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.