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.