OK so the title is a bit clickbaity which I hate, but accumulating ETFs really are an administrative blessing when it comes to the automation of your investments. This is why you really should consider them as an investment. Not only do they remove the extra steps involved when it comes to investing your money, but they also save you money by avoiding excess brokerage fees.
How they do this isn’t necessarily tricky in its own right, but understanding the full concept of accumulating ETFs, how they work and why, can be a bit difficult.
I’ve therefore written this article to try and help bridge the gap between the new(ish) investors out there and the concept of accumulating ETFs. I hope you find this as interesting as ETFs get!
Introduction to ETFs
Before we can dive into accumulating ETFs, we need to understand what an ETF is. I have written a whole article on ETFs, but in essence, they are pre-made baskets of assets (stocks, bonds, commodities, crypto etc.) that can be bought and sold by investors on a stock exchange. It is, therefore, no surprise that ETF stands for Exchange-Traded Fund.
I’ve used this example before, but imagine you’re going to buy 24 doughnuts. Instead of going to the store and picking out 24 specific doughnuts, you simply buy an assorted mix of 24 doughnuts saving you both time and energy, while sometimes earning you a discount to boot.
An ETF works in the same way. Instead of spending time, energy and money buying 24 stocks, bonds or commodities, you can just invest directly into one ETF that contains 24 (or a hundred, even a thousand) assets that you are interested in. This significantly simplifies your investment journey and provides immediate diversification, which is also important from a risk management perspective.
Different types of exchange-traded funds (ETFs)
Now, there are two types of exchange-traded funds: accumulating ETFs and distributing ETFs. Simply put, accumulating ETFs automatically reinvest any money earned from the investment back into the ETF, while a distributing ETF pays you, the investor, recurring dividend earnings from the investment.
These two types of ETFs benefit different investors. Accumulating ETFs are preferred by investors who are looking to take full advantage of compound interest, remove as much administrative work as possible when it comes to investing and don’t need more cash right now.
Distributing ETFs are usually prioritised by investors who want to withdraw the dividend earnings from the ETF to supplement their current income. Alternatively, some investors may also take those earnings and reinvest them into different assets depending on their investment strategy.
Accumulating ETFs and Taxes
Depending on where you live, accumulating ETFs are taxed differently to distributing ETFs. Sometimes earnings from these ETFs will be taxed as dividend income, sometimes capital gains. Some countries don’t distinguish between the two at all.
It’s always important to speak to a Tax specialist in your country of residence to determine your tax obligations.
How do accumulating ETFs work?
Now we’re going to be getting a little bit technical, but that’s ok. I’ll try to remove as much financial jargon as I can and simplify the concept as much as humanly possible. To all you technically specific individuals out there, give me a bit of lee-way here!
The value of an ETF’s share price is made up by the value of a fund’s assets, less their liabilities which is subsequently divided by the number of shares held by investors. This is known as the Net Asset Value (NAV). In other words, the NAV is the price that you pay for 1 share of an ETF.
Now, when an accumulating ETF receives dividend payments from the assets it invests in, the Fund Manager will take that money and use it to buy more of the assets it already holds.
For example, a Fund Manager managing an assorted mix ETF of 24 oil companies will take the money earned from those companies to buy more shares of the same 24 companies.
When the fund manager reinvests this money, the fund’s assets will increase because it simply owns more. When the fund’s assets increase, so does the NAV and, therefore, the value of the shares that you hold.
A common misconception is that you receive more shares of the ETF, which is not true. The value of your shares simply increases because the fund itself owns more of the assets in the basket.
Here’s a quick bulleted breakdown of how accumulating ETFs work.
- Dividend Payments: The underlying companies of an accumulating ETF pays the fund dividends.
- Reinvestment by Fund Manager: The ETF/fund manager takes that money and purchases more shares of the underlying companies.
- Net Asset Value Increases: The new shares increase the total assets of the ETF, which in turn leads to a higher NAV.
