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Fund Spotlight Series: Low Priced, Diversified ETFs for Dividend Reinvestment

In a recent article on Scottrade’s new Flexible Dividend Reinvestment Program (FRIP) – found here  – we talked about how important security selection is in order to reap the benefits of a dividend reinvestment program, particularly for new investors. Today, we highlight some funds that will help new investors make the most out of dividend reinvestment programs.

In our review of Scottrade’s new program, we gave a simple example:

 

“Consider a new investor who just opened a Roth IRA with $5,000. They invest that $5,000 into an S&P 500 index fund, like SPDR’s S&P 500 fund (ticker: SPY) and want to reinvest the dividends.

SPY is currently about $165 a share and currently pays out a quarterly dividend of $0.69 per share each quarter. $5,000 would buy 30 shares of SPY today, so the investor can expect a dividend of about $21 per quarter, or $84 per year, which means that they would not be able to buy an additional share of SPY for 2 years!”

 

 

Now, SPY is a great, diversified, low cost (in terms of the expense ratio) index fund. Reinvesting the dividends from an S&P 500 index fund would have boosted your returns substantially over the past few decades:

 

S&P 500 with dividends reinvested

 

Above, the orange lines represents the S&P 500 Total Return Index, which is calculated assuming reinvested dividends from the S&P 500 index. As you can see, by reinvesting dividends your returns are significantly higher and the effects only compound more over time!

 

But there is a problem for a new investor who wants to reinvest their dividends into a fund like SPY. It would take too long to build up enough dividends in order to be able to buy a share. This makes dividend reinvestment in Scottrade’s program nearly useless for new investors if you pick funds with a high share price. Your dividends would just sit in cash in your account, earning nothing.

 

So, I wanted to find some ETFs that are broadly diversified across the whole market AND have a low share price to make dividend reinvestment possible for new investors.

 

There are thousands of ETFs, and hundreds that have a low share price, but it seems that 99% of those with a low share price are in a very niche part of the market. Asian small caps, Norwegian mining companies, etc etc. I wanted to find fund that I would be happy reinvesting dividends into for decades to come. For me, this means broadly diversified in U.S. or worldwide equities. If you are looking to invest in small parts of the world wide economy, there is probably an ETF for you out there, but you will not find it featured here on Begin To Invest. For 99% of investors, I believe they need to stick to the basics, and just invest wisely for the long term. This is most easily accomplished with these types of funds.

 

Here is my train of thought:

 

A new investor, you just opened up your Roth IRA, and funded it with $5,000. You want to take advantage of dividend reinvestment (you can see from the chart above that it is worth it!). Assume that $5,000 is earning a yield of about 2% (The current yield on the S&P 500). This means that you are receiving about $25 per quarter in dividend payments.

 

A fund like SPY (~$165 a share) would take you about 2 years worth of dividends to buy 1 share!

Vanguard has an S&P 500 index fund (Ticker: VOO) that is currently $75 a share. This would mean every 3 quarters you would be able to buy 1 share. Better than using SPY, but still not taking the full advantage of dividend reinvestment.

 

Is there a passively managed, low cost (under 0.5% expense ratio), broadly diversified ETF that has a share price around $25 with greater than $100 million in assets, so that a new investor could take full advantage of dividend reinvestment?

To find out I used a simple ETF screener, like the one at ETF Database (Etfdb.com) found here: http://etfdb.com/screener/

 

How many funds do you guess would be out there?

 

I found only 1:

 

 

SPHQ – PowerShares S&P 500 High Quality Portfolio

  • Share Price of ~$18.00 a share
  • Dividend yield of 2%
  • Holds 150 securities, based on the S&P 500 high quality rankings index.
  • Expense ratio of 0.29%*

* – Note: Expense ratio is capped at 0.29% until August 2013. Keep an eye out of expense ratio increases after that.

Fund Prospectus is found here: http://www.invescopowershares.com/pdf/P-PS-PRO-4.pdf

Fund website is found here: http://www.invescopowershares.com/products/overview.aspx?ticker=sphq

 

 

This fund tracks an index that follows stocks rated A- or better by Standard and Poors based on their history of earnings and dividends.

The performance of this fund over the past 5 years:

SPHQ vs S&P 500

 

The fund limits your diversification compared to a simple S&P 500 index fund, however until your account generates enough dividends, this fund can keep your money in the market in a suitable ETF.

