Mutual Fund Distribution

Mutual fund distribution refers to payments made by mutual funds to their shareholders. The purpose of the distribution is to share the profits or income earned from the different securities in the portfolio with the unitholders and adhere to the legal requirements.

Typically, mutual funds derive these distributions from the income earned from the investments. This income can include interest received from bonds and dividends earned from stocks. Moreover, it may also consist of foreign non-business earnings, return of capital distributions and the capital gains generated by selling financial instruments in the portfolio.

Mutual fund distribution refers to the earnings generated by mutual funds that they pass on to their unitholders. Funds must make these payments at regular intervals to share their profits and ensure legal compliance.

Per the Investment Company Act introduced in 1940, mutual funds have an obligation to pass on a minimum of 98% of their overall net income earned to unitholders each year. Note that funds do not pay any tax on their earnings directly. Instead, the unitholders pay taxes on those earnings to the Internal Revenue Service or IRS.

At the end of each year, mutual funds add up all realized gains, losses, and dividends and distribute the same to every unitholder. The distribution to each unitholder is based on the number of units they hold on a particular date, i.e., the mutual fund distribution record date. In other words, the distribution to each unitholder will be proportional to their share of the income earned by the mutual fund.

 This payment to the shareholders lowers the cash available with the fund, which, in turn, decreases the net asset value or NAV. This decrease equals the distributed amount.

Let us look at the different types of mutual fund distribution in detail.

1. Interest Income: Mutual funds earn this form of income and distribute it from fixed-income securities or debt securities like bonds, debentures, etc., in their portfolio.
2. Dividend Income: Funds receive dividends and distribute the same when they allocate money to dividend-paying companies’ shares. 
3. Return of Capital (ROC): Such distributions occur if the fund returns the original investment amount of the shareholder to them. In this case, distributions exceed the fund’s earnings. This generally happens if funds aim to generate quarterly or monthly distributions.
4. Foreign Non-Business Income: Mutual funds’ distributions include these earnings when they generate income from interest payments, dividend payments, capital gains, or any other type of earnings from investments in foreign securities.
5. Capital Gains: These refer to the income generated by mutual funds through the purchase and sale of financial instruments. Simply put, funds realize capital gains when the selling price of securities exceeds the cost of purchase.

Distributions made by mutual funds may or may not have an impact on holdings based on the way in which unitholders choose to receive the distribution. Note that there are two ways of receiving it — as reinvested units or in cash. The three elements that distributions can affect are as follows:

• NAV: The NAV of a fund decreases when a fund distributes its income, irrespective of whether a unit holder receives it as reinvested units or in the form of cash.
• Book Value: Distributions received in the form of reinvested dividends generally increase the book value of unitholders’ holdings. That said, distributions in cash have no impact on the book value.
• Adjusted Cost Base or ACB:  Cash distribution does not have any effect on the ACB, whereas reinvested distributions increase the ACB.

Let us look at a few mutual fund distribution examples to understand the concept better.

Example #1

Suppose David was a unitholder in XYZ Mutual Fund who held 200 units on the mutual fund distribution record date. The fund announced a distribution of $1 per unit as it earned dividend income and capital gains during the year. David decided that he would receive the distribution in cash. Thus, he received an overall distribution worth $1 x 200 = $200. As the fund distributed its income to different unitholders, including David, its NAV decreased.

Note that since David opted to receive the payment in cash, the adjusted cost basis and book value of his holdings did not change because of the distribution. 

Example #2

In March 2024, CI Global Asset Management, one of the largest investment management companies in Canada, announced reinvested mutual fund distributions with respect to mergers of specific ETF Series of mutual funds and ETFs. These distributions were to be reinvested on/around April 5, 2024, and the record date was announced to be April 4, 2024. The units resulting from the reinvested distributions would get consolidated instantly. As a result, the overall units each shareholder held would not change.

One can understand the importance of the mutual fund distribution by going through the following points:

• Fulfilling the mutual fund distribution requirement is a legal obligation. Hence, funds need to make this type of payment to the unitholders to comply with the rules and regulations. 
• Paying distributions to shareholders lowers the overall taxes paid by a fund.
• Through these distributions, the unitholders can have a steady income stream. This is particularly beneficial for individuals seeking passive income, like retirees.
• Reinvesting these distributions can result in compound growth, which enhances investors’ total investment returns.