If an ETF directly reinvests its money back in to itself, does the "compound interest" approach to shares still apply?

Question

The idea of investing in ETFs was given to me as follows, I'll call this the "compound interest approach":

1. Historically speaking, unless you can time the market very well or have a very good mitigation strategy, if you were to make a large investment in an index over a large period of time, say the FTSE 100 for 20 years, and not reinvest the dividends, you would have lost money.
2. However, if you did reinvest the dividend, the number of units that you own will typically have increased significantly over time, meaning that, unless your timing is terrible or the market crashes and never recovers, your investment will have acted like compound interest, and therefore grew over time. This question covers the basic argument.
3. The above is basically what accumulation-type index-tracking ETFs do, so investing in them is a quick and easy way to do the above.

I bought in to this pitch, read all relevant documents carefully, and picked out an ETF that was from a big bank that was to my liking. Dividend day passed recently and I was surprised to see that my number of units had not gone up. It appears that the ETF that I have chosen reinvests the dividends that it gets from its underlying shares back in to the fund on the dividend day. In other words, rather than increasing my unit number, it increases its own unit price.

My question is this - does an ETF that works how I think mine works benefit from the three-step "compound interest approach" that I've given above? Or, at least mathematically, will it work differently?

Answer 1

Dividend day passed recently and I was surprised to see that my number of units had not gone up. It appears that the ETF that I have chosen reinvests the dividends that it gets from its underlying shares back in to the fund on the dividend day. In other words, rather than increasing my unit number, it increases its own unit price.

Awesome. Why would you want to have to pay income tax just to keep your money invested?

My question is this - does an ETF that works how I think mine works benefit from the three-step "compound interest approach" that I've given above? Or, at least mathematically, will it work differently?

It works precisely the same. The amount you have invested in the index fund has gone up by the value of your share of the dividends. So if the index goes up 2%, your position will increase in value by ~2% of your share of the dividends as well.

Answer 2

ETFs do not necessarily pass through all underlying dividends to investors. It may choose to reinvest them internally or to pay its own independent dividend depending on the terms of the fund. It sounds like the fund you chose does the former.

The fund also does not necessarily reinvest the dividend in the stocks that pay them. IT can keep the dividend in cash and reinvest in something else or use the cash to rebalance, make different investments (for an active fund), etc. The fees for the fund also come out of the net assets, so it may choose to keep the dividends in cash to feed the internal cash flow.

Note, though, that dividends have zero impact to your overall value. When a dividend is paid, the per-share (or per-unit) value goes down and the number of shares/units goes up (if you choose to reinvest). So mathematically it's a wash. If the price of the fund increased, it's not because of the dividend.

Also note that "compounding" does not come from the dividends, but comes from the overall growth of the company (or companies for a fund). If the companies within the fund grow at an average of 10% per year, that's where the "compounding" is observed. The compounding is not "built-in" to the investment (meaning you're not guaranteed growth unlike a bank account or CD. But the effect of growth works much like compounding interest.

Answer 3

Berkshire Hathaway shares are ~ $286,000 per share. BH does not give shareholders dividends, they just continue to reinvest profits. One can debate the use of the word "compounding", but I would say, yes, that's the effect.

Dividends skimmed off and spent on beer vs dividends reinvested, either by the shareholder, or the ETF manager.