ETF vs Mutual Fund question - my options are limited

[pedz]

Because of the nature of the business of my employee I am required to hold my broker account with them, so I cannot shop for the cheapest option. They charge .05 per share on trades, which is not bad but not as good as some of the low flat rates out there.
I am looking to switch to index investing and trying to choose between ETFs and funds. Even with the purchase commission etf's look cheaper (most of the cost comes from the fees).

My question is about dividend/cap gains reinvestment. For funds it is automatic, but for etf's it is not, and because I cannot choose my broker I cannot use one of the brokers that offer DRIPs. Question is, how much difference does that make? If I let the distributions accumulate in my account during the year and reinvest them as part of my annual rebalance will that make a big difference in performance? Would that give the edge to funds (in general, obviously it is a case by case basis). Guess I could do it quarterly if it would make a difference, but that would be a pain. And given these are indexes I wouldn't expect as many distributions (maybe dividends though). Just trying to understand if the quoted returns of funds vs etf's are as advertised regardless of reinvesting and if it makes a big enough difference for me to consider.

Sorry for the long post, appreciate any help anyone can give.

Thanks,
peter

[jIM_Ohio]

My question is about dividend/cap gains reinvestment. For funds it is automatic, but for etf's it is not, and because I cannot choose my broker I cannot use one of the brokers that offer DRIPs. Question is, how much difference does that make?

How long will money be invested? The longer it is invested, the more this makes a difference.

For example, if you were to tell me you might hold the job for 5-10 years, go ETFs. If you think you will have this job with these investments for 30-40 years, look at costs of dividend reinvestment on the etfs more closely.

As you pointed out, if you choose an index like wilshire 5000, the distributions- both in capital gains and dividends, will be low.

If you choose value indexes, or small indexes (like something with 100 stocks and high turnover) then distributions will be higher.

A strategy to consider is keeping a 25%-50% cash allocation, then strategically moving money into stocks 1-2X per year (so at some points of year you might be 50% stocks and 50% cash, at other points 75% stocks and 25% cash... directing all dividends to the cash allocation, then moving all that money in based on market (and not based on time of year).

The fees will be "the same", but it makes it easier to manage.

Another thing to look into is if you pay the trading fee with after tax money, I believe you can claim a tax deduction on it (if money came from inside a 401k or IRA, you cannot claim a deduction on money which has not been taxed yet).

Check me on the tax issue, but I know there is a question on turbo tax for similar issues (fees paid for investment advice and investments).

[pedz]

Thanks for the reply, appreciate it.

Will have these for 15 years or more most likely.

Why does the length of the overall investment factor in? If I reinvest the distributions at the end of the year then I would think the impact is the difference in time between when the mutual fund would reinvest and when I would. Not sure how funds do it, is it immediate, monthly, quarterly? But I assume it would average about 6 months assuming distributions are even over the year. Just not sure if that extra 6 months of investment time each year will make a material difference (since this only applies to the distributions, i will invest new money once a year).

As you suggest I am leaning towards ETFs but am still unclear on this? Wish there was a way to see what your accumulated value would be with all the usual parameters (starting amount, fees, return, ...) but also factoring in frequency of reinvestment.

Thanks again,
Peter

[frugalnoggin]

I'm not sure how much money you're talking about in dividends etc. here, so clearly YMMV. However, one thing to include in your thoughts might be the hassle of tracking your basis with many small purchases vs holding the dividend payouts in an interest bearing account for the year and balancing your portfolio annually.

[pedz]

Thanks for the reply, really appreciate it. This is a great forum, wish I had found it sooner.

Fair point on the overhead of multiple buys a year. I am definitely leaning towards just rebalancing once a year and reinvesting distributions at that point. That should keep the accounting pretty straightforward.

As far as basis goes, I assume that if i capture the transactions in quicken correctly i should be able to derive my basis. Is it easier with mutual funds?

Thanks,
Peter

[jIM_Ohio]

Thanks for the reply, appreciate it.

Will have these for 15 years or more most likely.

Why does the length of the overall investment factor in? If I reinvest the distributions at the end of the year then I would think the impact is the difference in time between when the mutual fund would reinvest and when I would. Not sure how funds do it, is it immediate, monthly, quarterly? But I assume it would average about 6 months assuming distributions are even over the year. Just not sure if that extra 6 months of investment time each year will make a material difference (since this only applies to the distributions, i will invest new money once a year).

As you suggest I am leaning towards ETFs but am still unclear on this? Wish there was a way to see what your accumulated value would be with all the usual parameters (starting amount, fees, return, ...) but also factoring in frequency of reinvestment.

Thanks again,
Peter

A simple example

fund A sells shares for $10/share

You buy 10 shares ($100).
The fund pays a dividend of $1

so you have 10 shares worth $9 each ($90) with $10 cash
and buy 1.11 shares for $9 each you give you

11.11 shares and $100 again

if dividends are reinvested automatically you have to look at 2 issues

1) fractional shares- if you had a money market, you would have bought 1 share for $9 and left $1 in the money market. Had you reinvested money immediately you would own fractional shares. Over time these fractions would compound. You lose that if you put dividends to money markets.

2) If you paying for the dividend reinvestment, most funds pay dividends quarterly. Yearly is the least frequent they could do it. If you pay $.05 for that 1 share you bought, not a big deal... this time... each time dividends are reinvested the cost will go up (because you will have more cash each time), so its possible at some point in 20-30 years you have dividends buying more shares than your deposits... meaning you can save yourself transaction fees in this situation if dividends are reinvested for free.

**in general, its probably better for investors to use funds if they buy and hold with small or moderate amounts of money. Brokerages (to me) are for stock owners or traders. People using brokerages will have higher costs of their transactions, and their transactions (to me, generally) will have higher dollar amounts on them than any transaction I ever make outside of a rollover.

[pedz]

Thanks again, this was very helpful, it is much clearer now (the potential impact).

With that I think I am still leaning towards ETFs. There is a broader selection and a few of the areas I would like to include are only available in ETF form. While the lack of immediate reinvestment will have an impact I don't think it will be so significant as to make it not worth doing (otherwise why would anyone choose the ETF option over a fund if both are available). In your example it was a 10% divident, which is not typical, and given I will reinvest by year end I don't see the impact being material enough to push me to change my choices to those available in funds.

Any other thoughts appreciated, and again, thank you very much for your taking the time to reply and give me your advice.
Peter