What are Distributions?
When you invest in certain funds, whether it’s a mutual fund, exchange-traded fund (ETF), pooled fund, or another type of collective investment vehicle, you may encounter the term “distributions.” These distributions represent the cash that a fund returns to its investors from the earnings generated by the underlying assets. Distributions can be made on a regular schedule (e.g., quarterly or annually) or on an ad hoc basis, depending on the fund’s structure and objectives.
Why do Funds Make Distributions?
Funds make distributions to share the income and gains generated from their investments with their fundholders. Some investors, particularly those seeking regular income, rely on these distributions to supplement their earnings or cover expenses. Additionally, most funds are required by law to distribute a significant portion of their income and capital gains to avoid paying taxes at the fund level. This helps maintain the fund’s tax-advantaged status. By making distributions, funds can ensure they comply with tax regulations while offering investors a tangible benefit on their investment
What are the Components of a Distribution?
Fund distributions can be broken down into several components, each reflecting a different source of earnings generated by the fund’s assets. These include:
- Dividends: If the fund holds dividend-paying securities, the dividends paid by these securities contribute to the distributions.
- Interest Income: For funds that hold bonds, fixed-income securities, or money market instruments, the interest generated from these investments is also a component of the distributions.
- Capital Gains: If the fund realized capital gains by selling securities at a profit, it can distribute these profits to investors as part of the distribution.
- Return of Capital: In certain circumstances, the fund may distribute an investor’s original capital investment (principal) back to them as part of the distribution.
What are the Tax Considerations of a Distribution?
When it comes to fund distributions, it is important to note the difference between a “distribution” and a “dividend”. Dividends are typically paid out of a company’s profits and are generally eligible for a favorable tax treatment. On the other hand, distributions from a fund may include income from interest, dividends, capital gains, or even a return of capital, each with different tax consequences. This means there is no standard tax rate for fund distributions, as the ultimate tax impact depends on the individual components of the distribution.
Are There Any Timing Considerations When Buying a Fund?
Purchasing a fund late in the year can have tax implications due to the potential for embedded gains within the fund at the time of purchase. Some funds distribute earnings to investors at the end of the year, reflecting the income and capital gains they have realized throughout the year. If you buy into a fund shortly before this distribution, you could be on the hook for taxes on those embedded gains, even though you may not have been invested in the fund for the entire year. This means you might receive a capital gains distribution and be taxed on it, without having benefited from the appreciation of the underlying securities during the year.
To avoid unexpected tax impacts, it is important to review a fund’s distribution history and look for any upcoming distributions before making a purchase. An investor can also make use of their registered accounts (RRSPs, TFSAs, etc.) when buying a fund near the end of the year to avoid any adverse tax impacts.
How Do Distributions Affect the Fund Price?
After a distribution is paid, the net asset value (NAV) of the fund drops by the amount of the distribution. For example, if a fund distributes $1 per share, the NAV will decrease by $1. It is important to recognize that this does not represent a loss on your investment, but rather a transfer of value from the fund to the investor. Understanding this can help prevent confusion over the perceived performance of the fund.
Many investors may also choose to reinvest their distributions, which can compound over time and help grow the overall value of their investment. Reinvesting allows you to buy more shares of the fund, potentially benefiting from future growth and income distributions. Many funds allow for automatic reinvestment so this process takes place without intervention from the investor.
The table below shows how a distribution and selecting either a cash distribution (Scenario 1) or choosing to reinvest the distribution (Scenario 2) does not impact the portfolio value.
|
PRE-DISTRIBUTION |
Formula |
||
|
Number of Units |
A |
100 |
|
|
Fund Net Asset Value (NAV) |
B |
$15 |
|
|
Portfolio Value |
A * B |
$1,500 |
|
|
POST-DISTRIBUTION |
Formula |
1. Cash Distribution |
2. Dist. Reinvestment |
|
Distribution/Share (5%) |
C = B * 0.05 |
$0.75 |
$0.75 |
|
Total Distribution |
D = C * A |
$75 |
$75 |
|
Fund NAV after Distribution |
E = B – C |
$14.25 |
$14.25 |
|
Additional Units Purchased (Reinvestment Only) |
F = D / E |
0.00 |
5.26 |
|
Total Number of Units |
G = A + F |
100 |
105.26 |
|
Cash on Hand |
H = D – E * F |
$75 |
$0 |
|
Portfolio Value |
E * G + H |
$1,500 |
$1,500 |
How Does Hemisphere Manage Distributions?
Hemisphere manages two in-house pooled funds: The Canadian Value Fund and the Select Shares U.S. Fund. Many of the companies held in these funds pay dividends, which means that our distributions are primarily composed of dividend income and capital gains realized over the year. To help reduce the tax impact on our clients, we engage in tax-loss harvesting when appropriate, using losses to offset gains. Hemisphere makes these distributions on an annual basis at the end of the calendar year. Our funds are also setup for automatic reinvestment so clients can expect to see an increase in the number of shares they own and an offsetting decrease in the fund price (NAV) after the distribution takes place.
Disclaimer: This information is not intended to be comprehensive investment, tax or legal advice applicable to the individual circumstances of a potential investor and should not be considered as personal investment advice, an offer, or solicitation to buy and/or sell investment products. Every effort has been made to ensure accurate information has been provided at the time of publication, however accuracy cannot be guaranteed. Interest rates, market conditions, tax rules and other factors change frequently and past investment performance does not guarantee future results. The manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein. Please consult an investment manager prior to making any investment decisions.