How do accumulating ETFs actually work?

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An ETF may receive dividends or interests from its holdings (e.g., companies, bonds, etc.). Distributing ETFs distribute that income by paying out dividends to investors. Accumulating ETFs reinvest that income within the fund and don’t pay out dividends. It sounds simple but accumulating ETFs cause a lot of confusion. Many don’t understand how they work and why accumulating and distributing ETFs have the same total returns.

To understand accumulating ETFs, you have to learn how a fund is valued and how dividends affect that valuation.

You can calculate the total net value of an ETF by estimating its assets and subtracting its liabilities. An asset is something the ETF owns. Often the assets are equities and bonds, but they may also be cash. A liability is something the ETF owes (e.g., management fees). At the time of writing, the iShares MSCI World UCTIS ETF (ISIN IE00B4WXJJ64) has a net value of € 4,128,985,920.

net_value = assets - liabilities

The NAV of an ETF is the net value divided by the total amount of shares. The NAV tells us how much each share is worth. You typically trade shares on the stock exchange at prices that are close to the NAV. At the time of writing, the iShares MSCI World UCITS ETF has a NAV of €135.79.

NAV = net_value / total_shares

Let’s imagine a hypothetical ETF with a net value of €100,000 allocated the following way:

  • Assets
    • 2,000 shares of Acme Corp at €40 each
    • 250 shares of Aurora Inc. at €80 each
    • €0 in cash
  • Liabilities
    • €0 

The ETF has 1,000 shares therefore its NAV is €100 (€100,000 / 1,000).

When Acme Corp issues a dividend of €0.8 per share, the ETF gets €1,600 (€0.8 * 2,000) in cash. The ETF now has a net value of €101,600 and a NAV of €101.60:

  • Assets
    • 2,000 shares of Acme Corp at €40 each
    • 250 shares of Aurora Inc. at €80 each
    • €1,600 in cash
  • Liabilities
    • €0

Let’s imagine Alice owns 20 shares of the ETF. Her balance is:

  • ETF: 20 shares at €101.60 = €2,032
  • Cash: €0
  • Total: €2,032

A distributing ETF will distribute the cash – €1,600, €1.6 per share – to its investors. After dividends are distributed, the ETF’s net value decreases to €100,000 and the NAV to €100:

  • Assets
    • 2,000 shares of Acme Corp at €40 each
    • 250 shares of Aurora Inc. at €80 each
    • €0 in cash
  • Liabilities
    • €0

Alice will get a total of €32 in dividends (20 * €1.6) from the distributing ETF. Her total balance is:

  • Distributing ETF: 20 shares at €100 = €2,000
  • Cash: €32
  • Total: €2,032

An accumulating ETF will keep the cash. It will eventually reinvest the cash by buying more shares of companies. The ETF’s net value/NAV (€101,600; €101.6) does not decrease because it kept the cash:

  • Assets
    • 2,000 shares of Acme Corp at €40 each
    • 250 shares of Aurora Inc. at €80 each
    • €1,600 in cash
  • Liabilities
    • €0

Alice’s total balance from the accumulating ETF would be:

  • Accumulating ETF: 20 shares at €101.60 = €2,032
  • Cash: €0
  • Total: €2,032

Alice’s total balance is the same regardless if the ETF is distributing or accumulating. The dividend distribution policy only affects the allocation of profits. Distributing funds have profits allocated across dividends and capital gains. Accumulating funds only have profits through capital gains. The total value of profits is the same when not considering taxes and brokerage fees.

Dividends affect the ETF’s net value. The ETF’s net value/NAV increases when the underlying companies distribute dividends to the ETF. The ETF’s net value/NAV decreases when the ETF distributes dividends to its investors.

A distributing ETF where you manually reinvest dividends has the same returns as an equivalent accumulating ETF when not considering taxes and fees. The graph below compares the accumulating (blue line) and distributing (red line) versions of the Vanguard FTSE All-World ETF. The lines overlap because the returns are the same, so you can’t even see the blue line.

Accumulating funds may have higher returns when considering taxes and brokerage fees.

Read my book, Introduction to Investing in Index Funds and ETFs, to learn more about investing in ETFs while living in Europe. The book gets frequent updates, and I just released its 2nd edition on December 16th 2020.

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Disclaimer: This information is for educational and entertainment purposes only. This does not represent, in any case, specific investment, legal nor tax advice nor recommendations to purchase a particular financial product. Learn more at https://indexfundinvestor.eu/disclaimers/