How an ETF reinvests dividends

Question

When a company gives dividends, the share price drops by the dividend amount. Now, if all the shareholders choose to reinvest their dividends, will the share price go back up to what it was prior to the dividend?

I ask because some ETFs like SPY automatically reinvest dividends. So what is the effect of this reinvestment on the stock price?

The other thing is, how does this reinvestment process work? Whenever an underlying company like AAPL gives a dividend, SPY uses the money to buy additional shares of AAPL?

Answer 1

Let me answer by parts:

When a company gives dividends, the share price drops by the dividend amount.

Not always by that exact amount for many different reasons (e.g. there are transaction costs if you reinvest, dividend taxes, etc). I have tested that empirically.

Now, if all the shareholders choose to reinvest their dividends, will the share price go back up to what it was prior to the dividend?

That is an interesting question. The final theoretical price of the company does not need to be that. When a company distributes dividends its liquidity diminish, there is an impact on the balance sheet of the company. If all investors go to the secondary market and reinvest the dividends in the shares, that does not restore the cash in the balance sheet of the company, hence the theoretical real value of the company is different before the dividends.

Of course, in practice there is not such a thing as one theoretical value. In reality, if everybody reinvest the dividend, that will put upward pressure over the price of the company and, depending on the depth of the offers, meaning how many orders will counterbalance the upward pressure at the moment, the final price will be determined, which can be higher or lower than before, not necessarily equal.

I ask because some ETFs like SPY automatically reinvest dividends. So what is the effect of this reinvestment on the stock price?

Let us see the mechanics of these purchases. When a non distributing ETF receives cash from the dividends of the companies, it takes that cash and reinvest it in the whole basket of stocks that compose the index, not just in the companies that provided the dividends. The net effect of that is a small leverage effect. Let us say you bought one unit of SPY, and during the whole year the shares pay 2% of dividends that are reinvested. At the end of that year, it will be equivalent to having 1.02 units of SPY.

Answer 2

SPY does not reinvest dividends. From the SPY prospectus:

No Dividend Reinvestment Service

No dividend reinvestment service is provided by the Trust. Broker-dealers, at their own discretion, may offer a dividend reinvestment service under which additional Units are purchased in the secondary market at current market prices.

SPY pays out quarterly the dividends it receives (after deducting fees and expenses). This is typical of ETFs. The SPY prospectus goes on to say:

Distributions in cash that are reinvested in additional Units through a dividend reinvestment service, if offered by an investor’s broker-dealer, will be taxable dividends to the same extent as if such dividends had been received in cash.

Answer 3

The shareholders can't all re-invest their dividends -- it's not possible. Paying a dividend doesn't issue any new shares, so unless some of the existing shareholders sell their shares instead of re-investing, there aren't any shares available for the shareholders to re-invest in.