Reinvesting the dividends you earn from your investments is an excellent way to grow your portfolio without dipping into your wallet. While mutual funds have made dividend reinvestment easy, reinvesting your dividends earned from exchange-traded funds (ETFs) can be slightly more complicated. Dividend reinvestment can be done manually by purchasing additional shares with the cash received from dividend payments or automatically if the ETF allows.
Automatic dividend reinvestment programs are not yet available on all ETFs. In addition, the longer settlement time required by ETFs and their market-based trading can make manual dividend reinvestment inefficient.
Dividend Reinvestment Plans
An automatic dividend reinvestment plan (DRIP) is simply a program offered by a mutual fund, ETF or brokerage firm that allows investors to have their dividends automatically used to purchase additional shares of the issuing security. This practice is widely used in mutual fund investments, but it is relatively new to ETFs.
Though DRIPs offer greater convenience and a handy way to grow your investments effortlessly, they can present some issues for ETF shareholders because of the variability in different programs. For example, some brokerage firms allow automatic dividend reinvestment but only allow the purchase of full shares. Any amount left over is deposited as cash into the investor's brokerage account, which may be easily forgotten. Other firms pool dividends and only reinvest dividends monthly or quarterly.
Some reinvest dividends at market opening on the payable date, while others wait until the cash is actually deposited, which is typically later in the day. Because ETFs trade like stocks and their market prices can fluctuate throughout the day, a reinvestment executed at 7 a.m. may buy a different number of shares than a trade executed at 10 a.m. This is one of the drawbacks of automatic ETF dividend reinvestment; the investor loses control of the trade and cannot "time" the market to his advantage.
If your brokerage firm does not provide a DRIP option, or if the ETFs you are invested in do not allow for automatic reinvestment, you can still reinvest dividends manually. Basically, manual reinvestment means taking the cash earned from a dividend payment and executing an additional trade to buy more shares of the ETF. Depending on where you hold your investment account, you may incur a commission charge for these trades just like you would with any other trades. However, some brokerage firms allow for commission-free dividend reinvestments.
Manual dividend reinvestment, while less convenient than a DRIP, provides the investor with greater control. Rather than simply paying market price for new shares on the payment date, you can elect to wait if you feel the share price may drop. It also offers the option of holding your dividends in cash if you feel the ETF is underperforming and you want to invest elsewhere.
If you elect to manually reinvest your ETF dividends, be aware of the effect of settlement delays on the buying power of your dividends. Because ETFs, unlike mutual funds, rely on brokerages to keep track of their shareholders, dividend payments typically take longer to settle. Rather than the one-day settlement period of most mutual funds, ETF payments can take three days or more to settle. If your ETF is doing well, the additional wait time can mean you end up paying more per share.
Reinvesting your ETF dividends is one of the easiest ways to grow your portfolio, but the structure and trading practices of ETFs means reinvesting may not be as simple as reinvesting mutual fund dividends. Consult your brokerage firm to see which of your ETFs is eligible for a DRIP and how the brokerage handles those trades. If you must manually reinvest, keep track of settlement periods to ensure you do not time your reinvestment poorly. Setting a market order for the moment your dividend is deposited may not get you the best price per share, so use manual reinvestment to your advantage by actively managing your trades.