When my mutual fund declares an income distribution, the fund price falls by a similar amount. How does this distribution benefit me?

Mutual Funds
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December 2016
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This is a great question and more complicated than you may think. A "distribution" is usually not the same thing as a dividend. Once you receive the distribution, the mutual fund company will tell you how to classify it. It could be income, capital gains, a dividend, or even a partial return of principal. And if this fund is in a taxable account, you will have to pay the appropriate tax rate depending upon how it is classified. If in a Traditional IRA, it will be ordinary income when any distributions are made. So, it might be important for you to match the investment tax treatment with the best type of account.

That said, you can either re-invest the distribution just like a "dividend reinvestment plan" on a stock, or you can take the distribution to the money market or even spend it. It is yours to do with whatever you choose. So it depends upon what your objectives are.  

But judging by the way you asked the question, I think your real question is "why does a distribution benefit me if the share price drops by the same amount?"  But think of it like this, if you own a company that that is worth $1M and makes $200K/year, what good is it if is always locked up within the company, assuming you are a passive owner-investor with no salary? Now, what if you paid yourself a 5% dividend or $10K/year to supplement your income or social security if retired? Is that company worth less, especially if their prospects are bright and they will replenish their coffers?

Theoretically, the share price should fall by the amount of distribution initially because if you have a 1 million dollar company - assets, cash, etc.. - and they pay out $50K in distributions, the company - assets and cash are now worth $950k - base upon some type of valuation. But they will replenish their coffers with new business and expectations about the company will also affect price.

In fact, that is why many times you will see that the price doesn't drop by the full dividend (think stock) or distribution (think mutual fund) because their prospects are bright and investors are buying up shares, pushing prices higher. Conversely, if their prospects are being lowered, the share price can drop below the distribution and you may need to revisit whether you should even hold the investment.

I wouldn't get too caught up in the mechanics of the distribution. What is far more important is whether your investment strategy makes sense to you. And you have a solid basis and reason for owning all the your funds, ETFs, stocks, bonds, etc. Then, once you decide on what mix of investments you have with a proper discipline, then determine which type of account or receptacle should hold the assets.

Best of Luck and Happy Holidays, Dan Stewart CFA®

June 2007
December 2016
December 2016