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."

Some advisors choose not to reinvest dividends because of the transaction costs. Others may park distributions in cash and later reallocate assets based on their investment strategies. Meanwhile, some advisors may use cash holdings to pay part of their asset management fees.

Jeremy Welther, a principal and senior financial advisor with Brinton Eaton Wealth Advisors, Madison, N.J., says he would need to pay commissions to reinvest dividends into clients' ETFs. Reason: He puts the dividends in cash investments. Periodically, he rebalances portfolios into exchange-traded funds in industry sectors.

"I use the dividends to even out allocations," says Welther, whose firm manages $600 million in assets. "My clients understand their returns are different from reported returns. But my clients are OK with that because they understand their investment objectives."

Richard Ferri, a Troy, Mich.-based financial advisor and author of The ETF Book (Wiley), says he always keeps dividends in cash. He typically rebalances client portfolios when their stock funds decline. Plus, he uses some of the cash to cover his advisor fee.
"We don't reinvest dividends back into the funds," he says. "Yes, we are giving up a little profit. There is a little bit of cash drag. But we use it to rebalance portfolios. Our trading costs are lower and it does not affect the risk-return relationship in our portfolios in a measurable way."

Ferri, who manages $800 million, estimates he loses just a few basis points in total return by not reinvesting dividends back into his ETFs. The trade-off in performance from not automatically reinvesting dividends is equalized by rebalancing portfolios over the long term in low-cost ETFs that defer capital gains tax payments until shares are sold. In addition, ETF intraday trading allows him to rebalance portfolios at the most advantageous share price.

He cautions others, however, about investing in ETFs organized as unit investment trusts. These funds keep dividends in cash before distribution. That cash drag, coupled with parking dividends in cash, can reduce total returns even more. Funds organized as unit investment trusts include SPDRs (SPY), PowerShares QQQQ (QQQQ), Diamonds Trust (DIA) and MidCap SPDR (MDY).

By contrast, ETFs organized as 1940 Act mutual funds, which represent most ETFs, reinvest dividends before quarterly distributions.

Other money managers say dividend reinvestment is critical. Dividends count, they say, when it comes to total returns as well as expected rates of return in relation to risk, as measured by a portfolio's standard deviation or beta value.

Research by Ned Davis Research, Venice, Fla., shows that from 1926 through 2009, 44% of the annual total return on the S&P 500 was due to the reinvestment of dividends. Plus, research by Standard & Poor's, New York, shows that dividend reinvestment reduces volatility. For example, S&P 500 dividend income of 7.8% contributed 14.60% of the 53.4% total return in the last three up markets, ending in 2009. On the downside, dividend income of 5.5% accounted for 11% of the -50.2% total return in the last three down markets.

Research by Robert Arnott, chairman of Research Affiliates LLC, Newport Beach, Calif., suggests that advisors may be shortchanging clients by not reinvesting dividends. Historically, 80 basis points in the annual return on the S&P 500 was due to the real growth of dividends issued by companies after factoring in inflation.

"Taking dividends in cash means you have more cash than you may want in your portfolio, unless that money is redeployed into other assets quickly," Arnott says. "It does impact the asset allocation and takes investors away from their optimized portfolios. Secondly, we can usually find something with a better return than cash, without taking on a lot of risk.

"While people say cash is king, really, liquidity is king. And ETFs mostly give us terrific liquidity. I think reinvesting dividends makes a lot of sense, unless one has some other investment specific in mind for the cash."

Shomari Hearn, financial planner and client services manager with Palisades Hudson Financial Group in Fort Lauderdale, Fla., reinvests his ETF dividends as soon as possible. If he does not, he says, the risk-return relationship of his clients' portfolios deviates too much from the expected return.

Palisades Hudson Financial has an arrangement with Charles Schwab, so he pays no commissions on reinvestments. And the dividends are reinvested the day after they're distributed.

Burns of Morningstar adds that many financial advisors use a model that calls for a maximum 5% cash position for the year. They may start with 2% cash at the beginning of the year, and the cash balance grows because of the dividend and interest from fund distributions. Later on, the cash is put to work to bring the portfolio mix in line.

"A lot of models rebalance out of cash and transaction costs are waived," Burns says.