Strategic Use of Dividend Payments by Mutual Funds

Abstract

Using a unique sample of open-ended mutual funds, which are flexible in dividend policy and not required to “pass through” dividend to investors, we test whether funds pay dividend to cater to investor’s demand for cash or they exploit investor’s imperfect rationality to serve fund managers’ own interests. We find that dividend yield (DY) is positively (negatively) related to a fund’s post-dividend net cash flow (performance). In addition, small funds and funds suffering from low net cash flows have stronger incentives to distribute high dividends. More importantly, high-DY funds attract disproportionally more individual investors. These results suggest that fund managers take advantage of the individual investors’ irrational dividend chasing behavior, thereby using dividends strategically to benefit managers at the expense of fund investors.