Q: I’m planning to use my 2013 TFSA room to purchase a bond ETF. How can I make sure I’m investing enough to benefit from a dividend reinvestment plan? – Phil B.
Dividend reinvestment plans (DRIPs) are a convenient way to make sure your money is compounding every month rather than sitting idly in your account. When you sign up for a DRIP, your distributions (whether dividends, interest or return of capital) are paid in new shares rather than in cash. Discount brokerages typically offer DRIPs for just about all Canadian ETFs, and you can arrange them with a simple phone call or email to the customer service desk.
The potential problem with DRIPs, however, is you can’t receive fractional shares: each distribution must be large enough to purchase one full ETF share, or it will just be paid in cash. Now that more ETFs are paying distributions monthly (as opposed to quarterly, which used to be the norm), each payout is small and you need a fairly significant holding before you’ll receive even a single new share with every distribution. But exactly how much do you need?
It’s not possible to calculate this amount precisely, but you can make a good estimate by following these four steps:
1. Visit the website of the ETF you’re considering and look up its distributions over the last 12 months. Some bond ETFs pay consistent distributions, while others vary them, but just add them together and divide by 12 to get the average monthly distribution.
2. Now get the current share price of the ETF. It’s probably more useful to figure out the average share price over the last year, which you can estimate using the 52-week high and low, also available on the fund’s web page. But bond ETFs are not particularly volatile, so the current price is close enough for our estimate. (It would be less useful with equity ETFs, however, whose prices are subject to greater swings.)
3. Once you have these numbers, simply divide the share price by the average distribution to get the approximate number of shares you’ll need in order to receive one full share each month with a DRIP.
4. Finally, multiply the minimum number of shares by the ETF’s current price to calculate the minimum amount you will need to invest in order to take advantage of a DRIP.
A couple of examples
Let’s look at two popular bond ETFs to see how these calculations work in practice. Below are the details for the Vanguard Canadian Aggregate Bond (VAB) and the iShares DEX Universe Bond (XBB). The monthly distributions for VAB and XBB are available on the fund’s respective web pages. A spreadsheet will do the rest:
|1. Average monthly distribution||$0.06461||$0.08591|
|2. Current share price||$25.47||$31.40|
|3. Minimum shares for DRIP||395||366|
|4. Minimum $ for DRIP||$10,060.65||$11,476.77|
Of course, these numbers are not precise, and it would be wise to tack on another 10 or 20 shares to be safe. But it’s clear from our back-of-the-envelope calculation that one year’s TFSA contribution ($5,500) is only about half what’s needed to make a DRIP useful with either of these bond ETFs. You’d need between $10,000 and $12,000 before your ETF holding will generate enough in distributions to buy one full share each month.
While income-oriented equity ETFs—such as those holding dividend stocks and REITs—also pay monthly distributions, many broad-market equity funds pay dividends every quarter. These less frequent payouts mean a DRIP will be useful on much smaller amounts, since each distribution is three times larger. But in all cases, before you’re tempted by the potential benefits of DRIPs, make sure you run the numbers.
Qtrade has informed us we must sign a DRIP authorization form for each ETF each time the ETF is purchased. With TD once the DRIP is in place no further authorizations are required. Has anyone else received these instructions from Qtrade or is the Qtrade CSR misinformed?
I have a Qtrade account, and I’ve had a DRIP in place with one of my ETFs for several months. I only had to sign one form to authorize setting up the DRIP, and nothing since then. Is it possible that there’s been some miscommunication?
I can see them saying that if you buy a *new* ETF, one that you haven’t owned before, then you need to sign a form to authorize a DRIP for that fund, if the fund offers it and you want it.
@CCP: this question is only obliquely related to the DRIP question. One way around the problem of not having enough shares in your TFSA is to reduce the number of asset categories to increase the room for having the required number of shares to be profitable for DRIPing. For instance, instead of having 1/3 each of Canadian/US/International Ex-US Equity, you can change your “mix” to a single category of Global Equity. This will likely keep the Canadian portion down to 5% or so, but otherwise your situation is similar to the prior scenario, isn’t that correct? I have often wondered, you can still periodically rebalance your portfolio to maintain the Equity:Bond ratio that you have previously decided upon, but you lose the ability to rebalance across the Canada:US:Rest of the World ratios — but on further thought, I wonder if I am missing something — does the fact of the fund tracking the index automatically keep those ratios in the original range? If this is so, then my perception that this is a disadvantage fully disappears.
@Oldie: A global equity fund typically weights each country according to its market cap, so you do lose a little of the “rebalancing bonus.” For example, you might decide to hold equal amounts of US and international stocks and rebalance these whenever they diverge from this 50-50 target mix. A global equity fund live Vanguard’s VT has a similar mix today, with about 45% in US equities and 55% in the rest of the world, but that’s just a coincidence. It reflects the current market cap of these countries. If the US were have a very bad year and the rest of the world’s stocks went up, the fund would not rebalance back to 45%/55%.
