Why ETF distributions fluctuate

Investors often wonder why Exchange-Traded Fund (ETF) distributions fluctuate even when the securities held by the fund and the distributions of the holdings change very little. To better understand the issue, let us take a look at the cash distributions from the iShares S&P/TSX Capped REIT ETF (TSX: XRE) in the table below.

The distributions from XRE dropped 26 percent in 2009 from the year before. What could explain such a steep drop?

Changes in Fund Holdings

XRE’s holdings changed very little in 2009. The fund held 11 REITs in 2008 and eliminated one of its holdings — InnVest REIT — in 2009. InnVest REIT made up just 2.9 percent of XRE’s total assets in 2008, so the change in fund holdings would not explain the big drop in distributions from XRE in 2009.

Changes in Distributions from Holdings

H&R REIT (TSX: HR.UN) cut its monthly distributions in half in January 2009. As H&R REIT had a weight of 10 to 15 percent in XRE in 2009, its distribution cut had an impact on XRE’s distributions. If we assume the H&R REIT and XRE had a similar distribution yield, all things being equal, a 50 percent cut in H&R’s distributions would translate into a 5 to 7.5 percent cut in distributions of XRE. H&R’s distribution cut partially explains XRE’s drop but we must look for the main culprit elsewhere

Exchange-Traded Fund Flows

When a fund experiences significant inflows (or outflows), it can result in a lower (or higher) distributions per unit. Suppose Pretend ETF has a NAV of $10 per unit and 100 units outstanding all of it owned by investor John. The fund then receives a $100 dividend and the NAV per unit increases to $11. John expects a distribution of $1 per unit ($100/100 units) at the end of the month. Later in the month, 100 more units were created at a NAV of $11 because investor Jane purchased units of Pretend ETF. The fund now has a NAV of $11 per unit and 200 units outstanding. At the end of the month, Pretend ETF distributes the $100 in dividends it received earlier in the month but the distributions per unit falls to $0.50 because the $100 dividend is spread over 200 units. After the distribution, the NAV of Pretend ETF falls to $10.50.

Note that the total wealth of all investors in Pretend ETF has not been affected even though distribution fell in half. John’s distributions fell by $0.50 but the NAV of the fund increased by $0.50, so his total gain is still $1. Jane invested $11 in the fund and received a distribution of $0.50 but the NAV of the fund fell to $10.50.¹

The bulk of the drop in distributions in XRE can be explained by fund inflows. XRE had total assets of $290 million at the end of 2008. In 2009, the fund experienced $407 million in inflows. Investors wondering why a new fund like the Vanguard FTSE Canada ETF (VCE) or Vanguard FTSE Canadian REIT ETF (VRE) has a distribution yield that is different from that of the index should also look at fund flows for an explanation.

^{1. Thanks to iShares Canada for this explanation↩}

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