Comparison of accumulating ETFs and distributing ETFs

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Non-US investors often have a choice between accumulating ETF and distributing ETF share classes. This page 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. Every investor should investigate their personal situation on taxes and costs to choose between distributing and accumulating ETFs.

Introduction

Depending on the country in which they are domiciled, a fund will need to adhere to different legislation and be subject on different taxation.

One of the main differences between US domiciled and Non-US domiciled funds and ETFs is that US fund regulations require a US domiciled mutual fund or ETF (exchange-traded fund) to distribute at least 90% of its income to shareholders.[1]

Non-US domiciled funds and ETFs do not have the same restriction, and depending on the regulations of the country in which they are domiciled, they can reinvest the received dividends and interest without distributing them. This allows them to create different classes of ETF shares. Those that pay dividends periodically to investors are known as distributing ETFs. Others can elect to 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 gain a tax advantage by preferring one class of ETF shares over another, depending on local country tax law. However, excluding 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 will periodically pay out dividend distributions, and may have to pay out capital gains distributions, both short-term and long-term. It does this to meet US regulations[1] for investment companies. These are the funds and ETFs generally discussed by and available to US investors.

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.

At the time of writing, most non-US domiciled ETFs are still distributing, but the number of accumulating ETFs is increasing. Where an ETF's dividend would be small, ETF issuers might find using accumulating share classes to be a convenient way to avoid the administrative overhead of paying dividends to investors.

Effect of distributions on fund net asset value (NAV)

When a distributing fund or ETF pays a distribution, its net asset value will drop by the per share amount of the distribution. However, ignoring costs and taxes the investor's position has not changed, because they will receive cash to the value of the drop in their ETF holding's valuation.

In comparison, 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 the long-term results returned to investors. 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 are launched 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.

Although the example uses EUR, this result is general to ETFs denominated or traded in any currency.

Accumulation phase

The following table compares the results of two investors, one who buys €10,000 of DIST and the other who buys €10,000 of ACCM. The DIST investor reinvests their entire annual dividend distribution into DIST shares as they receive it, and the ACCM investor does nothing. The table ignores both tax and trading costs, and assumes no capital gains or other non-dividend distributions.

Comparison of accumulating and distributing ETF investor outcomes, accumulation phase
Accumulating ETF investor Distributing ETF investor
Year ACCM net asset value Shares held Holding balance Cash balance DIST net asset value Shares held Holding balance Cash balance
€1.0000 10000 €10,000.00 €1.0000 10000 €10,000.00
1 €1.1000 10000 €11,000.00 €0.00 €1.0700 10280 €10,999.60 €0.40
2 €1.2100 10000 €12,100.00 €0.00 €1.1449 10568 €12,099.30 €0.66
3 €1.3310 10000 €13,310.00 €0.00 €1.2250 10864 €13,308.87 €1.02
4 €1.4641 10000 €14,641.00 €0.00 €1.3108 11169 €14,640.28 €0.50
5 €1.6105 10000 €16,105.10 €0.00 €1.4026 11482 €16,104.10 €0.71
6 €1.7716 10000 €17,715.61 €0.00 €1.5007 11804 €17,714.62 €0.59
7 €1.9487 10000 €19,487.17 €0.00 €1.6058 12135 €19,486.16 €0.52
8 €2.1436 10000 €21,435.89 €0.00 €1.7182 12475 €21,434.37 €0.92
9 €2.3579 10000 €23,579.48 €0.00 €1.8385 12825 €23,578.24 €0.49
10 €2.5937 10000 €25,937.42 €0.00 €1.9672 13184 €25,934.92 €1.63

At the start of year 1, the both investors 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, the DIST investor used this 3% dividend distribution, €300, to purchase 280 more shares of DIST, leaving €0.40 in cash because shares can only be purchased and held in whole numbers. The final position of both investors is the same.

At the end of year 2, the same happens. ACCM's net asset value rises to €1.21, DIST's to €1.1449, and the DIST investor uses the 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 the two investors 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 the investor holding DIST to buy one more share than is covered by the dividend paid out to them by the ETF.

