All investment companies (“Funds”) registered under The Investment Company Act of 1940 are required to calculate and present a Total Return in their financial statements. Total Return represents the rate that an investor would have earned (or lost) on an investment in the Fund, assuming reinvestment of all dividends and distributions. Instructions for computing Total Return can be found in the SEC instructions to the Registration Statement, Form N-1A for open-end funds and Form N-2 for closed-end funds. The instructions to form N-1A require Funds to compute Total Return assuming the initial investment is made at the net asset value at the beginning of the period, distributions are reinvested at the net asset value on the ex-dividend date, and all shares are redeemed at net asset value on the last business day of the period. For closed-end funds that file registration statements on Form N-2, Total Return is calculated assuming the initial shares are purchased at the market price on the first day of the period, distributions are reinvested at prices obtained by the Fund’s dividend reinvestment plan or, if there is no plan, at the lower of the per share net asset value or the closing market price of the Fund’s shares on either the ex-dividend or distribution pay date, and all shares are sold at the market price on the last day of the reporting period.

Most Exchange Traded Funds (“ETFs”) file their registration statements on Form N-1A, and therefore compute and present Total Return based on net asset values as required by the instructions to Form N-1A. However, ETFs contain characteristics of both open end and closed end funds, and therefore the net asset value total return is not representative of the return that most of the Fund’s shareholders would earn (please see previous post on the inadequacies of the two methods for computing total returns for ETFs.) As a result, it is common practice for ETFs to present both net asset value (N-1A) returns and market price (N-2) returns.

As ETFs do not have dividend reinvestment plans, when calculating the market price (N-2) returns, it is normally assumed that distributions are reinvested at the market price on the distribution pay date. Depending on the timing of the distributions, this can produce a Total Return that is not accurate. Most ETFs are structured as Regulated Investment Companies (“RICs”) for tax purposes. IRS rules for RICs require them to distribute income earned in the calendar year, and capital gains earned in the 12-month period ending October 31, by the end of each calendar year. Due to logistical difficulties in determining all of a Fund's calendar year income and distributing such income in the same calendar year, the IRS allows such distributions to be paid in January, so long as the record and ex-dividend dates are in the calendar year. Therefore, it is not uncommon for RICs, including ETFs, to make distributions with record and ex dates in December that are not paid until January. According to the Total Return methodology described above for market price returns, distributions paid under this assumption would not be reflected in a Fund’s calendar year Total Return calculation, even though the Fund’s shareholders on the ex-dividend date would be entitled to receive the distribution, and the net asset value and market price per share would have been reduced by the amount on the distribution on the ex-dividend date. Therefore, in such circumstances, it is necessary to assume the distribution was reinvested on the last day of the period in order to give an accurate portrayal of the Total Return an investor would have earned on an investment in the Fund’s shares during the period.

Consider the following example:

1. Market price at the beginning of the period (January 1) is $10.
2. The Fund appreciates to $11.50 and declares a $1.00 dividend, ex-dividend date in December, payable in January
3. The market price of the Fund on December 31^st is $10.50

Based on the facts above and according to the instructions in Form N-2, the total return of the Fund would be 5% as the distribution is not reinvested until the pay date in January. This is clearly not an accurate portrayal as a shareholder who redeemed their shares on December 31 would still be entitled to receive the $1 per share distribution in January and would have effectively earned $1.50 per share or 15% total return ($1 per share dividend and $.50 per share price appreciation.) Therefore, it is necessary to include the distribution in the calendar total return calculation. Assuming reinvestment on the last day of the period is the most accurate way of reflecting this would produce a correct Total Return figure of 15%.

As a financial statement preparer or an auditor of financial statements, it is important to apply the “smell” test when analyzing figures in a financial statement. There is a completely logical reason for assuming distributions are reinvested at the market price on the pay date when calculating market value returns. Market price on the pay date does represent, after all, the earliest date the distributions can be reinvested and the price at which they can be reinvested. However, one must assume the reinvestment of distributions on the pay date when the ex-dividend and pay dates straddle a reporting period will clearly produce an inaccurate total return figure. Although not contemplated in the N-2 Total Return instructions, assuming distributions are reinvested at period-end in such circumstances is undoubtedly the correct approach and helps to highlight the need for ETFs to have their own set of rules.