Ask the Spud: Do I Have Enough for a DRIP?

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:

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.