One area in investing that is often overlooked by investors is trade execution, which relates primarily to commissions, bid-ask spreads, and price impact. Yet sometimes it is trade-execution alone that can make the difference between and profitable trade and an unprofitable one.
In a new paper, “Ex-Dividend Profitability and Institutional Trading Skill,” by Henry and Koski, the authors examine whether institutions with superior trade execution skills can earn profits from a “dividend capture” strategy, which involves trading stocks around the ex-dividend date. (Note, we’ve covered some other dividend strategies in the past here and here and here).
Before getting into the paper, let’s review some mechanics of dividend announcement and payment.
The Ex-Dividend Date
The Theory
The ex-dividend date represents a temporal line in the sand. In order to be eligible to receive a dividend, an investor must own the stock before the ex-dividend date. If you buy a stock on the ex-dividend date you don’t get the dividend. This creates a dislocation point for the stock price that relates to the dividend that is to be paid.
The Modigliani-Miller model states that the payment of dividends is irrelevant to the market value of a company. Under the MM model, on the ex-dividend date any dividend payment is immediately offset by a decline in the stock price by the amount of the dividend.
The Reality
While academic theory offers neat solutions, the real world is always messier. As it turns out, dividend payments are not precisely offset by a decline in the stock price. In general, as a lot of empirical research has demonstrated, ex-day stock prices decline by an amount less than the dividend.(1)
Dividend Capture and Trading Skill
A dividend capture strategy, therefore, aims to profit from this discrepancy, by buying the stock before the ex-dividend date, selling on or after the ex-dividend date, capturing the dividend and this small premium, and thereby earning abnormal returns.
