Comparison of accumulating ETFs and distributing ETFs

Non-US investors often have a choice between accumulating ETF and distributing ETF share classes.  outlines the difference between these ETF share classes, and shows that the results obtained from both will be the same before trading costs, currency exchange spread and possible differences in local tax treatment.

Where you have a choice, it is worth looking closely at your own personal tax situation, to see if one type or another might give you a better tax outcome.

Introduction
Depending on the country in which they are domiciled, funds need to follow different regulatory and tax rules.

One of the main differences between US domiciled and non-US domiciled funds and ETFs is that US fund regulations mean that a US domiciled mutual fund or ETF (exchange-traded fund) must distribute at least 90% of its income to shareholders.

Non-US domiciled funds and ETFs do not have the same restriction, and they can reinvest the received dividends and interest without distributing them. This allows them to create different classes of ETF shares. Shares that pay dividends periodically are known as distributing ETFs. Others can instead retain the income from the assets they hold, and use it to invest in more of those assets automatically within the ETF itself. These are known as accumulating ETFs.

Investors in some countries can find that one class of ETF shares gives them a tax advantage, depending on local country tax law. However, except for any local tax advantages and trading costs, where two ETFs contain the exact same assets, but one is distributing and the other accumulating, the long-term performance of the two will be the same.

ETF distributions
A US domiciled fund or ETF must periodically pay dividend distributions, and may have to pay capital gains distributions, both short-term and long-term. It does this to meet US regulations for investment companies. These are the funds and ETFs that US investors commonly discuss and use.

Non-US domiciled funds and ETFs generally do not pay out capital gains distributions. This lets holders compound all the capital gains until fund units or shares are sold. For dividends:


 * Funds that pay out dividend distributions are distributing funds or ETFs.
 * Funds that retain dividend distributions and reinvest them internally are accumulating funds or ETFs.

Most non-US domiciled ETFs are distributing, but accumulating ETFs are becoming more widespread. For ETFs with smaller dividends, issuers might find accumulating share classes to be a convenient way to avoid the administrative overhead of paying dividends.

Effect of distributions on fund net asset value (NAV)
When a distributing fund or ETF pays you a distribution, its net asset value (NAV) drops by the per share amount of the distribution. However, ignoring costs and taxes your overall position has not changed, because you receive cash equivalent to the value of the drop in your ETF's NAV.

An accumulating fund or ETF pays no distribution, but uses the income generated by the assets in the fund to buy more of those assets internally and within the ETF. As a result, its net asset value does not drop periodically.

Modelling distributing and accumulating ETF outcomes
Whether an ETF is distributing or accumulating makes no difference to your long-term results. There are some cash flow and possible tax effects, but for two ETFs containing the exact same assets, one distributing and the other accumulating, the investment returns are the same.

Here is an example. Suppose two ETFs, one named DIST that is distributing, and one named ACCM that is accumulating. Both launch on the same day with an initial NAV of €1, and both contain the exact same assets. The assets return 10% annually, 7% as capital gains and 3% as dividends. ACCM reinvests the 3% dividend internally into more of the same assets that it already holds, and DIST pays this 3% to investors as a dividend distribution.

Accumulation phase
The following table compares the results of two imaginary investors. Alice buys €10,000 of DIST, and Bob buys €10,000 of ACCM. Alice reinvests her entire annual dividend distribution into DIST shares as she receives it, and Bob does nothing. The table ignores both tax and trading costs, and assumes no capital gains or other non-dividend distributions.

At the start of year 1, both Alice and Bob hold the same number of shares. At the end of the year, ACCM's net asset value is €1.10, because the ETF has internally reinvested the 3% dividend paid out by the stocks it holds into more of the same stocks, and DIST's net asset value is €1.07 because it dropped from €1.10 when it paid out 3% as a dividend. However, Alice used her 3% dividend distribution, €300, to purchase 280 more shares of DIST, leaving €0.40 in cash because she can only purchase and hold whole numbers of shares. So Alice and Bob finish the year equal.

At the end of year 2, the same happens. ACCM's net asset value rises to €1.21, DIST's to €1.1449, and as before, Alice uses her 3% dividend distribution, €329.99, to purchase 288 more shares of DIST at €1.1449/share, again leaving a tiny amount of cash but with Alice and Bob otherwise in the same final position.

