What is Dividend Drag?

When an ETF is not able to offer a quick, automatic dividend reinvestment option to clients, it can sometimes take a week or more to get the dividends back into the market.

In a rising market, this lag can cause the reinvested amounts to purchase higher-priced shares than they would have been otherwise. This drags the performance of the fund down, compared to an index or more efficient fund.

The structure of ETFs prevents them from immediately reinvesting dividends, and they often do not offer what is known as a DRIP, or dividend reinvestment plan, which is built into many pooled investments like mutual funds (and other ETFs).

This is because the assets in an ETF are pooled with an intermediary entity, called an Authorized Participant, and settlement and assignment lags for a few days due to the inefficiency of the middle-man, despite the fact that they can be traded intra-day.

Sometimes it can take a week or more to get dividends back into the market after the ETF has collected them on the investor's behalf. This stifles the performance of the ETF and has come to be called dividend drag.

The reason that redemptions and dividend payments take so long within the workings of the ETF is because the authorized participant, which is generally a large investment bank or broker-dealer, processes transactions to and from the actual ETF investment pool, which is separately managed, in large blocks of shares.

The size of these blocks might be 50,000 shares-worth, and the block purchases are called creation units.

The AP must essentially wait for the ferry boat to fill up with orders before it will take it across the river to the fund managers and vice-versa.