ETF Distributions - NAV Erosion, Annualization, and Reverse Splits

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By and large, exchange-traded funds (ETFs) are classified as “regulated investment companies” (RICs), a category that includes mutual funds, REITs, unit investment trusts, and any other vehicle that passes taxable income–from capital gains, interest, or dividends–to its investors.   

This is often done annually but can be done more frequently. There are a few basic ways an ETF can calculate its sub-annual distributions, but the one we’ll focus on here revolves around implied gross option premiums. This method does not take account for estimates of gains or losses, choosing instead to simply give the gross premiums back to shareholders, who can then decide what to do with them.  

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Ex-Dividend and NAV “Erosion”

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Now, we have to focus on a topic of frequent conversation among those thinking through ETF investments: NAV erosion. Recall that a fund’s NAV is akin to its share price, calculated by subtracting liabilities from assets and then dividing by the number of outstanding shares.

‍Before a distribution is made, cash is still held by the fund; after, it’s been paid out to the shareholders. Naturally, this distribution is subtracted from the fund’s NAV, which decreases. This is sometimes known as NAV erosion, but this term is based on a misunderstanding of what’s happening under the hood. There’s no erosion per se, it’s just that NAV decreases when distributions are paid out because there’s nowhere else for the money to come from. However, if an income focused ETF's total return underperforms the underlying exposure in a declining market, this could potentially mean that the distributions might be paid out of underlying capital, which can have more far-reaching deleterious consequences on the principle of a given investor. Income generated from the underlying assets in a fund is distributed in a set frequency and this income usually helps to mitigate the fund's down-side risk. If the income distribution is greater than the actual income generated by the assets in the fund, the fund can potentially lose greater asset value over time.

This distinction is very important for anyone wanting to invest wisely in ETFs. Rather than just looking at how big the annualized distribution for an ETF is, always important to understand the types of lessening NAV and monitor total returns of a fund against the underlying exposure can help investors determine if the distribution is proportional to the fund's income generating ability.

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What are Annualized Distributions?

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And speaking of annualized distributions, let’s spend a few moments disambiguating this term. We noted above that ETFs tend to pay distributions out annually but that they have the option of doing so more frequently. If they do so, they must annualize their figures by multiplying by an appropriate factor. 

Suppose, for example, a fund with a NAV of $100 has paid out a monthly distribution of $1 per share. They’d annualize by multiplying this number by 12 (the number of months in a year), and this figure would be divided into the NAV at the end of the month to yield an annualized distribution rate of 12% ($1 per share times 12 months divided by the $100 NAV).

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How do Reverse Splits Happen?

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Our final topic will be a discussion of reverse splits, which is worth understanding before you park your money in an ETF.

As their name implies, reverse splits work exactly the opposite of how a forward split works. If an ETF has 500,000 shares trading at $25 each, it could execute a 1-2 reverse stock split to halve its shares to 250,000 and double its per-share price to $50.

There are a few reasons why an ETF might execute a reverse split. If share prices decline enough a fund might risk being delisted, which calamity could be prevented with the price bump achieved through a reverse split. 

That said, reverse splits are generally not viewed favorably and often considered a warning sign. Market participants usually interpret reverse splits as evidence that a fund is in trouble and its managers are attempting to inflate a cratering share price. And, just as stock splits increase liquidity, reverse splits decrease liquidity. The ramifications of this fact are beyond the scope of this article, but it’s worth bearing in mind. 

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Conclusion

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As with any market vehicle or strategy, the wise investor will spend time understanding the underlying mechanics before deploying any capital. That’s no less true for ETFs, and a particular sticking point centers around NAV erosion and stock splits. Hopefully, this article has clarified how these work and how they might factor into your investing decisions.

If you have any questions or want to learn more, you may schedule a chat with Client Solutions team here.

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