Understanding ETFs and Dividends

December is a month filled with giving and reflection on the passing year. For investors in exchange-traded funds (ETFs), the spirit of giving also typically comes in the form of dividends and interest. While those payments are generally received as a welcome end to the year, they can sometimes lead to confusion for investors who aren't familiar with the technicalities of how dividend distributions occur and might be surprised by an unexpected change in their portfolio's value. If this happens to you, don't panic. These temporary drops in portfolio value are simply due to the short period between an ETF's ex-dividend date and when the dividend payment occurs.

Just like individual stocks and bonds, ETFs periodically pay interest and dividends. ETFs collect the interest and dividends paid by the individual securities they hold and then periodically distribute them to their shareholders. Payment schedules vary for different ETF providers and can be found in the prospectus or the provider's website. Bond ETFs typically distribute accrued interest monthly while stock ETFs may distribute dividends on a quarterly, semiannual or annual basis.

ETFs sometimes also distribute additional dividends in December, if needed, to meet distribution requirements to avoid additional tax implications. That means that investors in a diversified portfolio such as Schwab Intelligent Portfolios would be expected to see interest and dividends each month throughout the year, but they often see the largest monthly payments in December due to multiple ETFs with different distribution schedules all making payments that month. Those large year-end dividends are often when investors notice those temporary shifts in portfolio value that can cause confusion.

• Ex-Dividend Date: Investors who buy an ETF before this date will receive the dividend payment, while those who purchase the ETF on or after this date will not receive the dividend. Note that the price of an ETF rises as the fund accrues the dividends paid by the companies it holds, and then is adjusted downward by the amount of the dividend before the market opens on the ex-dividend date because the cash being distributed will no longer be part of the fund's total net asset value (NAV).
• Record Date: Investors must be a shareholder of the ETF on this date in order to receive the dividend. This is typically a day after the ex-dividend date due to the two-day settlement period for ETF trades. For example, an investor who bought the ETF on the ex-dividend date would not receive the dividend because the trade would not settle before the record date.
• Payable Date: This is the date the dividend payment is made and is reflected in the total value of your portfolio. For Schwab Intelligent Portfolios clients, dividends flow back into the portfolio's cash allocation. When the cash allocation rises above its targeted proportion of the portfolio, it triggers rebalancing to reinvest in the most underweight asset classes at that time according to the program's rebalancing methodology.

To illustrate how dividend distributions occur and affect overall portfolio value, consider a hypothetical ETF that pays dividends quarterly as shown in the table below. For Q4 2019, the ex-dividend date is December 12, the record date is December 13 and the payable date is December 17. For this hypothetical example, assume that the ETF will pay a dividend of $0.76 per share. The ETF closed on December 11 at a price of $71.06. Before the market opens the next day, the ETF's price was adjusted to $70.30 to account for the upcoming dividend. Investors who bought the ETF before the ex-dividend date of December 12 will receive the $0.76 per share dividend payment on December 17.

So what happens to the client's portfolio value between the ex-dividend date and the payable date? A hypothetical shareholder who owned 1,000 shares of the ETF would see their portfolio value decline by $760 on the ex-dividend date due to the upcoming dividend.² But that money didn't disappear. The portfolio value will increase by $760 when the dividend is paid on December 17. Of course, this just looks at one ETF's dividend payment in isolation. The total change in portfolio value on any given day is affected by the price movement of each ETF in the portfolio as well as any dividend payments from other ETFs.

Investors sometimes mistakenly think it might be beneficial to try to time ETF trades around dividend payments. However, because the dividend is essentially "baked into" the price of the ETF before the distribution, and the ETF's price is adjusted downward by the amount of the dividend before market open on the ex-dividend date, the effect is the same for either investor.³

Consider the examples below:

• Sarah would receive the dividend payment because she purchased the ETF before the ex-dividend date, but she paid a higher price for the ETF because the dividend amount is "baked into" the share price until the ex-dividend date.
• John would not receive the dividend payment because he purchased the ETF on the ex-dividend date. Due to the two-day settlement period for ETFs, the trade would not settle until December 14, which is after the record date. However, John would purchase the ETF at a lower price due to the price adjustment made to account for the upcoming dividend payment.

Likewise for investors who sell an ETF before or after the ex-dividend date.

• If Carolyn potentially had a rebalancing trade in her portfolio and sold shares of the ETF before the ex-dividend date, she would not receive the dividend. However, she sold the ETF at a higher price that reflected the "baked in" upcoming dividend distribution.
• By contrast, if Andrew sold the ETF after the ex-dividend date he would receive the dividend but would sell at a lower price due to the price adjustment to account for the dividend.

Interest and dividends make up an important portion of an investment's return in addition to potential price appreciation. Tracking of individual interest and dividend payments can be found in the Activity section of the Schwab Intelligent Portfolios website and in your monthly statements. Understanding how ETFs make these interest and dividend payments and how they affect your portfolio's value can help you enjoy receiving these distributions while avoiding potential confusion at year-end when these payments are often larger than in other months.

David Koenig CFA^®, FRM^®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios