Distribution Primer

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This time of year, many investors have questions about recent distributions in their accounts.  In short, a distribution is just an investment paying out cash for various reasons.  To help explain what these payments mean, here are a few simple definitions.

One of the most common types of distributions you’ll see throughout the year are dividend payments.  Generally these payments arise when the underlying investments in the funds in your portfolio either earn interest (as in bonds) or pay a dividend (as in stocks).  These distributions are simply a way of making the cash that’s created by the underlying investments in your funds come to you directly as the owner of the fund.  These distributions are typically considered income and therefore taxed at income tax rates.

A capital gain generally occurs when you sell something for more than you paid for it.  For example, if you bought a $100 investment and sell it later for $110, you incurred a capital gain of $10 which may be subject to taxes.  The nice thing about capital gains is that they are only based on the gain ($10 not $110 in this example) and long term gains (for positions held more than one year) might have a more favorable tax rate than rates used for short term gains or ordinary income. 

Mutual funds are creating capital gains and losses frequently as they buy and sell securities within the fund.  From time to time they must distribute the net capital gains to shareholders (usually in December).  One reason these distributions are required is that unless they were distributed nobody would pay taxes on those gains, perhaps indefinitely.  Mutual funds distribute these capital gains to you, so you likely have to pay the tax on these gains but also receive some cash to use for the tax. 

Fund pricing around a distribution can be confusing because big drops in share price can occur, but there is nothing to worry about.  Imagine a fund priced at $10 per share that is about to do a $2 capital gain distribution.  Just before this distribution, the fund must hold $8 in securities and $2 in cash ready to distribute, which adds up to the $10 net asset value of the fund.  Just after the distribution, you hold the $2 and the fund now holds only $8 in securities, so it’s NAV went from $10 to $8.  The fund didn’t really lose 20% of its value, it just gave it back to shareholders.  That’s why it’s important to consider total return (including all distributions) rather than just the change in any fund’s price over time.

When you receive your next statement, you will see these dividends and capital gains transactions have hit your accounts, which is welcome.  Dividends in particular are a huge contributor to long-term total return in investment markets.  These distributions are a normal part of the process of owning mutual funds and are just one more way your investments contribute to your secure financial future here at Telarray. 


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