The failure to carefully rein-vest exchange-traded fund dividends could be costing your clients thousands of dollars in performance.
"If you just blindly accumulate a cash portfolio, you will have a little more cash drag," says Scott Burns, director of exchange-traded fund analysis at Morningstar Inc., Chicago. "How much depends on where the cash is invested."

Burns estimates that keeping dividends in cash, rather than automatically reinvesting them, can cost an advisor 20 to 30 basis points in total return or $2,000 to $3,000 per $1 million invested.

In addition, it could cost another 20 basis points in annual returns if advisors paid brokerage commissions when they reinvest the distributions. Morningstar factors in this transaction cost when calculating ETFs' market price based on total returns.

Calendar year total returns that financial advisors earn on client exchange-traded funds differ from market-based, net asset value and dollar-weighted returns calculated by Morningstar or investment company reports.

That's because total return calculations for an exchange-traded fund are identical to those for open-end mutual funds. Both follow the requirements of Item 26 on SEC Form N-1A. The calculation compares an initial investment in the fund at the beginning of the period to the ending value. It assumes distributions will be reinvested-even though some exchange-traded funds do not offer the automatic reinvestment of dividends. Reinvestment of all income and capital gains distributions occurs on the actual reinvestment date. Unless identified as load-adjusted total returns, performance is not adjusted for sales charges and redemption fees. Total returns, however, factor in management, administrative, 12b-1 and other fees automatically deducted from fund assets.

The difference between actual returns and returns based on the SEC rule is due, in part, to what the advisor does with the dividends. Tracking errors and expenses also may account for differences.

"In a low interest rate environment, the difference is minimal and [the reinvestment of dividends] does not affect risk-return relationship of the portfolio," Burns says.

In a high interest rate environment, however, the differences between client total returns and reported returns can be greater if the advisor fails to rebalance the portfolio or reinvest dividends.

Data on the advisor use of ETFs is hard to come by. About 65% of advisors on Charles Schwab's platform have at least one subaccount set up for commission-free reinvestment, according to Peter Crawford, a Schwab senior vice president. Published reports indicate that 6,000 advisors clear through Schwab. Advisors using Schwab brand-name exchange-traded funds pay no commissions to buy, sell or reinvest dividends. There are also no charges for reinvesting dividends in non-Schwab funds. Of course, there can be bid-ask spreads and some tracking error.

Sean O'Hara, president of Revenue Shares' exchange-traded funds, says he does not know if advisors are reinvesting dividends back into his funds. "Most people use [ETFs] on an advisor platform and commissions are waived," he says. "My sense is that the typical buyer is a buy-and-hold investor building core positions. They use other ETFs to generate excess returns. But moderate traders don't reinvest dividends."