This repeats for years 3 to 10. In years 4, 6, 7 and 9, enough cash has accumulated to allow Alice to buy one more share than is covered by the dividends she receives.

At the end of ten years, although Alice has suffered a small cash drag because she cannot hold fractional ETF shares, the difference in the results is less than 0.01%. If she could have held fractional shares, the results would be exactly identical.

Decumulation phase
Now suppose that after ten years of accumulating, Alice and Bob start withdrawing from their portfolios instead. For simplicity, assume a 3% annual withdrawal rate, meaning that Alice simply withdraws the dividends as she receives them. Because Bob receives no dividend payments, he will need to sell ACCM shares to realise income. The following table compares the results. As above, the table ignores both tax and trading costs, and assumes no capital gains or other non-dividend distributions.

In year 1, Alice receives €778.05 in income and sells no shares. Bob needs to sell 272 shares to raise the same amount, less a small offset because he cannot use fractional ETF shares, leaving him with 9,728 shares. In year 2, Alice receives €832.51 and Bob raises the cash for his withdrawal by selling 265 shares.

This repeats for years 3 to 10. After ten years, Bob has withdrawn €10,728.55 from his portfolio and holds €51,055.00 in ACCM for a total €61,783.55, and Alice has withdrawn €10,749.86 and holds €51,017.92 in DIST for a total €61,767.78. The difference in outcomes is below 0.01%, and again results purely from cash effects due to fractional ETF shares not being available.

Effect of taxes
In some countries, investors do not have to pay taxes on dividends that they do not receive. If you live in one of these countries, holding accumulating ETFs could give you a useful tax advantage over distributing ones. Even if you have to pay tax later on the gains when you sell the shares, letting the dividends compound gives you a better tax result.

In other countries, for example the UK, investors need to pay income tax annually on dividends, whether distributed or not, but they can subtract these out later for capital gains tax. Under this arrangement, the long term tax result from both distributing and accumulating funds and ETFs is identical. There can however be a cash flow problem where you have to pay tax on a 'notional' dividend that you have not actually received.

In countries that do not tax dividends but do tax capital gains, distributing ETFs might be preferable. On the other hand, in countries that tax dividends but not capital gains, accumulating ETFs might be preferable. You need to analyse your own local tax situation carefully to make best use of the choice of share classes.

Effect of trading charges
If you would always reinvest your dividend income, you gain a modest but clear advantage from accumulating ETFs, because of lower cash drag, and because you avoid possible trading costs to reinvest. Accumulating funds are useful for long term buy and hold investments during the 'accumulation' phase of investing.

Conversely, if you would use ETF dividends for income, you might face higher trading costs if you used accumulating ETFs instead of distributing ones. So for the 'decumulation' phase of investing, distributing ETFs may be the better option.

In practice, when moving from 'accumulation' to 'decumulation' it may be difficult for you to switch between the two types of ETF without incurring a significant capital gains tax liability, particularly outside of tax-sheltered accounts. However, the effect of trading costs will generally be relatively low compared to the likely tax costs, so for most investors the tax effects will dominate.

Effect of large NAVs
A distributing ETF with a large NAV can result in larger cash drag, because most investors cannot hold fractional shares. This is particularly true for relatively small purchases when reinvesting dividends. Where one is available, using an equivalent or closely similar accumulating ETF helps to reduce this problem.

Comparing real distributing and accumulating ETFs
Comparing the performance of two real ETFs, one distributing and one accumulating, can be difficult in practice. The usual method is to add back any dividend distribution to the annual NAV gain. This is easy over a single year, but quickly becomes complicated to calculate manually over a longer period.

If 'total return' charts or statistics are available for each ETF then this should give you the best comparison. However, even here some care is required. For example, a 'total return' chart might assume a particular tax rate on dividends that is at best an estimate and which will distort the comparison.

Overall though, it should be safe to assume that apart from differences in tracking error, two ETFs that track the exact same index, one distributing and the other accumulating, should produce broadly identical results, because they hold broadly identical assets. While your local tax laws may change the final outcome, the fact that one ETF is accumulating and the other distributing does not affect your pre-tax results.