Phantom Distributions: How to Make Sense of Them?

Have you noticed that the book value (or Adjusted Cost Base - ACB) on your latest account statement has changed, and you cannot figure out why? This is often due to phantom distributions.

What are phantom distributions?

• These are distributions that are reinvested directly within the ETF rather than being paid out in cash or as additional units, as is the case with mutual funds.

Why does this happen?

• Normally, an ETF distributes most of its earnings in cash (deposited into your account), and you are taxed on this amount. However, in some cases, an ETF may choose to reinvest all or part of its distributions. Even if investors do not actually receive the cash, they are still taxed on the distribution. To compensate for this and avoid double taxation when the investment is sold, the ETF increases the book value (ACB) by the same amount as the reinvested distributions. These reinvested, taxable but non-received distributions are what we call phantom distributions. On T3 tax slips, there is no distinction between cash distributions and reinvested (phantom) distributions. Since no cash is received in the case of phantom distributions, it can be harder to track these transactions because the difference will only be reflected in the increase in book value.

Why not simply pay out all capital gains and other distributions in cash instead of reinvesting and increasing the ACB?

• This is because ETFs generally do not hold excess cash throughout the year to make these distributions. If they did, the retained cash could weigh down the ETF’s performance compared to its benchmark index (which it aims to replicate), giving the impression that the ETF is underperforming—something that fund managers want to avoid.

Why not just issue additional units like mutual funds instead of reinvesting and creating phantom distributions?

• The goal is to ensure that the net asset value (NAV) per unit and the number of units held by investors remain the same after the reinvested distribution. If this were not the case, it could create tracking errors when comparing the ETF’s unit price with its benchmark index, which we want to avoid (for an index-tracking ETF, accurately replicating the per-unit performance of the benchmark is crucial).
  

To clarify, here's an example:

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IMPORTANT DISCLAIMERS

Patrick Racicot and Loïc Poupart are associated with PEAK Securities Inc. PEAK Securities Inc. is a full-service investment dealer registered with the IIROC, limiting its responsibilities to investment products such as stocks, bonds, ETFs and mutual funds. PEAK Securities Inc. is a member of the Canadian Investor Protection Fund (CIPF). Services available only to residents of Quebec and Ontario. Consult our privacy policy.

The information contained in this document has been prepared by Patrick Racicot, Portfolio Manager, and Loïc Poupart, Investment Advisor, of PEAK Securities Inc. and has been obtained from sources believed to be reliable and relevant. The information in this document is of a general nature and may not be complete with respect to your personal situation. This document does not constitute investment advice. The opinions expressed herein do not necessarily reflect those of PEAK Securities Inc. PEAK Securities Inc. is not responsible for the content of this document.