When my mutual fund declares an income distribution, the fund price falls by a similar amount. How does this distribution benefit me?
An income distribution from a mutual fund to its shareholders can take two forms:
- A shareholder can elect to be paid directly, which puts the money in his or her pocket
- The shareholder can elect to buy more shares of the fund, which means that he or she is reinvesting the amount of the dividend in more shares.
Whichever scenario mutual fund shareholders choose, they either benefit from $100 paid to them in cash or $100 reinvested in additional shares of the ABC Fund. If you are living off investment income, you will choose one of the dividend payout alternatives. If you are building a retirement nest egg, you will choose to plow that dividend back into more shares of the fund and enjoy the long-term benefits of compounding your investment.(For related reading, see Compound Your Way To Retirement.)
For example, let's say the ABC Fund makes a quarterly income distribution of $100 as a dividend to shareholder Mary Smith. If the fund company has a money market fund, Mary could put the $100 there, which keeps it liquid and at her immediate disposal. The $100 could be sent to her by check or deposited to her bank account. In all of these instances, Mary gets to use the dividend amount any way she pleases. As an alternative, she can elect to reinvest the $100 dividend payment in more shares of the ABC Fund. Generally, this is done through automatic dividend reinvestment instructions established by Mary and automatically executed by the fund company for her account. The dollar amount of her investment in the fund will increase by $100.
By law, mutual funds must pay out income and realized capital gains to the funds' shareholders. These distributions come from a fund's assets, which why a fund's net asset value - and therefore its price - drops accordingly.
To learn more about how price and NAV are related, read Why is it that when investors realize returns on a mutual fund, its price tends to fall?
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®
When a mutual fund declares an income or capital gains distribution, the fund price drops by a similar amount, but you aren't losing money as a result. You will receive the distribution in cash, which you may reinvest in additional shares of the fund.
The distribution may or may not benefit you. If the fund has been successful and the net asset value is growing, that would be a good sign. But the distribution may be reflective of gains built up over time that are just now being realized. That could be cause for concern.
It would be more useful for you to focus on changes in the fund's net asset value and how those changes compare to the fund's benchmark. If, for example, the fund invests in a broad range of US stocks, the benchmark might be the Standard & Poor's 500 Index. If the NAV returns were better than those of the S&P, that would be good. And vice-versa.
Relative performance is more important than periodic distributions.
Well, it might not.
It is of benefit if:
- You need the income
- You are in a low tax bracket
It is not if:
- You are in a high tax bracket
- You don't need the funds
- Your options to reinvest the funds are limited or expensive
This is a conversation that should be had before the mutual fund is purchased. Some mutual funds have larger and more frequent distributions than others. Tax-efficient funds are usually good about keeping distributions to a minimum. Active funds or funds with high turnover are the worst culprits. If investors are moving money in and out of a mutual fund and the manager has to sell, it could be a reason for the distribution. It is one of the reasons Dimensional Funds (DFA) are only sold through advisors, it keeps trading in and out to a minimum.
In an attempt to be fair and balanced, I will offer two possible ways it might benefit you: 1) it could spread out the tax burden. If the capital gain just builds over years and your tax rate does not go down, you will just have a very large bill all at once. 2) The manager's frequent trading allows for better investment opportunity, possibly increasing returns.
I hope this helps!
Mark Struthers CFA, CFP®
For Sona’s Educational Series KnowThis! KnowThat! go to: