trading within a tax-advantaged account such as an IRA.
Finally, transaction costs can eat away at returns. While countless brokers now offer commission-free trading, there are implied costs of trading, such as poor bid/ask spreads, and order fills at above-market or below-market prices. These frictional costs can eat away at dividend capture returns, particularly as the trader will need to trade virtually every day to make dividend capture likely to produce any profits.
Final Thoughts
While the idea of dividend capture sounds simple enough, in practice, it is more complex. There remains a simple fact that efficient markets will virtually always price in upcoming dividend payments.
Due to these factors, we much prefer picking high-quality dividend stocks and holding for the long-term to generate income and compound wealth. That said, dividend capture is a potentially rewarding strategy for dividend investors who trade frequently.
