Will a Dividend Capturing Strategy Yield Free Money?

We all like free money, right?

I know I sure do, which is why I immediately became interested in a strategy called dividend capturing. It works something like this.

You find a stock that pays a very generous dividend. Right before that dividend gets paid, you buy some shares. The stock pays the dividend, and most of the time, shares tend to recover to at least the same level as before. After paying commissions–which are basically nothing these days–an investor is left with the profit from the dividend.

Here’s a real life example, something that just happened. Cominar Real Estate Investment Trust (TSX:CUF.UN) has a monthly dividend of 12.25 cents per month for each share. At the end of each month, the company declares a dividend to be payable on the 15th of the following month. This declaration is announced well in advance.

Because stock trades take three days to settle, you can’t just go on the last day of the month and buy up shares. You have to get in on (or before) the ex-dividend date, which is two business days before the dividend declaration date.

Getting back to Cominar, this means you would have to buy your shares on April 27th to get the dividend which was declared on April 29th.

On April 27th, Cominar shares traded at a range of between $17.20 per share and $17.34, closing at $17.33. Say you split the difference, and got in at $17.27.

On April 29th, Cominar shares spent the day in a range between $17.20 and $17.30 per share. Let’s say you got lucky, selling your shares at $17.30.

In total, you’d have a profit of $0.1525 per share, less any commissions. You would have made $0.03 per share in capital gains, and $0.1225 per share in dividends. 15 cents per share doesn’t sound like much, especially after commissions, but getting a 0.8% return in two days translates into close to 160% annualized.

Unfortunately, life isn’t quite that easy. Here’s why a dividend capturing strategy is difficult to pull off.

Pennies in front of a steamroller

The big issue when it comes to dividend capturing is the upside potential versus the downside.

Again, let’s go back to Cominar as our real-life example. If you wouldn’t have sold out on April 29th for a slight profit, it look more than a week for shares to get back to the point where you were making money on this move. Yes, shares did get back to that range, but human psychology is a powerful thing.

Dividend capturing is supposed to be a quick strategy. You get in, collect the dividend, and then get out, making a slight profit. All it would take is for Cominar shares to fall $0.13 each–less than 1% of its market price–for the strategy to turn from a guaranteed money maker into a loser.

Essentially, the strategy turns into something akin to trying to pick up pennies in front of a steamroller. Sure, most of the time you’ll get your pennies. But when things go badly, they’ll go really badly.

Are ETFs a better solution?

There are certain investors who swear by an alternate dividend capturing method. It goes a little something like this.

At the end of the year, many ETFs pay out accumulated dividends in one lump sum. Depending on the ETF, that can be a windfall of anywhere from 2% to 5% of the value of the fund.

Let’s look at one I personally own, the Market Vector Russia ETF Trust (NYSE:RSX), an ETF which tracks the biggest companies with significant exposure to Russia.

This ETF collects dividends from these companies throughout the year and then pays them out right before the year ends. In 2015, this payout was $0.519 per share, which worked out to a yield of 3.6%.

Rather than try to trade in and immediately out of this stock, an alternative strategy would be to buy it as a longer-term investment right before the ex-dividend date. You’d get a nice 3.6% boost without having to do anything. And since it’s a long-term hold, you wouldn’t have to worry about short-term price movements. It’s a small move that won’t make you rich, but it will slightly boost returns.

Dividend capturing isn’t a great strategy. Sure, it can work, but for me, it’s just too much effort for the small reward. If I had $10 million to invest maybe things would be different, but at this point I can’t recommend it as a viable strategy for regular folks. It’s better to stick to the same boring principles everyone else says.

Can You Retire Comfortably Only Saving 10% Of Your Salary

In The Wealthy Barber, which was one of the best-selling books on money in Canadian history, author David Chilton argues that the average Canadian can set themselves up for a comfortable retirement by doing one simple thing. All you have to do is set aside 10% of your income, invest it wisely using a mutual fund, and you’re in business.

Critics of the book point out it was first published in 1989, which was an era of much higher interest rates, and often uses aggressive return assumptions of 10-12% per year to “prove” setting aside just a small percentage of one’s income can work. And Chilton himself acknowledges that the advice to buy mutual funds is outdated, telling Canadian investors in 2015 to find exchange traded funds instead.

Are the critics right, especially considering the low interest world which we deal with today? Or is Chilton right? Let’s have a closer look.

The power of compounding

We all know that starting to invest earlier in life is a big part of making sure you’ve got enough cash for retirement. So let’s run the numbers on two imaginary investors.

Say they both make $50,000 per year, which is about average these days. One puts aside $5,000 per year starting at age 25, while the other horses around and doesn’t get serious about saving until age 40. We’ll assume each investor can earn a consistent 8% return over time and stops contributing at age 65.

The first investor does quite well for himself, turning his periodic investment into a nest egg worth more than $1.5 million. The second investor still does pretty well, but only accumulates $429,000.

Now we have to make an assumption about their retirement. If each retires at age 65, it’s prudent to assume they’ll still be kicking around at age 90, just to be safe. Each wants to keep the same lifestyle, so we’ll assume they withdraw $45,000 per year, since they don’t have to save for retirement any longer.

There’s just one wrinkle we’re missing, and that’s inflation. Over 40 years, inflation of just 2% will approximately halve the spending power of $50,000 per year. I’m not sure that it’s fair to include it though, since we haven’t given our imaginary borrowers a raise over their working lifetimes. So we’ll be a little conservative and assume they both want to live on $60,000 per year.

The conclusion is obvious. Our second investor only accumulated $429,000, which means he’ll have to withdraw 14% of his nest egg each year. It’s not going to last any longer than a decade at most.

Even our first investor might be in for a rough time. $60,000 per year is 4% of his $1.5 million retirement fund. If it continues to grow at a modest pace, he’ll be fine. But if it doesn’t, he’s running into danger of running out of money too.

The problem with projections

The investment business would take my hypothetical situation and use it to guilt people into buying more investments. Hey, it’s what they do.

But the future isn’t quite as dire as I’ve painted it out to be. Firstly, both of our fictitious savers would be eligible for Canada Pension Plan and Old Age Security payments, adding at least $1000 per month to their income. And if both were married, they can count on their spouse to get at least OAS.

Plus, there’s no reason to assume that much spending. Most retirees have their house paid for and their kids have left the nest, hopefully becoming financially independent. And like I previously mentioned, they no longer have to save for retirement.

In reality, I can picture a scenario where a retiree only needs $30,000 or $35,000 per year to live comfortably, with between $10,000 and $20,000 of that coming from the government. Suddenly, our two investors only need to generate $15,000 or $25,000 per year from their portfolios. In that situation, even the borrower with a $439,000 nest egg is still in pretty good shape, while the guy sitting on $1.5 million will never run out of money.

I’m not saying you don’t need to save for retirement, because of course you do. Just remember that likely your spending won’t be as high as it is now, and you’ll have help from the government. With those two things in your favor, saving 10% should be all it takes to ensure you’re not eating cat food during your golden years, provided you start at a relatively early age.