NAV Erosion Really Is (and Isnāt)
NAV erosion is somewhat of a scary term, and people use it almost like a scare tactic when speaking about high-yield investments. They proclaim āthat fund has NAV erosionā but there is no explanation as to what it is or how someone might deal with it if they are choosing to invest in these funds. That isnāt very useful, and it doesnāt help anyone who might want to look at investing in income funds.
Understanding NAV erosion is actually pretty simple. If a fund consistently pays out more than its portfolio is generating in total return, the difference has to come from somewhere. Over time, that can result in the fund's NAV declining.
We don't need a bunch of financial jargon to make it sound more complicated than it is. Just spending more than you make will eventually erode the capital, and that is a concept nearly everyone can understand.Ā
Where it gets a little more nuanced is with the distribution itself, because a distribution is not automatically erosion. This is why sometimes you hear people say NAV erosion is a myth. They're looking at the fact that a distribution causes NAV to fall and correctly pointing out that the investor received that money.
When a fund pays a distribution, its NAV normally drops by roughly the amount of the distribution because money has left the fund and gone to the investor.
You had $10 in the fund, the fund paid you $1, and you now have roughly $9 in the fund and $1 in cash. You didn't suddenly lose $1. The value simply moved from inside the fund into your hands. That is not NAV erosion.
A fund going down because market conditions changed and the underlying investments are worth less is not NAV erosion either. That's simply a market loss.
So if the distribution itself isn't NAV erosion, and the market going down isn't NAV erosion, then what actually is?
The issue starts when the fund does not generate enough total return over time to support what it is paying out. Say a fund starts with a NAV of $10. Over the period, the portfolio generates $0.50 of total return but pays out $1.00. After the distribution, the NAV would be around $9.50.
You received $1, but the fund only generated $0.50 to replace what it paid out. Where did the other $0.50 come from? It effectively came out of the fund's capital.
That might not look like much over one or two months, but keep doing it and it starts to add up. The fund is distributing more than its portfolio is generating and is left with a smaller asset base working inside the fund. A smaller asset base generally means less capital available to generate future income and capital gains.
That is NAV erosion: spending more than you are generating in total return.
For individual investors, there isn't anything you can do to repair NAV erosion because it is happening at the fund level. You don't control the investments, the option strategy or how much management chooses to distribute.
What you do control is what happens after the distribution reaches your account.
Spend all of it and that money is gone from the portfolio. If the fund keeps eroding and eventually cuts the distribution, you can end up with both a lower investment value and lower future income.
You could choose to reinvest some or all of the distribution which will change how you individually experience that erosion. It does not repair the fund's NAV, but it does buy you more units. If the distribution per unit stays the same, more units means more cash distributions.
Maybe your original investment was paying you $100 a month. By reinvesting, you gradually increase your unit count enough that the monthly distribution grows to $150. If the fund later cuts the distribution per unit by roughly one-third, your larger unit count could still leave you receiving around the original $100 a month.
You could also take that distribution and buy other funds and that gives you some diversification and potentially other cashflows.
The point is not that reinvesting somehow fixes the original fund. It doesn't. You are simply putting some of that cash back to work instead of consuming all of it.
Ultimately, we come back to the same point: the distribution yield doesn't really matter by itself. Total return is what matters. It doesn't really matter how the return is packaged. One fund might give you most of its return through price appreciation while another gives you a large portion through distributions.
If your intention is to preserve your capital over time, the basic rule is the same: you have to spend less than your portfolio generates in total return.
And if you are fine with consuming your portfolio, there is nothing inherently wrong with that either. A high-distribution fund can do it in a very similar way to periodically selling units yourself. When more money is leaving the portfolio than the portfolio is generating, capital is being consumed either way.
