Investors often wonder why Exchange-Traded Fund (ETF) distributions fluctuate even when the securities held by the fund and the distributions of the holdings change very little. To better understand the issue, let us take a look at the cash distributions from the iShares S&P/TSX Capped REIT ETF (TSX: XRE) in the table below.

Year | XRE Distributions |
---|---|

2012 | $0.74 |

2011 | $0.74 |

2010 | $0.68 |

2009 | $0.64 |

2008 | $0.86 |

2007 | $0.88 |

2006 | $0.77 |

2005 | $0.78 |

2004 | $0.77 |

The distributions from XRE dropped 26 percent in 2009 from the year before. What could explain such a steep drop?

## Changes in Fund Holdings

XRE’s holdings changed very little in 2009. The fund held 11 REITs in 2008 and eliminated one of its holdings — InnVest REIT — in 2009. InnVest REIT made up just 2.9 percent of XRE’s total assets in 2008, so the change in fund holdings would not explain the big drop in distributions from XRE in 2009.

## Changes in Distributions from Holdings

H&R REIT (TSX: HR.UN) cut its monthly distributions in half in January 2009. As H&R REIT had a weight of 10 to 15 percent in XRE in 2009, its distribution cut had an impact on XRE’s distributions. If we assume the H&R REIT and XRE had a similar distribution yield, all things being equal, a 50 percent cut in H&R’s distributions would translate into a 5 to 7.5 percent cut in distributions of XRE. H&R’s distribution cut partially explains XRE’s drop but we must look for the main culprit elsewhere

## Exchange-Traded Fund Flows

When a fund experiences significant inflows (or outflows), it can result in a lower (or higher) distributions per unit. Suppose Pretend ETF has a NAV of $10 per unit and 100 units outstanding all of it owned by investor John. The fund then receives a $100 dividend and the NAV per unit increases to $11. John expects a distribution of $1 per unit ($100/100 units) at the end of the month. Later in the month, 100 more units were created at a NAV of $11 because investor Jane purchased units of Pretend ETF. The fund now has a NAV of $11 per unit and 200 units outstanding. At the end of the month, Pretend ETF distributes the $100 in dividends it received earlier in the month but the distributions per unit falls to $0.50 because the $100 dividend is spread over 200 units. After the distribution, the NAV of Pretend ETF falls to $10.50.

Note that the total wealth of all investors in Pretend ETF has not been affected even though distribution fell in half. John’s distributions fell by $0.50 but the NAV of the fund increased by $0.50, so his total gain is still $1. Jane invested $11 in the fund and received a distribution of $0.50 but the NAV of the fund fell to $10.50.^{1}

The bulk of the drop in distributions in XRE can be explained by fund inflows. XRE had total assets of $290 million at the end of 2008. In 2009, the fund experienced $407 million in inflows. Investors wondering why a new fund like the Vanguard FTSE Canada ETF (VCE) or Vanguard FTSE Canadian REIT ETF (VRE) has a distribution yield that is different from that of the index should also look at fund flows for an explanation.

^{1. Thanks to iShares Canada for this explanation↩}

Thanks for the plain english explaination!

In your distribution table, are these numbers supposed to match the “Total Distribution per Unit for Tax Purposes” column?

http://ca.ishares.com/product_info/fund/distributions/XRE.htm

@Brian: No. Total distributions for tax purposes includes reinvested distributions, which unit holders did not receive as cash but was reinvested by the fund. The table in the post shows the *cash* distributions of XRE (i.e. total distribution per unit for tax purposes minus reinvested distributions).

Great post. I’ve been wondering about this for years.

I wonder if ETF providers try to avoid people buying in only to harvest dividends, especially for ETFs with one large distribution per year (thinking of VXUS in particular).

@PaulG: I don’t think so. Providers don’t have any control over how often investors buy and sell ETFs. It is perfectly feasible for investors to buy an ETF to harvest the dividends (though, I don’t know why investors would want to do that because one has to pay tax on the harvested dividend).

Well, in a registered account, it would be possible to buy up the ETF for the month when dividends are paid out, and have that money invested elsewhere (even other asset classes, as long as they’re in US dollars) for the rest of the year.

VXF has a 1-percent distribution every year in December, am I the only one who’d be happy with a one percent return for a one month period ?

@Paul G: When a ETF pays a distribution, all things being equal, its NAV falls by the same amount. For e.g. let’s say an ETF has a NAV of $11.00 and is about to pay a $1 dividend. On the day that the ETF goes ex. dividend, the NAV will fall by the amount of distribution ($1.00 in this case to a NAV of $10.00). Now, of course, stocks go up or down by 1% or more in a day, the drop in NAV may be hard to notice but it is there.

I know that a stocks value has to go down by the value of the dividend, but with ETFs being the combination of dozens or hundreds of stocks, they pay out dividends they’ve gotten in the past months, and the price drop for most of the dividends is already cooked into the price of the ETF, since the price of the ETF follows the price of the components of the index.

There are a number of ETFs with monthly distributions that seem to try and keep their monthly distributions constant. One that comes to mind is ZRE. How do they do this? Wouldn’t they be subject to the same effects when units are created?

@Tennis Lover: Good question. I don’t know exactly how some ETFs manage to make constant distributions. I’ll get back to you on this.

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I am confused on something…

Imagine an ETF with only one investor and only one holding, say 1 share of XYZ stock worth $10/share. XYZ declares a $1 dividend and goes ex-dividend (XYZ price drops to $9). XYZ shareholders will receive their dividend on the payout date, but the ETF holder will receive his payout at a date later than that. My question is, after the stock’s ex-dividend date, is the NAV of the ETF decreased by $1 and only increased again once the fund actually receives the payment from the underlying company? If so, does this represent an opportunity for a second ETF investor to buy ETF shares at a temporarily reduced price? I realize the $1 dividend will be distributed among all ETF holders on the ETF ex-dividend date, but still the new ETF investor is able to buy one ETF share for $9 and wait for the $1 dividend to come to the fund, then will receive a $0.50 ETF dividend.

Am I missing something? Or is it that after the XYZ ex-dividend date, the NAV of the ETF still includes this dividend payment even though it has not yet actually been credited to the fund?

@Greg, I believe the second ETF Investor would also pay 10$ as the 1$ dividend would be included in the ETF assets as a recevable the moment it is earned (ex-dividend date) and not the moment it is paid.

Some ETF’s that investors buy for income pay out a constant distribution that is sometimes more than the dividend and interest that is earned by the underlying assets. They also distribute funds from capital appreciation. The danger is if the assets under perform for a long period of time, the distribution could be cut. Lots of income mutual funds does this and in 2013, BMO slashed the distribution on some of it’s income funds as it was paying out more than it was earning with the dividend, interest and capital appreciation.