If you’re familiar with ETFs, you probably know that they can differ in the way they handle dividends depending on whether they’re Distributing (Dist) or Accumulating (Acc) ETFs.
I wrote a post going through some of the differences between Dist and Acc ETFs, but I never went into detail about how Acc ETFs actually work.
Dist ETFs behave similarly to dividend-paying stocks in that dividends are paid out to investors who own shares of the ETF, so they’re relatively easy to understand.
However, it isn’t so straightforward for Acc ETFs.
Acc ETFs receive dividends from their underlying stocks in the same way that Dist ETFs do, but these dividends never reach us as investors.
So, what happens to these dividends?
How do they affect the ETF’s performance and our returns?
These are things that I’ll aim to cover in this post.
What Happens To Dividends?
When the underlying stocks in an ETF distribute dividends, they are always paid to the ETF first, regardless of whether it is a Dist or Acc ETF.
As mentioned above, Dist ETFs simply pay these dividends that they receive to their shareholders.
On the other hand, Acc ETFs don’t pay any of these dividends to their investors.
Instead, they first hold onto it as cash.
Eventually, this cash is used to buy more units of the underlying stocks of the ETF, while still maintaining the % allocation of the index that the ETF is tracking.
To gain a better understanding of how Acc and Dist ETFs can affect returns, it’s helpful to understand the Net Asset Value (NAV) of an ETF.
For the financially savvy, the NAV of an entity is equal to its total assets less its total liabilities.
In laymen’s terms, it’s simply a metric for defining the value of an entity or fund.
For ETFs, NAV is typically defined on a per-share basis.
Cash is considered an asset.
When an ETF receives dividends in the form of cash, the ETF’s NAV will increase due to the increased cash component of its portfolio.
Or, when the underlying stocks of an ETF experience a net growth, the NAV of the ETF increases as well to reflect the higher value of the underlying stocks.
How Does This Affect Returns?
This subtle difference in the way ETFs handle dividends has minimal impact in the short term but can have a significant impact in the long term.
In the short term, an investor’s returns should be unaffected by whether an ETF is Dist or Acc.
This is based on the assumption that in the short term, the dividends received by Acc ETFs are held as cash and have not resulted in any significant compounding effect.
The sum of the dividend that would be paid out to investors in a Dist ETF is simply held as cash by a similar Acc ETF.
In other words, for 2 otherwise identical ETFs, the only difference between a Dist and Acc ETF when it comes to dividends is where the cash is held.
Since Dist ETFs pay dividends to their investors, the dividend is owned as cash by the individual investor and there is no change to the NAV of the ETF.
Instead, an investor who owns shares of a Dist ETF experiences an increase in their assets since they now own more cash.
Meanwhile, Acc ETFs keep the cash from the dividends as part of their holdings, increasing the NAV of the ETF.
As a result, an investor who owns shares of an Acc ETF experiences an increase in their assets because these shares are now worth more.
In both scenarios, the cash sum from dividends should be the same, again assuming that the ETFs are otherwise identical and that the effect of taxes can be ignored.
Investors experience the same increase in assets – just in different ways.
This is where things start to get more complicated.
In the long term, all dividends that would be received by Acc ETFs would already be reinvested back into the fund.
That is, every time the ETF receives dividends, it uses the cash to buy more units of each of its underlying shares.
The NAV of the ETF is still higher relative to before the dividends were received, just that it is now reflected by increased holdings in the underlying stocks of the ETF rather than cash.
This reinvestment of dividends allows Acc ETFs to capitalise on the compounding effect of investing.
This effect is 2-fold, compounding on both dividend and capital gains.
By buying more of its underlying shares, Acc ETFs receive more dividends in each subsequent dividend payout because dividends are usually paid on a per-share basis.
This is assuming that the dividend yield of the underlying shares remains relatively constant.
Acc ETFs also experience compounded capital gains when their underlying stocks go up in value since it continuously increases their position in their underlying stocks.
Acc ETFs basically automate the process of reinvesting dividends to make it easier for investors to take advantage of compounding.
Drawing a comparison to Dist ETFs, Acc ETFs are more likely to produce higher long-term returns.
Even if the dividends from Dist ETFs are manually reinvested by the investor, there are several areas of inefficiencies that would diminish returns.