 

This fund should keep you invested in high quality names, give you a decent yield and good growth until your portfolio becomes large enough to generate enough dividends to invest in the larger funds, whose share prices range from $80 to $170. (See our Fund Spotlight Series on S&P 500 index funds here: )

 

Is this fund the perfect investment? Of course not. But half of the battle is getting investors started in the right direction. A new investor can get started with a Roth IRA in a simple S&P 500 index fund, and get started investing the dividends right away. I think it is important to:

1)      Start the habit of investing dividends early (see chart above if you disagree) and,

2)       Get the most out of your money. Not keeping it in cash earning nothing. Even small amounts compounded over time really add up. This fund will let new investors get going faster and really add up over the long term.

 

Years down the road, when your account is much larger, you can think about switching into a more traditional index ETF. See our Fund Spotlight Series  for more investing ideas.

 

 

 

It turns out, there are not many broadly diversified ETFs with share prices under $25. Who knew? Below is one runner up, with a share price slightly above $25, but still less than the $60+ per share most ETFs are at.

 

 

SCHF – Charles Schwab International Equity ETF Profile

  • Share Price of ~$28.00 a share
  • Dividend yield of 2.15%
  • Holds over 1,100 different stocks, in over 20 countries.
  • Expense ratio of only 0.09%!

Fund prospectus found here: https://www.schwabetfs.com/reports.asp

Fund homepage found here: https://www.schwabetfs.com/summary.asp?symbol=SCHF

 

At $28 per share, an investor with $5600 invested in an S&P 500 index fund yielding 2%, paying dividends quarterly, would be able to buy 1 share of SCHF each quarter.

 

This fund is a great international equity ETF. Broadly diversified, very low expense ratio and decent yield.

Of the 1,100 holdings you have heard of many of the top companies in this fund. BP, Samsung, Shell, Toyota, Vodafone, HSBC bank, etc. You are invested in some very good companies in this fund.

A well diversified international equities fund is a very good “core” holding in your portfolio and will serve you well for years to come. This fund serves as an alternative to investors who may be looking to add international equities in their portfolio instead of U.S. equities.

 

 

In Conclusion

 

I didn’t start this article out hoping to only feature 2 funds. It was a big surprise you me that there are so few broadly diversified ETFs under $25 per share.

Investors choose to reinvest dividends because of the increased compounding effect it generates. Over time, the results are staggering (see the first chart in this post). For new investors that want to get started, unfortunately, we just found out there are not many options.

 

 

For that reason I believe this article also helps new investors choose a broker if they haven’t already. As I said in my initial review of Scottrade’s new “Flexible Dividend Program”:

“In the end, it is a valiant attempt by Scottrade to get back in the game, but I just don’t see it as a game changer in the industry….

Since the program is nearly useless for new investors, I stick with my recommendation of new investors using a brokerage like Fidelity, Vanguard, Charles Schwab or even TD Ameritrade because of the wide selection of commission free ETFs and Mutual Funds.”
With one of the brokers mentioned above that offer commission free ETFs (See a list of each broker’s commission free ETFs here) investors will be able to invest small amount of money, more often, into better funds for no commission.

Lets compare the experience of 2 new investors; 1 with Scottrade and 1 with Vanguard.

Each investor has $5,000 invested into an S&P 500 index fund. So they receive about $21 each quarter in dividends. They want to reinvest the dividends into the ETF VOO, Vanguard’s S&P 500 index fund.

 

VOO has a share price of $75 a share. This means that if they investor wants to buy 1 share of VOO a quarter, they need to deposit an extra $54 each quarter to buy the share.

 

For the investor with Vanguard, they will pay no commission buying that share of VOO, so a small purchase such as this is free.

 

For the investor with Scottrade, they pay $7 in commissions. That $7 represents nearly 9.5% of their investment…this means that purchasing that one share per quarter may not be worth it, as commissions will eat up your total returns.

 

Of course, you can replace VOO and Vanguard with any other broker and their corresponding commission free S&P 500 index fund. The results are the same, for new investors, choosing a brokerage with commission free ETFs can be much more beneficial than using Scottrade’s dividend reinvestment program.

 

With Scottrade, new investors would have to choose between waiting several quarters to build up the dividends to be able to buy a share, or depositing a little extra money each quarter and paying a commission. Broker’s offering commission free dividends make that choice much easier for new investors.

 

Although it requires a little more hands on approach than a dividend reinvestment program, it should be worth it from the improved results you can expect by investing in lower cost funds.

 

Hopefully, this article gives new investors a couple of options for getting their dividend reinvestment started, or finding an alternative strategy to increase you investing returns.

 

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