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What does a manager do with the dividends of the companies in the index? Does he reinvest the dividends in the company in which he got the dividends or will just choose whichever company suits him? How will this affect the investor?

Finally, how does an investor get dividends an index fund?

These questions for sure have a very simplistic answer but I am getting a bit confused.

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They are distributed to investors much like any other mutual fund, same thing with capital gains, although those distributions tend to be lower in value.

Here is some info from the Fidelity S&P 500 fund:

From the Fidelity S&P500 fund

Note that you may not see the dividends in your cash account because they are typically reinvested. In Fidelity, the default is to reinvest dividends and capital gains, and you have to manually set the distributions to not reinvest if that is what you wish. Then they would appear in the cash part of your account.

  • What is reinvestment price? I was wondering if the dividends received directly from the companies the manager invested in are always directly distributed to the shareholders or are reinvested by the manager to the same or other companies. "In Fidelity, the default is to reinvest dividends and capital gains, and you have to manually set the distributions to not reinvest if that is what you wish." When talking about capital gains, are you talking about the profit you make when selling shares? There is an option to directly reinvest those profits? Thank you for your time and your answer. – Louis Feb 3 '18 at 5:02
  • @Louis: The "capital gains distributions" are the profits from the fund manager selling securities held by the fund. It has nothing to do with you selling shares of the fund. – Ben Voigt Feb 13 '18 at 2:31
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... just choose whichever company suits him?

No, that would be an actively managed fund, not an index fund.

The dividends would be invested like any other monies until it was time to disperse the dividends to fund holders.

Being an index fund the theory is that the dividends would be reinvested in the stocks of the index in the proportion the index dictates, to maintain the same rate of return as the index. Then when it is time to disperse the dividends to the fund holders, that would be done.

In practice index funds are not invested exactly in the index. Some of monies have to be on hand for redemption. And some funds use a sampling strategy instead of holding all the stocks in the index.

  • Wouldn't they more likely just put the dividends in a cash account until they distribute them, rather than reinvesting them (which might then require selling shares to get the needed funds for distributions)? – Barmar Feb 2 '18 at 21:40
  • @Barmar I don't have any inside knowledge, but I expect cash flow management that looks at today's cash flow and anticipated future cash flow to decide how much cash to hold. There are probably days where most cash coming in, from dividends & fund share purchases are kept in cash for anticipated short term needs and other days when the cash on hand is already enough and everything coming in, from all sources, is invested. – Shannon Severance Feb 3 '18 at 1:08
  • So if I understand correctly this means that the fund manager will first decide what the quarterly dividend is going to be and then if the companies in the fund pay out more than that of the quarterly dividend he wants to give out then he will reinvest the money into the companies in the fund. Is this correct? Thank you for your time and answer. – Louis Feb 3 '18 at 5:37
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There are different types of stock indexes that deal with dividends differently. Index funds will also behave differently depending on which type of index they track, which is often indicated in the fund name by an abbreviation such as “TRN”.

The standard version of the S&P 500, e.g., is a price return (PR) index: It only takes into account the share prices, ignoring any dividends. That means that, typically, the index will fall slightly when one of its stocks pays a dividend. An index fund tracking the S&P 500 doesn’t need the dividends it receives in order to match the index, so it will forward them by paying a dividend itself. However, it is impractical for the fund to pay a dividend whenever one of the 500 stocks in the S&P 500 has done so; instead, it will keep the cash until some fixed day (e.g. each quarter) on which it distributes the money to the fund owners.

The other relevant type of index is the total return (TR) index. In it, any dividends are considered immediately reinvested. A fund tracking such a total return index will need to keep any dividends it has received or it will fall behind its index; therefore, it doesn’t pay dividends itself, and instead will use the cash to buy more stocks (according to the index weighting). From the point of view of the owner, the fund price will grow more rapidly than for an equivalent PR index fund.

Since funds typically won’t actually get the full dividend amount – a percentage is withheld as tax –, there is also the net total return (TRN) index, a variant of the TR index which only takes into account the after-tax dividend amount.

Almost all indexes exist in multiple variants. However, which variant is considered “the index” may differ between indexes. Traditionally, “the S&P 500” is the PR variant; on the other hand, “the MSCI World” normally will refer to the TRN version.

In practice, the difference between index funds with and without dividends will often not matter that much. In many cases, investment companies will provide automated reinvestment of dividends: Whenever a fund pays a dividend, they will automatically use this money to buy new shares in the fund. This happens on a different level, though, outside of the fund.

  • Do you have instances of what you call TR funds where dividends are not paid to the investors but retained by the fund and reinvested? At least in the US, mutual fund dividends that are not distributed to the shareholders are income to the fund which must then pay taxes on the dividends. So, at least in the US, most, if not all, funds distribute the dividends (capital gains too) to the shareholders, and allow them to reinvest in the fund if they so choose. Even though no cash leaves the fund's coffers, on paper, the dividends become taxable income to the shareholder, not the fund – Dilip Sarwate Feb 3 '18 at 15:57
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    @Dilip Sarwate: They are quite common in Europe. How they are treated for tax purposes depends on the country of residence of the investor. For examples, see the list of iShares’s European funds – the funds are classified as “distributing” (with dividends) or “accumulating” (no dividends). – chirlu Feb 3 '18 at 18:20

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