For one, the collection of dividends from the ETF may trigger taxes like a dividend withholding tax.
Also, investors may not be able to reinvest all of the dividends received due to the disparity between the sum of dividends received and the share price of the ETF if fractional shares are not allowed.
Then, brokerage fees would also be incurred during the reinvestment process.
So, as you can see, Acc ETFs are generally preferred over Dist ETFs if you intend to reinvest dividends anyway.
Case Study Example
Let’s drive home your understanding of Acc ETFs with an example.
For simplicity, let’s assume that there are 2 ETFs – ACC and DIST – which are Acc and Dist ETFs respectively, but are otherwise identical.
That is, they track the same index, own the same shares in the same proportions, have the same dividend yield, and etc.
Note that this example is in no way meant to simulate real-world conditions and is only meant to illustrate the behaviour of Acc ETFs in a simplistic manner.
- In the short term, dividends received by ACC are held as cash and/or have not resulted in any significant compounding
- Dividends paid out by DIST are not reinvested
- ETFs in question are well diversified and follow business cycles such that it always goes up in the long run
- ACC and DIST are otherwise identical
- Effect of taxes are ignored (for simplicity)
Now – Dec 2021
Currently, both ACC and DIST are trading at $100/share.
Adam owns 10 shares of ACC and Dave owns 10 shares of DIST.
Both ETFs are due to receive dividends from their underlying stocks next month at a dividend yield of 1%.
Both Adam and Dave start out with the same amount of assets.
1 Month Later – Jan 2022
Both ACC and DIST receive their dividends of $1/share.
Since ACC is an Acc ETF and doesn’t pay out dividends, it keeps the dividends in its portfolio as cash, causing its NAV to increase by $1.
The price of ACC is now $101/share.
Adam receives no cash from dividends.
DIST pays its dividends to its shareholders and there is no change to its NAV.
Dave receives $1 for each of his 10 shares of DIST for a total of $10.
In the short term after dividends are received, Adam and Dave still have the same amount of total assets but different portfolios.
11 Months Later – Dec 2022
Throughout the year, the underlying index (and thus DIST) grew by 10%.
The cash that ACC was holding from its dividends was reinvested back into its underlying stocks, allowing it to experience a 10% growth as well.
ACC is now trading at $111.10 and DIST is now trading at $110.
Assuming that Dave did not reinvest his dividends, we can see that Adam’s assets are now greater than Dave’s.
This is an example of the compounding effect of capital gains.
Both ETFs are again due to receive dividends from their underlying stocks at a yield of 1% in 1 month’s time.
1 Month Later – Jan 2023
ACC receives dividends of $1.11/share while DIST receives dividends of $1.10/share.
As before, ACC keeps the dividends as cash to increase its NAV and DIST pays out its dividends to its shareholders.
The price of ACC is now $112.21/share and Dave receives $11 in dividends.
Now, not only do Adam’s assets exceed that of Dave’s, but ACC also received more dividends than DIST.
This is an example of how dividends can be compounded by reinvesting.
The difference in the value of assets may seem minimal in this example, but that’s because the capital and dividend yield in this example are low ($1000 and 1% respectively).
Also, the time period we looked at was only for 1 year, which is a very short time where the effect of compounding has not been demonstrated.
If we extrapolate these results over a period of 5, 10, or even 20 years, it would look vastly different.
Again, this example is based on the assumption that dividends from the Dist ETF are not reinvested.
If they are, or if the cash received from dividends are used for other investment purposes, the difference wouldn’t be quite as large.
But as I mentioned above, manual reinvestment of dividends is less efficient than investing in Acc ETFs, potentially incurring fees in several ways.
Acc ETFs help investors automatically reinvest dividends, which minimises the cost of reinvesting for investors.
In doing so, investors are able to effectively take advantage of the compounding effect of investing to snowball returns over the years.
However, this is only helpful if investors wish to reinvest dividends back into the same ETF rather than to deploy the cash for other purposes.
Also, remember that all comparisons drawn to Dist ETFs in this post are based on ideal scenarios where 2 almost identical Dist and Acc ETFs exist.
In reality, this is seldom the case, and there are bound to be differences between any 2 ETFs even if they have many similarities.