"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.