The truth about reinvesting distributions - it doesn't always pay
Simply reinvesting distributions to benefit from compounding may not be the best strategy
Sixteen years ago when I invested $10,000 in an Australian small companies fund, I was asked if I wanted to have the dividends and capital gains sent to me or have them reinvested in more units in the fund.
I had bought into the fund as a long-term investment so I opted for reinvestment. I believed this would be the most fruitful way to make my money snowball.
But when the fund was wound up recently, I wondered what would have happened if, instead of reinvesting the distributions in this fund, I had taken them as cash and then invested them in the sharemarket, for example, via an index-tracking exchange traded fund.
My strategy of reinvesting in the fund by acquiring more units left me with a final redemption of $31,557. But if I had invested the distributions outside the fund, I would have been left with $34,865 based on the S&P/ASX 200. In other words, I would have been around 10% better off by taking my distributions as cash and then buying an index ETF.
This is hypothetical because small investments in ETFs aren't practical on a continuing basis and I may not have had the discipline and energy to directly manage the investment of distributions.
But it does raise broader questions about the wisdom of casually reinvesting distributions. Does it sometimes pay to take your fund manager's capital gains and dividends out instead of rolling them back into the fund?
What I discovered was that my Australian small companies fund was more high risk than I had thought. It was very actively managed, with high turnover of assets. Some managed funds have a less risky strategy - for example, an indexed share fund spread across the top 200 Australian companies.
While I was hanging onto the good returns of the early years, this didn't mean it would continue to perform well.
My small companies fund had a revolving door of investment managers, too. It started out as a Portfolio Partners fund and when it closed down it was run by a descendant, Antares.
"You do need to review your investments," says Michael Hutton, head of wealth management at HLB Mann Judd. "We use managed funds quite a bit. It's not a set-and-forget strategy - you do need to be across the portfolio."
Does he recommend reinvesting?
"Broadly speaking it is good to get the cash," he says. "It gives you the opportunity to rebalance the portfolio regularly."
For pensioners who need income from their investments and have low tax rates, taking out the distributions certainly makes sense.
But I was in the accumulation phase, acquiring wealth for my long retirement years. Hutton says if investors are accumulating their investments, there are advantages to reinvesting, such as:
- The investing happens automatically and you don't have to actively invest. - There are no entry fees for the reinvested amounts. - You are buying additional shares at various prices in what is called dollar cost averaging. You can average out the price per unit over the long term. - You are compounding your investment's growth by adding more shares that will earn dividends of their own over time.
"If you take out the cash, you need to use it to build up your investments or else it may be spent," says Hutton. "You need to keep your wealth ticking upwards."
If you don't want to add more money to your investment, one of the best ways to make sure you keep your dividends specifically for reinvestments is to put them in a separate account so that when the dividends have built up you can use that money to rebalance your portfolio back to your target allocation at a later date.