- Share Prices are Adjusted: When the total value of the ETF (represented by its NAV) increases, the price of each share increases proportionally, as well.
- No New Shares: While you specifically don’t receive any new shares, the value of your existing ETF share increases due to the NAV and share price increase.
Accumulating ETFs and Strawberry Farms
You can kind of think of accumulating ETFs as a strawberry farm. If you give me, the farm manager, $100 to buy 10 strawberry plants I will buy and plant them for you. When these strawberry plants yield strawberries I, as an accumulating strawberry farm manager, will re-plant those strawberries instead of giving them to you to eat.
If two of those strawberries take root and grow, there will now be 12 strawberry plants instead of 10, which increases the value of my strawberry farm and, by extension, the value of your investment. You can at this point choose to sell your investment for profit or leave your money invested and hope that I can grow 12 strawberry plants into 14.
This growth upon growth is known as compound interest and can lead to significant gains over the long-term.
Of course, locusts may devour all my strawberries, decreasing the value of my farm and also your investment. This is why we have to seriously consider risk.
The advantages of accumulating ETFs
As mentioned throughout this article, so far, the main advantage of accumulating ETFs is that they allow investors to automatically benefit from the power of compounding interest without having to do any personal admin. Since the fund manager actively reinvests all dividends and interest payments back into the exchange-traded fund itself, your shares will increase in value without you lifting a finger.
This is, however, not the only pro when you invest in an accumulating ETF. Major benefits include:
- Growth from Underlying Assets: If the assets within the exchange-traded fund increase in value, so too will your investment
- Reinvested Growth: When the fund manager purchases more assets from any dividends or interest, then your investment will also grow
- Removes Active Involvement: You will not have to actively reinvest any dividends earned which allows you to only passively manage your investment portfolio
- Saves Costs: Buying shares of any investment will usually come with a transaction fee. The automatic reinvestment of money within the fund itself minimises these fees
- Removes Any Behavioural Issues: Emotions and inherited financial habits could lead to you spending any dividends paid out by an ETF. Automatic accumulation removes this factor from the equation
How do you invest in accumulating ETFs?
Investing in accumulating ETFs is no different than investing in company shares listed on public stock exchanges. This is because exchange-traded funds are traded exactly like stocks.
What you will need is:
- An account with an online brokerage
- Money in your brokerage account
- Find an accumulating ETF in which you want to invest
- Place a ‘buy’ trade through your online brokerage account for your identified ETF
When you understand what brokerages are and jump through all the necessary hoops of opening an account, investing in easy. However, it is equally as important to know that you can lose money when investing.
If the underlying assets of your chosen ETF perform poorly, then the value of your investment in the ETF will decrease. The odds are incredibly slim that ETF investing will result in losing all your money, but your investment may be valued less than your initial purchase for long periods. You should really have a pre-made investment strategy before diving in and if you’re nervous about investing, you really should speak to a financial planner!
Frequently Asked Questions
What is the difference between an accumulating ETF and a traditional ETF?
Accumulating ETFs reinvest dividends and interest payments back into the fund, thereby increasing the value of your shares. Traditional, also known as distributing ETFs, pay out earned dividends and interest to the investor in cash.
Do I get more shares from accumulating ETFs?
No. A common misconception of accumulating ETFs is that you accumulate more shares. What actually happens is that the fund manager takes dividends and buys more of the underlying asset. This increases the Net Asset Value of the ETF which, in turn, increases the value of the shares you already hold. You do not get new shares.
Can I buy and sell accumulating ETFs just like traditional ETFs?
Yes, accumulating ETFs are exchange-traded funds, meaning that you buy and sell them on stock exchanges.
What are the advantages of investing in accumulating ETFs?
The primary advantage of accumulating ETFs is that they allow investors to automatically benefit from compound interest without having to personally reinvest any dividends or earnings from interest.