Is it possible for you to do a year-end comparison of a few key index funds to the indexes they’re supposed to be tracking? I was just looking at TDB900, and unless I’m doing something completely wrong in my calculations, when I include distributions, I got a 7.24% return in 2012, while the TSX only gained 4.00%. I’m not going to complain about better returns, but doesn’t this create a risk that the fund could be this much below the index in a given year?
@CCP: OK, thanks, I see now. But how much of a disadvantage is it, not being able to rebalance between your Canada(ok, it’s only 5%)/US/Rest of the World Ratios? I suppose the answer has something to do with historically, how out of sync to the Canada/US/Rest of the World economies get, or in practical terms, how much range of drift actually occurs in the US/Rest of World Cap Ratio? My guess is that it results in only a minor disadvantage, compared with the ability to rebalance between your Bond and Total Equity Categories. (I am going to rejig my TFSA portfolio with all Couch Potato Index funds when I inject the 2013 contribution allowance, so the question has some immediate relevance!)
@Oldie: I would consider the 5% allocation to Canadian stocks to be trivial. (There is a small allocation to Canada in VXUS, which I ignore in my Complete Couch Potato.) A better solution might be to hold 1/3 of one’s equity allocation in a Canadian equity ETF and 2/3 in a global fund.
@Ian: You must have made an error somewhere. Perhaps you are including your contributions as part of your return? The performance of index funds is always available on their web pages, updated monthly:
A way a person could avoid this problem ( getting a whole share through a DRIP) all together is to purchase shares in a company and have the shares made out in your own name. Then set up a DRIP directly with the company and DRIP through their program ( if the company offers a DRIP). The company’s allow for fractions of shares to be bought if its done through their program and not a broker. Some even offer a 5% discount on the DRIP.
Some Canadian company’s also offer a Share Purchase Plan (SPP or OCP, same thing) so you can buy more shares directly through them – for free – and avoid the cost of buying shares all together.
@Dave: This is true, but it only applies to people who are interested in buying individual stocks. I’m concerned that it would be difficult, if not impossible, to a build a diversified portfolio using direct-purchase plans like this. In a taxable account, I imagine the chore of calculating your adjusted cost base would awfully time-consuming as well.
Dan, again, your timing is impeccable. I was looking at deciding between VAB or XBB for my bond holding. I’m just wondering why your monthly distribution for VAB is different from the website http://www.tmx.com (or from my td waterhouse account for that matter). TMX shows VAB to have a yield of 2.2%, whereas from your calculation, the yield is 3%. I was going to go with XBB because of the higher yield, but from your numbers, it looks like the yields are similar, VAB 3% XBB 3.2%
Your calculation is correct. TDB900 fund gives you the TSX total return (including dividends).
2012 TSX without dividends was around 4%
@Jungle: Thanks, that’s probably the explanation. Certainly a 300 bps tracking error is not going to happen with an index fund like TDB900. Interestingly, I have seen a number of investment firms benchmark their performance (including dividends) against price-only indexes, which as this reminds us, is extremely misleading.
@donj: An ETF’s yield is not fixed: it depends on the most recent distributions and the current market price, both of which can change. It looks like VAB’s distributions in 2012 changed quite a bit from month to month, so the figures will be different depending on exactly when the yield was calculated. For this reason, I would never choose one fund over a similar one another based on yield.
Note that one would expect VAB’s yield to be a bit higher simply because it is 10 bps cheaper than XBB, and fees are typically subtracted from distributions.
Thanks for the explanation. Would you recommend VAB now, or is still not liquid enough?
@Donj: I’m pretty agnostic on VAB vs. XBB. I have noticed VAB trading with fairly high bid-ask spreads, but as I’ve discussed elsewhere on the blog, that should not be a significant issue. Just make sure you use limit orders when you trade to avoid any surprises.
Thanks, Jungle! I was pretty sure I’d done my calculations correctly, but I forgot all about the dividends on the TSX stocks themselves. Which is clearly why it’s a good thing I’m doing index investing, as I’d screw everything up otherwise.
I just received DRIP from XDV ETF I hold. It is end of the year DRIP and amounts to almost 3%. Sounds very good, but actually my XDV stock is in my TFSA account. So really money were not deposited, but rather my adjusted cost base was increased. But for TFSA account adjusted cost base is not really tracked. So did I loose my DRIP amount forever? If so, what other canadian dividend ETF would you recommend for TFSA/RRSP?
@Vidas: I think it’s safe to say you did not lose anything: best to call your brokerage and ask them to explain what happened.