Reinvesting ETF Dividends (Usually) Won't Cost You

Question: I am trying to decide whether to invest in a traditional mutual fund or an exchange-traded fund. If I go the ETF route, can I choose to have the dividends and other income the ETF pays out reinvested, and will I have to pay a commission each time?

Answer: Just as you can with a traditional mutual fund or some stocks, you may also be able to have dividends and income generated by ETF shares reinvested. But because ETFs are bought and sold through brokerages, the process is subject to the brokerage's rules.

The idea behind such programs is simple: Rather than pay out dividends or income payments to shareholders in the form of cash, mutual funds or publicly traded companies may allow shareholders to buy additional shares with these forms of payout (in the case of companies, these are known as DRIPs, for "dividend-reinvestment plans"). Such plans provide a convenient way for shareholders who don't need the income from their investments to acquire more shares with little effort.

However, not all ETFs or brokerages allow dividends and income to be reinvested, so you would be wise to find out ahead of time whether this is an option. When purchasing an ETF, if the brokerage doesn't ask whether you want the dividends and income reinvested, it may mean it doesn't offer the service, but you might want to investigate further.

Usually Free, but Make Sure
Fortunately, most major brokerages do offer reinvestment of ETF dividends and do not charge a commission to do so. Here again, if you're unsure whether the brokerage charges a commission to reinvest dividends, be sure to find out. You'd hate to reinvest bond income from an ETF that makes income payments monthly, as many fixed-income-focused ETFs do, only to find that you must pay a commission 12 times a year for the privilege.  

Typically dividend reinvestment occurs the day the dividend payment is received, with the dividend used to purchase as many whole ETF shares as possible and anything left over either credited to the account as a fractional share or cash, depending on the brokerage. At least one brokerage, Scottrade, allows customers to pool income and dividend distributions from all their investments and reinvest them in up to five other investments without paying a commission. For example, income payments from a bond ETF could be used to purchase shares in up to five equity ETFs. Some major brokerages also offer a variety of commission-free ETFs; this would essentially allow customers to do the same thing by having their income and dividend distributions paid out in cash, which they could then use to buy new commission-free ETF shares.

An Effective, Fee-Free Way to Add Shares
For investors who do pay commissions on ETF trades, one benefit of reinvesting dividends is that it allows them to acquire additional shares at no extra cost (provided the brokerage doesn't charge a commission for this service). Thus, over time, a one-time purchase of shares in a dividend-paying ETF with dividends reinvested could turn into a much larger amount than would taking the dividends as cash. For example, an investor who makes a one-time purchase of 50 shares of an ETF that costs $100 per share and pays a steady 5% annual dividend would end up owning 81 shares from having reinvested $3,144 in dividends during 10 years as opposed to owning 50 shares and receiving $2,500 in dividends by taking them as cash. (This example assumes no change in the ETF price or the dividend during that time.)

Another benefit of reinvesting dividends from ETFs and other securities is that doing so applies a form of dollar-cost averaging over time. Because dividends are paid out at regular intervals--typically quarterly for equity ETFs and monthly for fixed-income ETFs--shares are purchased at consistent intervals, which helps investors buy more shares when prices are low and fewer when they are high. Of course, a DRIP isn't truly dollar-cost averaging because the amount of the dividend payout may vary from period to period. But the regular timing of the dividend payment instills a form of investor discipline that is likely to be more effective than trying to time the market, for example.

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