Why is an ETF that generates less capital gain distributions better for some investors?

Question
From an investor prospective, why an ETF that generates less capital gain distributions to the investors is better than one that generates more distributions? Note, I am not talking about "capital gain", but "capital gain distributions". Thank you.

Example
I have one share of an ETF.
The ETF price and the NAV are 100.
The ETF realizes capital gain and distributes 2 to me.
I pay 0.5 taxes on it, so the after tax distribution is 1.5.
After the distribution the new NAV is 100-2 = 98. The ETF price is still temporarily at 100.
The Authorized Partecipants use arbitrage to bring the ETF price and NAV to a new value somewhere between 98 and 100, say that the new value is 99.
From the investor prospective:

• Before the distribution I had 100
• After the distribution I have 99 + 1.5 = 100.5

So, in this example, the capital gain distribution was a good thing for the investor. I understand that, for example, if the new equilibrium was at a different price (say 98.1) you may have that the investor lost money with the distribution.

Conclusion
I think that sometimes the distribution is a good thing, sometimes it is not.

Your assumption that the value of the ETF will be "somewhere between 98 and 99" is too imprecise. It's not "arbitrage" that draws the price down; the actual price makes a discontinuous jump at the time of the dividend since the exchange modifies limit orders (which determine the bid/ask range) to account for the dividend. After the distribution of 2 and taxes of 0.5, the "value" (the amount you would get if you sold) of the ETF would be 98, and you'd have

``````98 + 1.5 = 99.5
``````

where the 0.5 loss is all attributable to taxes. If you did not account for taxes and reinvested the distribution, you'd have 100 total either way (either 100 of the ETF or 98 of the ETF and 2 in cash)

So the main drawback of distributing ETFs is the immediate tax impact. As mentioned in other answers, this is of no consequence in tax-deferred retirement accounts, and if you reinvest the distribution you'd end up with 100 of the ETF whether it paid a dividend or not.

• Reinvesting the distribution may involve friction, especially if there is no automatic reinvestment plan available. This could be in the form of a transaction fee, bid/ask spread, or simply the inability to purchase an exact integer number of shares with the distribution. Commented Sep 13, 2023 at 21:51
• Stanley, please clarify "It's not "arbitrage" that draws the price down; the actual price makes a discontinuous jump at the time of the dividend.". What is the mechanism that makes the jump on the price that you describe? I believe that the ETF price is driven by market forces (I mean the usual" market orders vs limit orders" type of mechanism that drive also stock prices). So for example, in theory, the market may (for whatever reason) move the price up even with the distribution. Commented Sep 14, 2023 at 22:01
• money.stackexchange.com/questions/152339, money.stackexchange.com/questions/110554. The exchange modifies limit orders to account for the dividend. Commented Sep 15, 2023 at 13:47
• @KarlKnechtel That's true - I am ignoring transaction costs (both explicit and implicit) Commented Sep 15, 2023 at 17:50
• @Fuzzy You are right that "market forces" can and do change the price; my point was that it's not market forces that change the price due to the dividend. It's the exchange itself that changes it so that it's largely transparent to market participants (no one is stuck buying at a higher price because they don't know about the dividend, or able to sell at a higher price to exploit it) Commented Sep 15, 2023 at 17:52

Why an ETF that generates less capital gain distributions to the investors is better than one that generates more distributions?

This answer will use United States terms:

• If a person has the money in a Roth account, the distributions have no tax impact.
• If a person has the money in a traditional 401(k) or traditional IRA, the tax impact of the distribution is deferred.
• if the person has the money in a taxable account, then there is a tax impact this year instead of when they sell.

Each group of people will view capital gains distributions differently. Even the people in the taxable account group will view the distributions differently depending on if they want the distributions as income this year.

from a comment:

Can you elaborate on "Even the people in the taxable account group will view the distributions differently depending on if they want the distributions as income this year."? I thought that an ETF capital gain distribution is always taxes (usually as long term capital gain)

If a person is decades from retirement then a distribution triggers a tax with no immediate benefit. But if they are retired, then those distributions may be part of their income plan. They might not be reinvesting distributions, so they will keep the same number of shares and spend the distribution.

• Can you elaborate on "Even the people in the taxable account group will view the distributions differently depending on if they want the distributions as income this year."? I thoght that an ETF capital gain distributikn is always taxes (usually as long term capital gain) Commented Sep 13, 2023 at 12:36
• You might want to control which year those taxes are paid in, taking the gain in a year when you are in a lower tax bracket. Or you might donate the shares to a tax deductible charity and avoid the capital gains tax entirely. Or this may make not make enough difference to be worth worrying about, or you might actually prefer to pay smaller amounts of tax as you go rather than taking a larger hit at the end; either approach will be better for some people, not as good for others, and more hassle than it's worth worrying about for me. Commented Sep 13, 2023 at 14:18