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Should I expect prices of mutual fund shares to go up in anticipation of dividends, down after dividends have paid out ... or just trust that the market has already reacted to that and the price is basically fair throughout the period?

(I've generally been paranoid and tended not to play with my funds around this time of year, but that may be pure superstition.)

Clarifications: USA, open-ended index funds are my immediate interest, but the answers would be most general if we could cover some of the other varieties (and, if folks are so inclined, locations).

  • Are you talking about open-end funds, closed-end funds or exchange-traded funds? Each would be different to my mind. – JB King Dec 9 '14 at 0:52
  • What country are you talking about? In some countries, like the US, funds often distribute capital gains towards the end of the year, which may affect your decision to buy. – littleadv Dec 9 '14 at 1:02
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This answer is applicable to the US. Similar rules may hold in some other countries as well.

The shares in an open-ended (non-exchange-traded) mutual fund are not traded on stock exchanges and the "market" does not determine the share price the way it does for shares in companies as brokers make offers to buy and sell stock shares. The price of one share of the mutual fund (usually called Net Asset Value (NAV) per share) is usually calculated at the close of business, and is, as the name implies, the net worth of all the shares in companies that the fund owns plus cash on hand etc divided by the number of mutual fund shares outstanding.

The NAV per share of a mutual fund might or might not increase in anticipation of the distribution to occur, but the NAV per share very definitely falls on the day that the distribution is declared. If you choose to re-invest your distribution in the same fund, then you will own more shares at a lower NAV per share but the total value of your investment will not change at all. If you had 100 shares currently priced at $10 and the fund declares a distribution of $2 per share, you will be reinvesting $200 to buy more shares but the fund will be selling you additional shares at $8 per share (and of course, the 100 shares you hold will be priced at $8 per share too. So, you will have

100 previous shares worth only $800 now + 25 new shares worth $200 for a total of 125 shares at $8 = $1000 total investment, just as before.

If you take the distribution in cash, then you still hold the 100 shares but they are worth only $800 now, and the fund will send you the $200 as cash. Either way, there is no change in your net worth.

However, (assuming that the fund is is not in a tax-advantaged account), that $200 is taxable income to you regardless of whether you reinvest it or take it as cash. The fund will tell you what part of that $200 is dividend income (as well as what part is Qualified Dividend income), what part is short-term capital gains, and what part is long-term capital gains; you declare the income in the appropriate categories on your tax return, and are taxed accordingly.

So, what advantage is there in re-investing? Well, your basis in those shares has increased and so if and when you sell the shares, you will owe less tax. If you had bought the original 100 shares at $10 and sell the 125 shares a few years later at $11 and collect $1375, you owe (long-term capital gains) tax on just $1375-$1200 =$175 (which can also be calculated as $1 gain on each of the original 100 shares = $100 plus $3 gain on the 25 new shares = $175). In the past, some people would forget the intermediate transactions and think that they had invested $1000 initially and gotten $1375 back for a gain of $375 and pay taxes on $375 instead. This is less likely to occur now since mutual funds are now required to report more information on the sale to the shareseller than they used to in the past.

So, should you buy shares in a mutual fund right now? Most mutual fund companies publish preliminary estimates in November and December of what distributions each fund will be making by the end of the year. They also usually advise against purchasing new shares during this period because one ends up "buying a dividend". If, for example, you bought those 100 shares at $10 on the Friday after Thanksgiving and the fund distributes that $2 per share on December 15, you still have $1000 on December 15, but now owe taxes on $200 that you would not have had to pay if you had postponed buying those shares till after the distribution was paid.

Nitpickers: for simplicity of exposition, I have not gone into the detailed chronology of when the fund goes ex-dividend, when the distribution is recorded, and when cash is paid out, etc., but merely treated all these events as happening simultaneously.

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    Dividend is not a problem, and more than that - many funds actually accrue dividends, so buying the day before dividend won't help you much. In any case - dividends is something you actually get in hand. The more costly issue is capital gains distribution - you don't get any money, but you end up owing taxes for your portion of the fund's capital gains. That is why it is not advisable to buy in during the last couple of months: you're not buying dividends - you're buying capital gains. – littleadv Dec 9 '14 at 5:49
  • @littleadv I thought that if a mutual fund did not distribute dividends earned from the stocks they held (as well as the net capital gains from the stocks they sold during the year to the fund's shareholders), then the fund had to pay income taxes on the non-distributed amounts? Some mutual funds distribute dividends and capital gains in March and December, and since I choose to receive these as cash (and not re-invest them), I do receive the capital gains distributions as cash, not just the dividends part as cash. – Dilip Sarwate Dec 9 '14 at 12:48
  • No, in the US funds don't pay taxes. They have capital gains due to selling of stocks to rebalance, or to pay cashing out investors, and it is reported to the fund holders at the end of the year based on their rate of holdings. – littleadv Dec 9 '14 at 17:03
  • @littleadv I just don't understand the point you are trying to make. Are you saying that capital gains distributions by the fund are always reinvested into the fund and the shareholder gets no cash in hand; just more shares at a lower NAV, while distributions of the dividends collected by the fund over the year are always sent as cash and so the shareholder gets cash from which to pay the taxes due? And the notion of "you are not buying dividends - you are buying capital gains" seems to imply that the the distribution of the dividend income does not result in a reduction of the NAV, ... – Dilip Sarwate Dec 9 '14 at 23:08
  • @littleadv ... while distribution of the capital gains does result in a reduction of the NAV? – Dilip Sarwate Dec 9 '14 at 23:09

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