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Let's suppose a fund is tracking an index A, and let's suppose that it does it with 100% of accuracy. Therefore, given a particular period of time, the value of the fund should fall and rise exactly in the same proportion as A does. For simplicity, let's supposed as well that during the given period of time the index only rises.

Let's say now that that fund is of type 'accumulation', that is, all the dividends earned by the fund are automatically reinvested.

In the above hypothesis, I don't understand how the fund can still track the index. I mean, if all the dividends of the fund are reinvested, shouldn't a particular investor see a performance greater than the index itself? In addition, shouldn't the fund's monetary mass be incremented more than the index' one?

In other words, my understanding is that a distribution index fund (dividends are distributed to investors) should have a lower value compared to the same fund, but in its accumulation version, right?

EDIT

I have realized that, for the first point (how can the investor see the same performance as the index, regardless of have reinvested the dividends), the investor earns more net value, but he has technically invested more as well, therefore the porcentual gain will make sense.

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    Depends on which specific index you are using to benchmark your index fund. For example, S&P 500 comes in three variants: price return index, total return index, and net total return index.
    – Flux
    Commented Aug 26, 2020 at 18:07

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On the ex-dividend date, the stock exchanges reduce share price by the EXACT amount of the dividend. That means that the ex-dividend date has caused a capital loss in your share position.

Suppose you own 10 shares of a $100 stock (or an ETF) that is going ex-dividend tomorrow for $1. At today's close, the market value of your portfolio is $1,000 and you have $0 in cash. Tomorrow morning, you own 10 shares of stock, with a value of $99/share.

If you don’t reinvest your dividends, in the morning you'll have a share position worth $990 and $10 of cash (to be received on the Pay Date) and your account value is still $1,000.

If you reinvest your dividends, then you end up with $1,000 of ownership in the company (cost basis). The only change which has taken place is that now you own more shares which are each worth less individually. The overall cost basis is still the same $1,000.

Given that an index is composed of many such stocks, this ex-dividend process happens to many positions. But the result is the same.

The price of an index is not adjusted for dividends so it experiences the same share price reduction every time one of its components goes ex-dividend.

In summary, the index fund and the index track each other. When the index drops because of a dividend, so too does the fund. A dividend does not increase or decrease the value of your position other than the possibility of taxes due if the dividend is received in a non sheltered account. Whether you invest your dividend or spend it has no effect on the tracking only how whether you maintain the size of your investment via reinvestment or you reduce it by withdrawing the dividend.

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  • But if that is the case, the next day, the index itlself should have lost value (since their shares have lost value due to the dividend yield), therefore an accumulation index should have a greater value than it (since it reinvests dividends, therefore 'recovers' that lost). What am I missing?
    – Martel
    Commented Dec 15, 2020 at 13:15
  • Forget that, I have just read that some indexes (e.g. S&P 500) do include the dividends yield in its value. That explains everything.
    – Martel
    Commented Dec 15, 2020 at 13:27

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