This Is One Of The Silliest Mistakes I See Income Investors
We’ve got some superb dividends sitting in front of us in CEFs right now—as I write this, these funds yield an incredible 7.9%, on average!
That’s way more than Treasuries (especially after their yields were pummeled last week). And far more than the 1.3% dribbled out by the typical S&P 500 stock.
Best of all, many CEFs hold the same stocks you likely hold now—including household names like Apple
Those high dividends, as you can likely imagine, get a lot of attention from investors—so much so that some may be tempted to try a technique known as “dividend capture” with CEFs. That’s where you buy just before the dividend is paid, pocket the high payout, then get out.
It’s a particularly tempting strategy with CEFs like General American Investors (GAM), which pays out most of its dividend as a one-time payout at the end of the year.
It sounds like a pretty great way to pocket a big payout with minimal downside risk. But does it work? Let’s run the numbers and see.
A Dividend-Capture Trade in Action
Let’s rewind to the end of 2021 and say a hypothetical investor we’ll call Marvin spots this opportunity with GAM. The fund ended up yielding a high 8.8% in 2021, counting its year-end special payout, which normally drops at the end of the year. (The fund also regularly pays a much smaller dividend near the start of the year.)
Adding to GAM’s appeal for Marvin is the fact that it holds a lot of blue chips he knows well. In addition to Microsoft and Apple, GAM’s top 10 holdings include Alphabet (GOOGL), Berkshire Hathaway
Knowing the year-end “special” was coming, Marvin decided to buy 100 shares of GAM on the day the payout was declared on November 3, 2021. He took that big dividend and sold his shares on December 30, 2021, after the payout was distributed (note that for simplicity we’ll use the fund’s closing price on these days).
Here’s how that would have played out:
By trying to just “capture” the dividend and selling after collecting, Marvin earned $123. That’s a lot of legwork for a $123 profit! And now he has to find somewhere else to put his money, or he has to somehow know when to get back into GAM. Otherwise he leaves his cash exposed to today’s high inflation.
I think you’ll agree that this is a less-than-optimal result for income seekers like us.
You’d be better off if you simply held GAM for the long haul, as this well-established fund, as we mentioned off the top, makes money a lot more often than not as the years pass.
Dividend Capture Is No Way to Dodge a Down Market
Investors tend to be more interested in dividend capture and strategies like it in rough years like 2022. That makes sense, as they look to capture cash dividends and minimize paper losses. So let’s see if Marvin’s strategy would’ve served him better in the down year that was 2022 versus the up year that was 2021.
First off, Marvin is playing for a smaller payout: last year GAM’s yield turned out to be 4.1%, based on the market price at the end of the year. That was a theme throughout the world: companies were shoring up cash due to concern about a recession.
In light of those worries, Marvin wants to get out of GAM fast to get that dividend and not be exposed to a potential recession. So he buys 100 shares again on November 2, 2022, when the special dividend is declared, and sells November 14, the fund’s record date, so he’s eligible to receive the payout.
That’s a decent trade: Marvin earns $190 in profits, with $100 of that from the dividend and the rest from capital gains.
This is better: a roughly 5.4% profit, which is a decent return in a bear market.
But here’s the thing: we’re nearly a full quarter into 2023 and the feared recession still hasn’t arrived. Moreover, there are further gains ahead for GAM, as its strong performance history shows. Its wide 17% discount to net asset value (NAV, or the value of the stocks it holds) adds another potential source of upside.
Trouble is, no one can tell when the fund’s next big move will start. Which is why we’re best to hold on instead of trying to capture the fund’s dividend at year end.
It goes to show that short-term trading based solely on timing the dividend payout isn’t your best play: if we’re going to trade on a shorter-term basis, that’s fine—we do it occasionally in my CEF Insider service, but those trades usually play out over months, rather than days, to take advantage of an opportunity others may have missed. But we prefer to hold for years to take full advantage of the gains (and high income streams) CEFs deliver.
Moreover, when we sell, we always do so with an eye to moving that cash into longer-term CEF dividend-payers.
This is why every issue of CEF Insider service carries my top recommendations from our portfolio for investing new money now. These picks (usually four to five funds in all, found right at the end of the issue) are my top destinations for long-term buys in which to move any fresh cash—say from a short-term trade that went your way.
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report “Indestructible Income: 5 Bargain Funds with Steady 10.2% Dividends.”
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