This video explainer is based on a question from a member who wanted to know the role of dividend-paying vs non-dividend-paying stocks and funds and about the free dividend fallacy. So I discuss the merits of income funds (which pay you an income) and accumulation funds (which reinvest their income automatically). I also discuss why high-dividend-paying stocks might not be so great after all and might even be responsible for making London the Jurassic Park of stock exchanges!
Outside the US it’s possible to buy funds where the income generated by a fund’s assets is automatically reinvested into the fund by the fund manager
This is what most people choose to do before retirement because
The fund manager can do this more cost-effectively than we can (their trading costs are almost zero and they will do this as soon as the funds become available)
You don’t have to do the work! Investing cash that appears in your brokerage account is an additional choice you have to make and work you have to do
Even after retirement you could still benefit from holding accumulation funds
You can sell some of your funds to generate cash
Many platforms now charge very little (or nothing) for trading so sales will not add much additional cost
The income of the accumulation fund appears as a capital gain
Some funds come with both an income and accumulation version so we can compare the two
Here’s LifeStrategy 60% income (red) and accumulation (black)
Notice how the accumulation fund gradually rises above the income fund due to reinvested dividends. Those dividends come from the stocks and bonds held by LifeStrategy 60.
The contents and weights of the two funds are identical but their returns are different
Assuming you reinvested the dividends from LifeStrategy 60 immediately after receiving them you would closely approximate the return from the accumulation fund but the chances are that you’d leave the cash knocking about in your account during which time it wouldn’t be compounding so I suspect in practice you’d underperform long-term
The tax treatment of accumulation funds held outside a tax-sheltered account (i.e. in a general investment account rather than an ISA or SIPP) still requires you to report the dividend income as income separately from capital gains
Your broker should provide you with a report to help you split this out e.g. Vanguard UK says “If you hold a Vanguard General Account you’ll receive a Consolidated Tax Certificate (CTC) from us. This will include details of your dividends and interest income for the tax year. You’ll find this in your inbox when you log in.”
They provide more information here https://www.vanguardinvestor.co.uk/investing-explained/general-account-tax-information
The thing which the taxman is looking for is “excess reportable income” which Vanguard defines as follows:
“Excess reportable income is the amount an offshore fund earns beyond income declared as distributions – whether that’s dividends or interest. This is extra income that can accumulate in your fund throughout the year”
If you buy single stocks there’s something called the “free dividend fallacy”
When a company pays you a dividend its value falls by the amount of dividend it pays out i.e. you get money in the form of cash but lose money because the price of the stock falls
If you monitor stock prices you’ll see when a stock goes ex-dividend (the date after which you will not receive the next dividend payment) that its price usually falls
This effect is biggest for stocks that pay a large dividend with low frequency (some pay quarterly, some semi-annually and some annually) but the stock is often so volatile that it swamps the theoretical fall e.g. St James’s Place went ex-dividend on April 15th 2021. You can make out a fall on the ex-div day but if you didn’t know it went ex-div you might just think this was a bad day for SJP e.g. when I make a video about their fees
BUT investors often mentally separate dividend income from capital gain e.g. see “The Dividend Disconnect” by Samuel Hartzmark and David Solomon
“Investors behave as if they track capital gains and dividends as separate and largely independent variables”
“Dividend-paying stocks are sold less frequently, and the propensity to sell depends less on price changes”
“Demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to high valuations and lower future returns for dividend paying stocks”
This is an article by Paul Marshall from the active fund manager Marshall Wace in the FT “London is becoming the Jurassic Park of stock exchanges” who highlights how paying out high dividends may have damaged the entire UK stock market
The full article is here
“The UK stock market is becoming a global backwater as US and Chinese markets forge ahead. It has largely failed to take part in the global rally that began in 2015.”
“But there are also homegrown reasons for the UK’s market decline. None is more peculiar (or farcical) than the role of income funds, the UK fund management sector’s signature dish. These funds are a uniquely UK phenomenon. They prioritise dividends over any other kind of return from a company and therefore by definition penalise growth”
“The City of London is in danger of becoming a sort of Jurassic Park where fund managers dedicate themselves to clipping coupons rather than encouraging growth and innovation. It is time the income fund sector was phased out and replaced with funds that are more focused on growth than dividends, on the future rather than the past.”