WITH earnings season once again upon us, investors are turning their minds towards the possibility that their share holdings will pay them at least some dividend income.
Although figures earlier this week from Capita Registrars showed that British firms paid out 2.5 per cent less in dividends in the first quarter than the same period of 2009, it was the slowest annual rate of decline since the recession began and 186 firms paid a dividend in the first quarter compared to 161 a year ago.
Exchange-traded fund (ETF) investors ought to be just as interested in what is happening to dividend payouts as traditional shareholders because ETF holders will also receive the equivalent of a dividend payment.
The provider of a FTSE 100 ETF, say, owns shares in the index’s constituents and will receive dividend income from the underlying securities accordingly. The provider then passes this on to the ETF holders in one of two ways. If it is a distributing fund, it will pay out the dividend income to investors on a periodic basis, perhaps quarterly or annually. In contrast, an accumulating fund will automatically reinvest any income received back into the fund rather than paying it out to the investor.
Investors in accumulating ETFs will therefore not receive any cash income from their holdings; they would have to liquidate their position to free up the cash.
The distinction between the two might seem negligible since you are receiving the same dividend payout – indeed providers are keen to emphasise that the difference in the way the income is treated shouldn’t affect an investor’s exposure to a benchmark or result in greater tracking error.
However, there can be some impact on the performance of the ETF relative to the benchmark.
The frequency with which the ETF providers make dividend payouts to their investors can have an impact on the performance of the fund although the net performance should be the same in principle, says Manooj Mistry, UK head of Deutsche Bank’s ETF division db x-trackers.
“The difference occurs depending on how regularly the cash has been distributed. If the distributing ETF only makes an annual payout then you will get a build-up of cash in the fund and this could act as a drag in a rising market because you are not fully invested,” he says. But he points out that in a falling market, this cash could actually act as a cushion.
In contrast, an accumulating ETF does not experience any cash drag because the dividends are instantaneously reinvested. Mistry says that about 85-90 per cent of db x-trackers’ products are accumulating ETFs, in response to demand from institutional clients.
“We noted from our institutional clients that they were not too bothered about a regular payout and were keener on reinvesting income – they want to be invested all the time.”
The difference between distributing and accumulating ETFs has important tax implications for individual investors as well. While private investors might be more inclined to choose funds that provide regular income in the form of payouts, they need to check how this stream of income will be taxed.
Dividends paid by ETFs which have distributor status certification (at the moment this is true for most London-listed funds) are liable to income tax at the investor’s marginal rate of income tax while any gains on disposal would be subject to capital gains tax (CGT) of 18 per cent. Investors without this status are subject to income tax on any dividends paid and on any capital gains on disposal.
As of last December, HMRC introduced the reporting fund regime applicable to offshore funds (for example, say, ones domiciled in Dublin or Luxembourg) for UK investors to simplify some aspects of the distributor status regime and create a level playing field with on-shore UK funds.
The key, as with any investment, is to know exactly what you are getting yourself into before you jump into the market.