Wednesday, February 23, 2011

Treatment of reinvestment of income in returns

A colleague sent us a note recently inquiring about the proper treatment of accounts that have dividends reinvested; that is, how the flows are to be handled from a return perspective. The essential question is "should the money flowing into the account, to purchase additional shares, be treated as a cash flow?" And the answer is a conditional one:
  • If you treated the dividend that flowed out of the account as a cash flow, then yes
  • If you didn't treat the divided that flowed out as a cash flow, then no.
We essentially want our flows to cancel each other out, as the dividend's impact should be kept within the account, and the manager should benefit from it. We cannot treat only the money coming in as a flow because then the manager wouldn't get credit for creating it.

2 comments:

  1. If I understand the client's query correctly, then a more thorough understanding of portfolio mechanics is due. The issue isn't so much about dividends and flows, bur rather income's relationship to an asset. An asset's value comprises 3 elements: price value, accrued income, and income receivable. The difference between the second and third elements has to do with physical receipt of the income. The reason income (dividend or coupon) isn't a flow at the total account is because the release of the accrual is offset by the cash receipt of the income payment. It's because of this that income is treated as an outflow when doing segment returns since the cash side of things is fire-walled from "pure" asset-type buckets.

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  2. Dear Any (short for "anonymous"),
    Interesting perspective, and thanks for sharing. Yes, at the subportfolio level we WOULD be treating income as a flow. And, if the flow returned to that particular asset, fine; it would cancel; otherwise, it's just a flow.

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