One of the most important considerations when it comes to your investments is cost. If you have to pay to reinvest the dividends of your exchange-traded bond fund, that cost lowers your investment performance. Every dollar of commission or fees you pay to buy, sell or maintain your fund comes directly out of your investment return. If the cost is too high, it might turn an otherwise good investment into a bad one.
An exchange-traded fund is a mutual fund that, as the name suggests, trades on an exchange. This is the main difference between an ETF and a more traditional mutual fund. Another important distinction is that traditional mutual funds are typically actively managed, meaning professional investors make constant buy and sell decisions regarding the securities in a portfolio. Exchange-traded funds are typically passive investments, designed to track a particular market index, such as the S&P 500 stock index. With a bond ETF, the investment objective is usually to mirror the performance of a specific type of bond index, such as one that tracks long-term Treasury bonds or short-term corporate bonds.
In general, bond ETFs generate most of their return from income. When bonds owned by the fund pay interest, the fund passes that income along to investors. For most funds, interest is paid out monthly. As an investor, you can choose to either take a cash payment or reinvest that interest into additional shares of the fund. Typically, you can reinvest your bond interest in an ETF without paying a commission. In rare cases, a financial services firm may charge you a fee to process your reinvestment, but the funds themselves usually charge no commission.
Through reinvestment, you can benefit from the "magic" of compound interest. As soon as you reinvest a payment, you begin earning interest on the reinvested amount as well. For example, if you own a fund that pays 10 percent in interest per year, you'll earn $10 for every $100 you have invested in the fund. If you reinvest, you'll have $110 in the fund after the first year. In year two, you'll earn 10 percent on the entire $110, generating $11 in interest. Over time, the effects of dividend reinvestment can be dramatic. However, if you have to pay commission on your reinvested interest, you'll end up earning significantly less.
Even if you reinvest your bond ETF interest, you'll still owe taxes on the amount you're paid. If you're in a tax-advantaged account, such as a traditional individual retirement account, you can defer these taxes. However, in a regular investment account, you'll owe the tax whether you reinvest or not. When it comes time to sell your fund, tracking your gain and loss can be difficult. With every reinvestment, you'll be purchasing additional shares in the ETF, at various costs. When you sell the fund, you'll have to match up the sales price with these varying purchases. Most financial services firms can help you track reinvested interest.
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