Have you ever noticed your portfolio’s value drop on a day when the markets are seemingly moving in a positive direction. This may leave you scratching your head but don’t fret, this phenomenon is most likely due to the payment of an annual distribution from the mutual fund that you hold.
Throughout the year, your mutual fund earns various sources of income (interest, dividends & capital gains). If this income were retained within the fund, then the mutual fund would pay tax on this income at the top marginal tax rate. To avoid this outcome, this taxable income is flowed out to the unit holders so that each investor can benefit from their own marginal tax rate (which is likely lower) and to potentially avoid the tax altogether if their fund is held within a registered account. It’s in everyone’s best interest to have the mutual fund pay a distribution.
Why does the Net Asset Value (NAV) drop when a distribution is paid?
The NAV represents the value of the fund’s underlying assets. Distributions reduce the fund’s NAV since cash leaves the fund and is paid to each unit holder. Since the fund holds fewer assets once the distribution has been made, it stands to reason that the NAV would decrease by that same amount.
It’s worth noting that you will likely only notice a drop in the NAV if you are receiving your distributions in cash. If you are reinvesting your distributions, then any drop in the NAV will be offset by an increase to the number of units you own. Here’s an example:
If the distribution is paid in cash:
|
Pre-Distribution Value of Investment |
Distribution | Cash Paid to Investor | Post-Distribution Value of Investment |
| 1,500 units @ $10 = $15,000 | 1,500 units @ $0.50 = $750 | $750 |
1,500 units @ $9.50 = $14,250 |
If the distribution is reinvested:
|
Pre-Distribution Value of Investment |
Distribution | Reinvested Distribution | Post-Distribution Value of Investment |
| 1,500 units @ $10 = $15,000 | 1,500 units @ $0.50 = $750 | $750/$9.50 = 78.9474 new units |
1,578.9474 units @ $9.50 = $15,000 |
Can a mutual fund pay a distribution in a year of negative performance?
Yes. Distributions are comprised of taxable income that has been earned over the year. This includes interest, dividends and net realized capital gains (ie. when the fund manager sells a security at a profit). However, unrealized gains and losses (ie. securities that have risen or fallen in value) are not considered for tax purposes until they are actually sold. Therefore, it is possible for a mutual fund to experience negative performance in a given year and still have a taxable distribution. This occurs when unrealized losses exceed realized gains and the annual income received.