Who trades around the ex-dividend day? Evidence from NYSE audit file data

Financial Management (Financial Management Association), Autumn, 1998 by Jennifer Lynch Koski, John T. Scruggs

Our paper analyzes the identity of traders around ex-dividend days, using audit file data from the New York Stock Exchange (NYSE)TORQ database to distinguish between short-term trading by securities dealers and short-term corporate dividend-capture trading.(1) Understanding who trades on ex-dividend days is important in determining whether ex-day returns reflect marginal investors' tax rates, trading costs, or both, and to understand the determinants of exdividend returns and trading volume.

Two types of traders have incentives to implement short-term, dividend-related trading strategies. The first type is securities dealers who have the same tax rates on both dividend and capital gains income, and very low transaction costs. Stock prices typically decline on the ex-dividend date, when the stock no longer trades with the right to a forthcoming dividend. If the expected capital loss differs from the dividend amount by more than their transaction costs, securities dealers will trade to profit from the difference. The second type is taxable corporations. Corporations were exempt from taxes on 70% of intercorporate dividends received during our sample period (subject to some additional constraints, discussed below). Because of the preferential tax treatment of dividend income relative to capital gains, corporations have a strong incentive to capture dividend income.

Previous research is consistent with the existence of short-term dividend trading. However, whether short-term dividend traders are taxable corporations or securities dealers remains an open question. Our paper addresses this question by examining audit file data from the TORQ database. In addition to price and volume data, the TORQ database includes information about the type of trader for both the buy and sell sides of each trade. These additional data allow more detailed tests of hypotheses on ex-dividend trading.

Specifically, if the expected capital loss is less than the dividend, securities dealers could buy the stock with the dividend and sell the stock without the dividend. Opposite predictions hold if the expected capital loss is greater than the dividend.(2) Dealers could (short) sell these securities before the dividend and purchase them afterward. As argued by Lakonishok and Vermaelen (1986) and Michaely and Vila (1996), short-term trading activity should decrease with transaction costs and increase with dividend yield.

Dividend capture by taxable corporations, which face lower taxes on dividend income than on capital gains, represents a special type of short-term trading. Corporate dividend-capture trading could also cause a net increase in cum-dividend buying and ex-dividend selling around ex-dates.(3) This trading should also be negatively related to transaction costs and positively related to yield.

In the TORQ database, trading by corporations is classified differently from trading by securities dealers. We are therefore able to distinguish between short-term trading by securities dealers and taxable corporations. This distinction is an important step in identifying the marginal ex-dividend trader, and therefore the determinants of ex-dividend returns and volume.

The paper is organized as follows. Section I discusses related research. Section II describes the data, and Section III defines theoretical predictions. Section IV discusses the statistical tests. Empirical results are reported in Section V, and Section VI concludes.

I. Related Research

Previous ex-dividend research has debated extensively whether the behavior of stock prices around ex-dividend days is determined by long-term tax-clientele investors (Miller and Modigliani, 1961, and Elton and Gruber, 1970) or short-term traders (Kalay, 1982, and Miller and Scholes, 1982). Recent research notes theoretical differences between short-term trading by securities dealers and short-term corporate dividend-capture trading (Karpoff and Walkling, 1990, and Michaely and Vila, 1995, 1996), but cannot distinguish empirically between the two.

Elton and Gruber (1970) describe tax-clientele traders as risk-neutral long-term investors who decide to buy or sell stock for reasons unrelated to the dividend, and who choose only the optimal time to trade during the ex-dividend period. In contrast, short-term traders trade specifically because of the dividend. In a dividend-capture trading strategy, traders buy the stock with the dividend and sell without the dividend, to "capture" the dividend income. The costs of this trading strategy are the capital loss and any associated transaction costs.

Many previous empirical tests of these dividend-trading theories examine ex-dividend price behavior. Eades, Hess, and Kim (1984, 1994), Karpoff and Walkling (1988, 1990), Grammatikos (1989), Fedenia and Grammatikos (1991), Michaely (1991), Robin (1991), Venkatesh (1991), Dubofsky (1992), Koski (1996), and Bali and Hite (1998), among others, analyze ex-dividend stock price behavior for US firms. Recent papers by Kato and Lowenstein (1995), Lasfer (1995), Michaely and Murgia (1995), and Frank and Jagannathan (1998) analyze ex-day returns for stocks in various foreign markets. Lakonishok and Vermaelen (1986) note that it is difficult to distinguish between ex-dividend-trading hypotheses using price data alone. For example, both the tax-clientele and short-term trading models predict a positive relation between the ex-dividend price decline as a percentage of the dividend, and dividend yield. Boyd and Jagannathan (1994) derive an equilibrium model in which this relation is complex and nonlinear.