A quick guide to how income distributions on ETFs and mutual funds work


Q. I’m wondering if the reinvested income in mutual funds and ETFs paid only to existing investors who hold the units at the time of the distribution. If I sold my holding just before the distribution, am I out of luck? Or would the income still accrue to me, since I held the shares when that income was being earned?
Steve

A. If you’re used to holding individual dividend-paying stocks, distributions from mutual funds and ETFs can be complex and confusing. But you’ll be happy to know that you’re not “out of luck” if you sell your mutual fund or ETF units before they pay out income to their investors.

Let’s break this down by imagining two investors: Sheila holds 50 individual dividend-paying stocks, while Harold owns a mutual fund that holds those same 50 stocks. Each of these companies is likely to have a slightly different dividend schedule, so Sheila will likely receive dividend income in dribs and drabs throughout the year.

Meanwhile, Harold’s mutual fund will receive all of the same dividend income, and on the same schedule as Sheila. However, it will reinvest at least some of those dividends as they are received, rather than paying them out to Harold immediately. All of these reinvested dividends will be reflected in the net asset value (NAV) of the fund, which is adjusted daily. So Harold and all of the other unitholders are getting their fair share, just like Sheila is by holding the stocks directly.

Mutual funds and ETFs do eventually distribute that income to investors—often quarterly, but sometimes semi-annually, or even monthly. If you elect to receive your fund distributions in cash, you will notice that the fund’s NAV drops when your payout is made.

For example, assume Harold owns 1,000 units of a mutual fund with a NAV of $20 per unit, so his holding is valued at $20,000. If the fund pays a distribution of $0.30 per unit, Harold will receive $300 in cash, and the value of his fund units will fall to $19.70. The total value of his holding will remain unchanged: he still has $20,000, but now it is in the form of $19,700 of fund units plus $300 in cash.

This comes as a surprise to many, but it makes sense when you think about it. The distribution is not created out of thin air: it is simply money that has accrued in the fund over time and is now being paid out to investors.

Indeed, despite widespread belief to the contrary, a dividend from a stock is not “free money.” When a company pays a dividend, its share price typically falls by a roughly equal amount. After all, if a company distributes $1 million in cash to its shareholders, it must be worth $1 million less than it was before the payout.

If you choose to reinvest all of your distributions, the overall impact is similar. To return to our example, if Harold owns 1,000 units of a fund valued at $20 each, and the fund pays a reinvested distribution of $0.30, the unit price would fall to $19.70 and Harold would receive 15.2284 additional units ($300 / $19.70). He would now own 1,015.2284 units valued at $19.70 each, and his holding would still be worth $20,000.

So, Steve, to return to your question, the date on which you sell your mutual fund should not make any meaningful difference. If you sell the fund before the distribution is paid, the per-unit value is likely to be correspondingly higher. If you sell after the distribution, the unit price will be lower, but you will have also receive the cash dividend or additional units of the fund.

Dan Bortolotti, CFP, CIM, is an associate portfolio manager and financial planner with PWL Capital in Toronto.

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