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The Sunday Paper – The ‘Ex-Dividend Day’ Anomaly Under a Behavioral Dividend Clientele View: Evidence From China

[The work in the paper highlighted today from Huanchang Du (et. al.) of Princeton is important for practitioners but, for the sake of brevity, I’ll address only the laity in the summary. There’s a link at the bottom if you need the deeper dive.]

If a stock is priced at $100 and has a dividend of $10 due what should the price be on its first day ‘XD’ that dividend? Easy, right?

There’s no free money in this world so the holder gets the $10 but the stock price drops to $90 so the next buyer doesn’t get the dividend but the holder is in the same position a day after the XD-date as before i.e. their stock is ‘worth’ $90 now but they collect $10. Makes sense, and that’s what all students who are still being taught the Capital Asset Pricing Model* will assume. Except that, in the real world, it doesn’t happen like that.

[*A branch of financial theory now so discredited it’s shocking its still taught at all; but it is. If anybody tries to sell you on the rightness of this approach [Most hedge funds, still. Ed.] run away! Its the financial-theory equivalent of tapping a leather globe with a dead dog to relive the flux.]

What happens, in reality in most developed markets, is the stock price is higher than $90 on the XD-date. Why, because for many a capital gain is taxed at a lower rate than ‘income’ so institutional investors where possible try and avoid receiving dividends but are keener to buy the stock after a dividend would have been due to them.

OK, so in a market where there’s no capital gains tax the CAPM-predicted outcome i.e. $90 should be the XD-date price? That would describe China; but there something remarkable happens. The XD-date price tends to be lower than $90!

The why of this is not fully explained in the paper and it’d be useful to talk directly to operators to find out what, precisely, causes this behavior. Clearly there’s some ‘behavioral’ bias at work; but knowing why this occurs is less important than simply knowing there’s a regular pattern.

So, maybe there is some free money here? If we know that $100 regularly turns into, say, $89 on the XD-day (with our $10 dividend still in play) then a smart operator could sell the stock short before the event at, say, $100 (pay the $10 dividend due to the buyer) and buy the stock back for $89 the next day. That’s +$100-$10-$89=$1 for a $1 profit. Again, easy right?

There are two barriers to easy-street. First, many stocks can’t be sold short in the China markets and second, trading activity is observed to regularly decline on and after the XD-date there so even if setting up a position was possible getting out of it efficiently is another real-world problem that would retard the smooth operation of such a strategy.

Whilst the paper doesn’t shine a light on a free-money strategy its conclusions are helpful for we regular investors in terms of timing trades with China stocks around XD-dates; especially stocks with large yields where this effect is observed to be greatest.

In brief then, if you’re a buyer of a stock ahead of it’s XD-date and the dividend is large hang on until the XD-date has passed. If you’re a seller, clear out as close to but ahead of the XD-date as possible.

You can access the paper in full via the link here XD-date Anomaly in China.

Happy Sunday.

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