How Do I Make Money?

Fundamentals of Market Investing by Adam J. McKee

In the world of investing, there are several different ways that profits are realized:

Dividend Payments.  Depending on the underlying securities, a mutual fund or ETF may earn income in the form of dividends on the securities in its portfolio.  The mutual fund or ETF then pays its shareholders nearly all of the income (minus disclosed expenses) it has earned.

Capital Gains Distributions.  The price of the securities a mutual fund or ETF owns may increase.  When a mutual fund or ETF sells a security that has increased in price, the mutual fund or ETF has a capital gain.  At the end of the year, most mutual funds and ETFs distribute these capital gains (minus any capital losses) to shareholders.  ETFs seek to minimize these capital gains by making in-kind exchanges to redeeming Authorized Participants instead of selling portfolio securities.  In other words, they trade stocks with other companies to keep from making any actual money in the short term.

Increased NAV / Increased Market Price.  If the market value of a mutual fund’s portfolio increases, after deduction of expenses and liabilities, then the net asset value of the mutual fund and its shares increases.  If the market value of an ETF’s portfolio increases, after deduction of expenses and liabilities, then the net asset value of the ETF increases and the market price of its shares may also increase.

With respect to dividend payments and capital gains distributions, mutual funds usually will give investors a choice: the mutual fund can send the investor a check or other form of payment, or the investor can have the dividends or distributions reinvested in the mutual fund to buy more shares (often without paying an additional sales load).  If an ETF investor wants to reinvest a dividend payment or capital gains distribution, the process can be more complicated, and the investor may have to pay additional brokerage commissions.

You should check with your broker to make sure about your particular holdings, but mutual funds usually allow reinvestment with no costs, while ETF earnings tend to show up in your trading account as cash.  Most brokers have a reinvestment program that can plow them right back into your holdings.

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