Investors using the TD e-Series mutual funds may have noticed an unusual episode at year-end. The TD International Index Fund (TDB911), which has been making quarterly distributions for years, did not make one in December 2020. This has caused some confusion, so let’s try to clear up The Curious Case of the Missing Distribution.
The first thing to appreciate is that fund investors didn’t get short-changed. While TDB911 did not pay out a cash distribution in the fourth quarter of 2020, investors still got the full benefit of the dividends paid by the stocks in the fund.
Since equity index funds often hold hundreds or thousands of individual stocks, they receive a steady stream of dividends. Of course, they don’t pay them out as fast as they come in. Instead, they typically reinvest most of that cash by purchasing more shares, and this is reflected in the fund’s net asset value: in other words, its unit price.
At regular intervals—most often quarterly, but sometimes monthly, semi-annually, or annually—funds can pay out the dividends in cash to unitholders, but they’re not required to. If the fund doesn’t make a cash distribution, investors still benefit, since the value of the fund includes dividends that were retained and reinvested.
If the fund does pay a cash distribution, then things get more complicated. The fund’s price will fall by an amount equal to the distribution, just like a stock or ETF does on the ex-dividend date. And if you’ve elected to reinvest all distributions (as most mutual funds investors do), you’ll receive additional units of the fund.
The key point here is that the distribution policy doesn’t make any meaningful difference: in both cases, the overall value of the holding would be the same.
Consider Rob, who owns 1,000 units of a fund with a unit price of $30, so his holding is valued at $30,000. At year-end, the fund pays no cash distribution. Nothing changes: Rob still holds 1,000 shares, they’re still priced at $30, and his holding is still worth $30,000.
Now imagine Patty also owns 1,000 units of a fund with a unit price of $30, so her holding is valued at $30,000. At year-end, this fund pays a cash distribution of $1.50 per unit, or $1,500 in total, which is automatically reinvested.
In Patty’s case, the unit price of the fund will fall to $28.50 when the distribution is paid, and the $1,500 will be used to purchase 52.6316 new units (that’s $1,500 divided by $28.50). Patty now owns 1,052.6316 units of the fund at $28.50 each, for a total value of $30,000.
The ETF that lies beneath
You can see this principle at work when you compare the 2020 return of TDB911 to that of its underlying holding, the TD International Equity Index ETF (TPE). The ETF paid all four quarterly cash distributions in 2020, and these added up to just over $0.47 for the year. Assuming those distributions were reinvested immediately (this is the way ETF performance is always measured) the fund reported a total return of 5.75% in 2020.
Compare this to TDB911 which made just three quarterly distributions, skipping out on the December payout. However, the fund still delivered an annual return of 5.48% for the year. The difference in return between the ETF and the mutual fund is explained entirely by fees: TPE is 27 basis points cheaper. The distribution policy had no effect.
If you hold TDB911 in a TFSA or an RRSP and you reinvest your distributions, you should be indifferent to whether the fund pays cash distributions or simply reinvests all the dividends. It won’t affect your returns in any way. The only difference is, if there is no cash distribution, you won’t see any change in the number of units you own, nor will you see an adjustment to the unit price.
Yeah, you still need to pay the tax
If you hold TDB911 in a taxable account, however, there’s a second important idea to understand. Even though you received no cash distribution, you will still need to pay tax on the reinvested dividends.
This can be confusing, and the situation apparently hasn’t been helped by TD’s customer service reps. One reader said he contacted TD about the missing distribution and was told it would provide a tax benefit: “It is generally more valuable to the client to have no payout,” the rep told him, because only cash distributions are taxable. This is nonsense. Despite the TD rep’s wishful thinking, you can’t escape paying taxes on dividends by reinvesting them instead of taking them in cash. Wouldn’t it be nice if you could.
As we’ve said, the ETF version of this fund paid a cash distribution of about $0.47 per unit last year, which works out to a yield of about 2.5%. Since TDB911 is almost entirely made up of this ETF, its unitholders would have received those same dividends, so they will face essentially the same tax liability. If you held $10,000 worth of TDB911 in a taxable account for all of 2020, you should expect to receive a T3 slip at tax time, and this should declare foreign dividends of approximately $250.
I can’t explain why TD elected not to make a cash distribution from its international index fund at the end of 2020. But if you’re using the e-Series funds in your portfolio, rest assured the decision won’t have any material effect on your performance or your tax bill.