Exchange traded funds, also known as ETFs, often specialize in the type of stocks they own, and one of these specialties is dividend stocks. When an ETF owns stocks that pay dividends, it passes them on to shareholders.
If you own such an ETF, you will receive cash as it pays dividends. However, you can forgo the cash payments and elect to use the dividends to buy more shares of the ETF. Even in this case, the fund doesn't pay you in shares – it still pays out cash. Your broker will then in turn buy the new shares for you.
ETF dividend payments are in the form of cash. However, you can take this cash and reinvest in new shares.
Receiving Cash Payments
Most ETFs pay dividends quarterly. The fund simply holds all of the dividends paid by companies during the quarter and then pays them to shareholders on a set date. However, some ETFs pay dividends as soon as they are collected from the company. If you own an ETF that holds dividend stocks, you will receive cash dividend payments if you do not tell your broker otherwise.
Acquiring New Shares
You can ask to have your dividends automatically reinvested in the ETF you own. Your broker will place an order on the day the dividends arrive, and you will purchase shares of the ETF at the current market price. It is important to keep in mind that you cannot buy partial shares, so you may have some cash left over in your brokerage account.
Ask About Commissions
If you elect to have your dividends reinvested, ask whether or not your broker charges a commission on your reinvestment purchases. Many brokers, especially online brokers, offer reinvestment of dividends with no commission.
Because you likely will be buying small quantities of shares each quarter, you could be subject to a minimum commission charge with a broker, and this commission fee could eat away at your profits. So, to be sure you completely understand all the associated fees, clarify whether your broker offers commission-free reinvestment of dividends before you choose this option.
How Compounding Works
As you buy more shares with your dividends, the more dividends you earn. This is because you receive a dividend per share, and the more shares you own the more dividends you receive. You can buy a higher number of shares with the higher dividends, and these additional shares result in an even higher dividends. This is known as compounding, and the power of steady compounding can build your position in an ETF gradually and automatically with little effort on your part.
Rebalancing Your Portfolio
You should check the value of your ETF periodically to see if you have too much of your portfolio in one investment. If you're in the habit of practicing ETF dividend reinvestment, your holdings may be larger than you thought. You can rebalance your portfolio by selling some of the ETF shares and buying another type of investment.
When you diversify or rebalance your investment portfolio, you are more capable of weathering those rocky moments when markets take a downturn or certain investments under-perform.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.