At the end of ten years, although the DIST investor has suffered a small cash drag because they cannot hold fractional ETF shares, the difference in the results is less than 0.01%. If fractional shares were available, the results would be exactly identical.

Decumulation phase

Now suppose that after ten years of accumulating, these investors start withdrawing from their portfolios instead. For simplicity, assume a 3% annual withdrawal rate, meaning that the DIST investor simply withdraws the dividends as they receive them. Because the ACCM investor receives no dividend payments, they will need to sell ACCM shares to realise their income. As above, the table ignores both tax and trading costs, and assumes no capital gains or other non-dividend distributions.

Comparison of accumulating and distributing ETF investor outcomes, decumulation phase
Accumulating ETF investor Distributing ETF investor
Year ACCM net asset value Shares held Holding balance Cash withdrawal DIST net asset value Shares held Holding balance Cash withdrawal
€2.5937 10000 €25,937.42 €1.9672 13184 €25,934.92
1 €2.8531 9728 €27,755.12 €776.05 €2.1049 13184 €27,750.37 €778.05
2 €3.1384 9463 €29,698.95 €831.68 €2.2522 13184 €29,692.89 €832.51
3 €3.4523 9205 €31,778.16 €890.69 €2.4098 13184 €31,771.40 €890.79
4 €3.7975 8955 €34,006.60 €949.37 €2.5785 13184 €33,995.39 €953.14
5 €4.1772 8711 €36,388.01 €1,019.25 €2.7590 13184 €36,375.07 €1,019.86
6 €4.5950 8474 €38,937.80 €1,089.01 €2.9522 13184 €38,921.33 €1,091.25
7 €5.0545 8243 €41,664.00 €1,167.58 €3.1588 13184 €41,645.82 €1,167.64
8 €5.5599 8019 €44,584.98 €1,245.42 €3.3799 13184 €44,561.03 €1,249.37
9 €6.1159 7801 €47,710.21 €1,333.27 €3.6165 13184 €47,680.30 €1,336.83
10 €6.7275 7589 €51,055.00 €1,426.23 €3.8697 13184 €51,017.92 €1,430.41

In year 1, the DIST investor receives €778.05 in income and sells no shares. The ACCM investor needs to sell 272 shares to raise the same amount, less a small offset because fractional ETF shares cannot be held, leaving them with 9,728 shares. In year 2, the DIST investor receives €832.51 and the ACCM investor raises the cash for their withdrawal by selling 265 shares.

This repeats for years 3 to 10. After ten years, the ACCM investor has withdrawn €10,728.55 from their portfolio and holds €51,055.00 in ACCM for a total €61,783.55, and the DIST investor has withdrawn €10,749.86 and holds €51,017.92 in DIST for a total €61,767.78. The difference in these 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. For investors in these countries, holding accumulating ETFs can provide a usable tax advantage over distributing ones. Even if there is a tax to pay later on the gains when the shares are sold, allowing the dividends to compound with taxes deferred is a useful advantage.

In other countries, for example the UK,[2] investors need to pay income tax annually on dividends, whether distributed or not, but these can be subtracted out later for capital gains tax. Under this regime, the long term tax result from both distributing and accumulating funds and ETFs is identical. There can however be a cash flow problem where tax has to be paid on a 'notional' dividend that the investor has not actually received.

In countries that do not tax dividends but 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. Investors need to analyse their own local tax situation carefully to make best use of the choice of share classes.

Effect of trading charges

An investor who always reinvests dividend income gains a modest but clear advantage from accumulating ETFs, because they avoid the trading cost of reinvesting. Accumulating funds are useful for long term buy and hold investments during the 'accumulation' phase of investing.

Conversely, an investor using ETFs to provide income might face higher trading costs if they 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 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. Using an equivalent or closely similar accumulating ETF, if one is available, will help to mitigate 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[3]. 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 provide 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 the assets they hold will themselves produced broadly identical results. While local tax laws may change the final outcome, the fact that one ETF is accumulating and the other distributing does not affect the results returned by the ETF by the investor.

See also

References

External links