When you purchase a mutual fund, what type of income it generates and when distributions occur can affect returns. This is why it’s important investors understand how distributions work, as well as why the timing of purchases and the kind of income used to cover fund expenses also matter.
The effect of distributions on returns isn’t always clear to investors. Some investors don’t even realize they affect overall returns. So, while distributions only influence published fund returns when distributions are reinvested, all distributions affect the total return investors earn from a fund.
Distributions and Net Asset Value Per Unit (NAVPU)
NAV is the market value of all the assets in a fund, while NAV per unit (NAVPU) is the market value of the fund divided by the number of fund units outstanding. For the remainder of this article we’ll use NAV and NAVPU interchangeably when referring to the per unit cost of a fund, as is often done in the industry.
When investors check NAVs, they’re not getting a complete estimation of their return. Looking at funds on a purely NAV basis doesn’t give the total return on those funds since comparing the purchase price to current NAV won’t include the impact of any distributions received by unitholders.
With mutual funds, investors receive distributions, which are paid in cash or reinvested. If the distributions are reinvested, then investors will have more units of the funds that made distributions. Cash distributions cause the NAV to decline by the amount of the distribution. Please refer to the sample calculation example in this article.
Total return explained
Total return, meanwhile, includes all interest, dividends, capital gains, and distributions realized over a given period.
The inclusion of distributions in return calculations is important to accurately gauge fund performance. Absent the effect of distributions, investors aren’t getting the full picture.
Total returns enable the comparison of investments and can be used to make more informed investment decisions. Just remember that past performance doesn’t guarantee future results.
Determining total return
NAV is an accounting measure that reports the actual value of the assets in a fund at the end of a trading day. This means that dividends, interest, and capital gains distributions made to unitholders would not be included in the total assets unless they were reinvested.
The total return of a mutual fund should yield a performance figure that includes distributions. And, it should account for distributions made to unitholders, whether they’re reinvested in the fund or not.
Note that common practice amongst fund companies is to present fund returns as though all distributions were reinvested. So, investors comparing portfolio returns might see lower returns on their fund holdings, but they must consider any cash distributions as part of their own total return.
Distributions are a common source of confusion about differences between total returns and those based on simple NAV comparisons.
When you buy matters
If an investor holds a fund with a monthly distribution frequency for two months, they would receive taxable distributions for two months of fund activity. This would reflect their actual participation in any gains by the fund.
But, if an investor purchases a mutual fund with an annual distribution frequency right before the distribution date, they would receive a distribution for nearly a year’s worth of activity.
While this seems odd when investors didn’t participate in the gains realized prior to their investment into that fund, it’s common practice to distribute capital gains only once per year.
Investors can sometimes obtain distribution estimates to gauge the potential tax impact, but these estimates are subject to potentially considerable change based on what happens between their issuance and the end of the mutual fund tax year.
To lessen the tax impact in non-registered accounts, the best advice for investors tends to be to buy mutual fund units shortly after a distribution is made.
Distributions and fund expenses
All mutual funds incur expenses, but fund companies can allocate expenses against income in such a way as to reduce distributions of more heavily-taxed income, like interest.
For example, say a fund has interest income of $100, Canadian dividend income of $50 and expenses of $75, then the fund company would fully allocate $75 of expenses against the $100 of interest. This way only $25 of interest income and $50 of Canadian dividend income would be distributed, which results in a more tax-favourable outcome for unitholders.
Distributions are an important component of the mutual fund investing experience and not well-understood by a lot of investors, but it’s important to be aware of the effect of distributions to get a clear picture of actual fund returns.
