Fund distributions are nice, especially when markets are down.
But it can be frustrating to reinvest fund distributions, especially when you have to pay a commission fee to buy new ETF shares.
Maybe you solve this by letting distributions pile up and reinvesting them in a bulk transaction.
Automatic distribution reinvestment solves these problems by reinvesting the distribution back into the ETF that paid the distribution at zero cost.
I’ll answer specific questions about distribution reinvestment with Canadian Index ETFs in this post.
What is a Fund Distribution
An index Exchange Trade Fund holds a collection of stocks or bonds.
For a stock fund, the underlying stocks pay dividends (a core source of stock returns). The fund then collects these dividends. Finally, the dividends are distributed to you as cash.
Distributions from bond funds work similarly. The difference is that the bond fund distribution consists of interest from the underlying bonds.
Then there are asset allocation ETFs. These guys hold underlying stock and bond index funds.
Distributions from asset allocation ETFs contain a mix of dividend and interest income.
You can learn more about index funds in these posts, including the evidence in support of an index investing approach:
Can ETFs Reinvest Distributions?
You can turn on automatic reinvestment of fund distributions for most index ETFs in Canada if your brokerage supports distribution reinvestment.
The leading ETF providers allow automatic reinvestment of fund distributions.
Here are the pages from Blackrock, Vanguard, and BMO on their Distribution Reinvestment Programs:
All you need to do is call your brokerage and ask to set up DRIP on the specific ETFs.
What Is A Distribution Reinvestment Plan?
As you noticed, the plans above are labeled “DRIP.” I’m not talking about water. Nor am I talking about swag.
Here, DRIP stands for Distribution Re-Investment Plan. There are two types of DRIP – traditional and synthetic.
Under traditional DRIP, the ETF provider issues ETF fund shares in place of the cash distribution. This essentially bypasses your brokerage.
Another version of DRIP is called “synthetic DRIP”. This version is handled directly by your brokerage.
Synthetic DRIP doesn’t involve the underlying ETF provider. Instead, your brokerage buys new shares with cash distribution in the same ETF for free.
Both traditional and synthetic DRIP have the same effect, and I’m unsure what DRIP mechanism is used for Canadian ETFs.
An Example of DRIP With an ETF
Here is an example of DRIP applied to VCN at the brokerage RBC Direct Investing.
VCN is a total market ETF that tracks the S&P/TSX Composite Index by holding ~180 of the ~240 stocks listed on the index.
In this case, you can see that $243 was received in fund distributions. The next line shows that six shares of VCN were automatically repurchased at $38.44 per share.
The total for six shares is $230.58. Since only whole shares can be purchased, the remaining amount ($12.55) stays in the account as cash.
The six shares will then pay their own distributions in four months. Compounding in action.
Does DRIP Work In The TFSA, RRSP and Taxable Accounts?
You can turn on DRIP in the TFSA, RRSP, and taxable accounts. I apply DRIP to ETFs held in all three accounts.
DRIP and Taxes
Using DRIP does not save you from taxes on the distributions. The fund distributions are taxable, even when immediately reinvested with DRIP.
This is irrelevant to ETFs held in a TFSA or RRSP (except for foreign withholding tax). But it is relevant for ETFs in a taxable account. Such an occurrence often happens when the TFSA is maxed.
The exact breakdown of your ETF distributions will be captured on the T3 issued by the ETF provider at the end of the year. The T3 will break down the distributions into:
- Interest
- Dividends
- Capital gains.
You can learn more about how investment income is taxed in this ultimate guide.
How To Enable DRIP With Your Brokerage
All it took was a quick message, and RBC Direct Investing recently enabled DRIP for all ETFs in my TFSA.
After some quick research, I found that Wealth Simple does not support DRIP (source).
But you can manually reinvest distributions for free since Wealth Simple Trade is a zero-commission brokerage.
Most other brokerages support DRIP:
- RBC Direct Investing supports DRIP. Here is a list of RBC DRIP-eligible securities.
- BMO Investor Line supports DRIP for most index ETFs. Here is BMO’s list of DRIP Eligible Securities.
- Scotia Bank I-Trade supports DRIP (source).
- Quest Trade supports DRIP. Learn more at their website.
I’ve covered only a few of the brokerages. You have to do your own research to see if your specific brokerage permits DRIP.
DIRP With Asset Allocation ETFs: Very Simple
Asset allocation ETFs are a “portfolio in a box”. These ETFs hold underlying total market stock and bond index ETFs.
Asset allocation ETFs re-balance to maintain your target mix of stocks and bonds. They also maintain a target geographic distribution of stocks and bonds.
You can probably see why I view asset allocation ETFs as the pinnacle of simple investing.
The leading providers of these ETFs (Vanguard, BMO, and iShares) permit DRIP. Therefore, you can enable DRIP on asset allocation ETFs as long as your brokerage supports it.
An asset allocation ETF with DRIP enabled is entirely hands-off. No more rebalancing and no more dividend reinvestment.
But changes are only required when your risk tolerance changes.
Simple Investing = Good Investing
Simplicity has many benefits to building wealth.
First, it allows your wealth to compound in the background while you focus on the things that improve well-being, like fitness, relationships, and the pursuit of meaning.
Second, simplicity helps keep your emotions out of your portfolio, protecting yourself from yourself.
The Canadian Portfolio Manager blog post is an excellent resource for learning more about asset allocation ETFs.
The Effect Of DRIP On Long-Run Returns
Using DRIP to reinvest distributions immediately can maximize your time in the market.
You may be wondering, how does this impact long-run returns?
We can consider a reference situation where you let the distributions pile up for a year. Then you invest them all at year’s end. I’ll call this scenario 1.
Scenario 2 is when you use DRIP to reinvest the distributions every quarter, or four times per year.
When we look at the S&P TSX Composite Index fund XIC, DRIP will save you 0.2% annually versus scenario 1. For more details on this comparison, check out this this post.
DRIP won’t increase your returns a ton, but it isn’t useless. The effect of DRIP increases as the distribution yield increases.
Conclusion
Automatic dividend reinvestment can be applied to index ETFs if DRIP is supported by your brokerage and the ETF provider.
The big three index ETF providers in Canada support DRIP for their ETFs, therefore the limitation is your brokerage.
Hopefully that helps you automate and simplify part of your investing system so you can focus your time/energy on the things that bring wellbeing.
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Jake out.
