ETF launches are generally unexciting these days: most new products focus on increasingly narrow niches or exotic strategies. But last month BMO unveiled an innovative ETF structure that may just have some lasting appeal. They launched a new share class of four existing short-term bond ETFs: called “Accumulating Units,” these new funds do not pay their distributions in cash like traditional ETFs. Instead, they reinvest all the interest payments immediately and increase the net asset value (and market price) accordingly.
An example will help. Consider a bond ETF with a unit price of $15 at the beginning of the year. Over the next 12 months it pays out 3% in interest and falls in price by 1%. The fund’s one-year total return would therefore be 2% (the 3% interest minus the 1% capital loss). If this ETF were available in both the traditional and Accumulating Units structure, both would report the same performance. But they would arrive there in different ways:
|Traditional ETF||Accumulating Units|
|Unit price at beginning of year||$15.00||$15.00|
|Cash distributions (3%)||$0.45||$0|
|Reinvested distributions (3%)||$0||$0.45|
|Capital loss (1%)||-$0.15||-$0.15|
|Unit price at end of year||$14.85||$15.30|
|Value of ETF unit + cash||$15.30||$15.30|
|One-year total return||2%||2%|
What they’re not
The idea of reinvested distributions is not new, but the Accumulating Units structure is quite different from other strategies you may be familiar with:
They don’t work like mutual funds. One of the benefits of mutual funds is that interest and dividends can be fully reinvested rather than paid in cash. The net asset value of the fund increases to reflect this reinvested income over the course of the year, the same as in the Accumulating Units structure.
With a mutual fund, however, the unit price falls at the end of the year when the fund declares that distribution. Then each unitholder receives additional shares at that lower price. The value of your overall holding stays the same, but you now have more shares, each with a lower price. (For an excellent explanation of reinvested distributions in mutual funds, see page 10 of this guide from RBC.)
BMO’s Accumulation Units do not work the same way: when these ETFs declare their distributions, you won’t see the unit price fall, and you won’t receive any additional shares.
They’re not glorified DRIPs. A dividend reinvestment plan (DRIP) allows you to receive ETF distributions in the form of new shares rather than cash. You can set these up through your brokerage, and they’re a convenient way to reduce trading costs and keep your cash balance to a minimum. Unlike with mutual funds, which allow you to hold fractional shares, with ETFs you can only receive whole shares. So if the fund’s price is $20 and the distribution is $104, you’ll get five new shares plus $4 in cash.
BMO’s Accumulation Units do allow you reinvest every cent of the ETF’s distributions, but it’s not helpful to think of them as glorified DRIPs: they work quite differently. With a DRIP, the number of shares you hold increases with each reinvested distribution. But with these new ETFs, the number of units you hold stays constant and the reinvestment is reflected in a higher price per unit.
They’re not the same as swaps. Horizons ETFs offers several funds that use total-return swaps rather than holding stocks or bonds directly. These ETFs do not pay any distributions: the effect of dividends and interest causes the share price of the ETF to increase. Swap-based ETFs and Accumulating Units have that much in common, but the similarities end there.
The appeal of swap-based ETFs is they generate no taxable dividends or interest: all of the price increases will eventually be taxed as capital gains (or losses) when you sell your shares. But Accumulating Units offer absolutely no tax advantage over traditional ETFs: all of the reinvested distributions from BMO’s new bond ETFs will be fully taxable as interest.
Another important difference between swap-based ETFs and Accumulating Units is that the latter hold the underlying securities directly. The Horizons ETFs use a derivative and carry some additional risk due to this “synthetic” structure.
Where to use them
BMO’s Accumulating Units structure is an innovative idea, and they may be useful for investors who don’t need income and would prefer to take full advantage of compounding.
There may be a behavioural benefit as well, at least when it comes to bond ETFs. These days most bonds in traditional ETFs trade at a premium, which means their current price is above their par value because the bonds were issued when interest rates were higher. As these bonds approach maturity their prices gradually decline, and the ETF’s unit price falls along with it—like the traditional ETF in the example above. Investors holding that ETF would have enjoyed a 2% return, but many would have failed to account for the cash distributions: they would have seen their ETF fall in price from $15 to $14.85 and figured they lost money. Meanwhile, an investor using Accumulating Units would clearly see the 2% return in the price increase from $15 to $15.30.
That said, I strongly recommend against using Accumulating Units in a taxable account. These funds would make tracking your adjusted cost base a nightmare. You would need to adjust the book value of the fund upwards for every reinvested distribution or you could end up reporting capital gains that didn’t exist and paying a large amount of unnecessary tax.
Let’s return to the above example to illustrate. An investor who sold her traditional ETF units at the end of the year would properly report a capital loss of $0.15 per share, since she bought the ETF at $15 and sold it at $14.85. But the investor in the Accumulating Units might find himself reporting a capital gain of $0.30 per share, since be bought at $15 and sold at $15.30. But this is incorrect: he should have adjusted his cost base by adding the $0.45 in reinvested distributions, resulting in a book value of $15.45 per share. Then when he sold the shares at $15.30 he would report the same $0.15 capital loss.
As I’ve written about many times, even traditional bond ETFs are poor choice in a non-registered account, so perhaps these four new funds from BMO won’t be tempting for taxable investors. But if the structure catches on and fund providers start offering, say, Canadian equity ETFs with an Accumulating Units structure, they have the potential to trip up a lot of investors with taxable accounts. And the cost of improper tax reporting could be huge. So keep these ETFs where they belong: in your RRSP or other registered account.