In my most recent podcast, I addressed an excellent question from Philip, who asked, “Are there days when ETF investors should avoid trading?”

Philip’s question has nothing to do with trying to time the market. He simply wants to know whether there might be days when you should not buy or sell ETFs close to the dates when distributions (dividends or interest payments) are made. And the answer to that question is—maybe.

Let’s begin with a reminder that when you buy or sell shares of an ETF, the trade settles two business days later (weekends and holidays are excluded). In the industry, this is known as T+2 settlement. For example, say you buy 500 shares of an ETF at $20 each on Monday. Assuming no holidays, the trade settles on Wednesday, so you do not necessarily need to have the $10,000 in your account until that day. (In practice, some brokerages do not allow you to place a trade if you have insufficient cash in the account on the trade date.)

If you sold those 500 shares for $20 each on Monday, the cash balance in your account might read $10,000 immediately, but your brokerage almost certainly will not allow you to withdraw that cash until after the trade settles on Wednesday.

How settlement dates affect dividends

Now let’s consider how settlement dates affect the payment of dividends. When an ETF announces a dividend (or, in the case of a bond ETF, an interest payment), it will declare a record date and a payment date. To use a real-world example, the most recent dividend paid by the Vanguard FTSE Canada All Cap Index ETF (VCN) was $0.24 per share, with a record date of April 1 and a payment date of April 8.

This means any investor who owned VCN on April 1 would receive the dividend one week later, and this would be true even if he or she sold the holding during the intervening days. If you owned the ETF on Monday, April 1, but sold it on Wednesday the 3rd, the trade would settle on Friday the 5th, and you would still receive the dividend on the following Monday.

So let’s consider how things would work if you had just recently bought some shares in VCN on Friday, March 29. You would see the shares of VCN in your account on April 1, but your trade would not settle until Tuesday the 2nd. So you would not receive the next dividend. For this reason, the business day before the record date is known as the ex-dividend date (in this context, ex means without).

You might be wondering whether there is an opportunity to profit here by purchasing shares on the day before the ex-dividend date (Thursday, March 28 in this example), and then selling them the next day? That would entitle you to the dividend and—assuming you could sell your shares for roughly the same amount you paid—you would be collecting that income with very little risk.

Well, as you can imagine, if it were that easy, every hedge fund would have an algorithm programmed to harvest free dividends in this way. The reason this doesn’t work is that on the ex-dividend date, the share price of the ETF will fall by an amount roughly equal to that of the expected dividend. This makes logical sense, because a share of an ETF is more valuable if it comes with the promise of the dividend, and less valuable if the dividend is not included. The market is efficient enough to recognize this, so you can’t make a risk-free profit.

All of this means that if you’re buying or selling ETFs close to the dividend record date in an RRSP or TFSA, there is no specifically good or bad time to place your trade. Either you’ll pay less for the shares and forfeit the dividend, or you’ll pay more and receive the distribution. There is no theoretical advantage or disadvantage either way.

Swapping dividends for capital gains

In a non-registered account, however, there can be tax implications to the timing of an ETF trade.

Say you hold 1,000 shares of a Canadian equity ETF that announces a dividend of $0.50 per share with a record date of Thursday, May 9. The ex-dividend date is the previous day, Wednesday the 8th, so you should expect the ETF’s price to fall by about $0.50 on that date.

Now let’s assume your ETF shares have appreciated by $2,000 as of Tuesday, May 7. If you sell them on that day (just before the ex-dividend date), you would realize a capital gain of $2,000. However, if you sold the shares the following day, on the ex-dividend date, the share price is expected to fall by $0.50, so your realized capital gain would be only $1,500. You would also receive $500 in dividends, so the total proceeds are the same in both cases.

As we’ve said, in a registered account these are equivalent. But dividends and capital gains are taxed at different rates. If you’re in a low tax bracket (where Canadian dividends are taxed more favourably), you’re better off collecting the dividend. If you’re in a high tax bracket, you’ll likely pay less tax if you take the larger capital gain.

The opposite is true if you’re buying an ETF immediately before it pays a dividend. In our example above, if you buy the shares in a taxable account the day before the ex-dividend date, you will receive a taxable cash dividend almost immediately. It might be better to buy the next day, when the price should be lower and you won’t receive the taxable dividend (even though you’d incur a larger capital gain when you sell your shares in the future).

I need to stress that these explanations are theoretical: markets move quickly in the real world, and by waiting a day or two to make a purchase, the normal fluctuations of the market can easily work against you. For example, you might expect an ETF’s price to fall $0.50 on its ex-dividend date because that is the amount of the distribution, but the markets may cause the shares to go up or down by much more than that. So don’t try to be too clever here: the point is simply to understand the issues you may encounter when trading ETFs near their dividend dates.