Is That High Yield Coming From Your Own Principal?
A monthly payout landing in your account every few weeks feels great, but where that money comes from matters. If an ETF distributes more than what its underlying holdings actually earn, it has to make up the shortfall by drawing down net asset value (NAV). Cash keeps hitting your account, but your principal quietly shrinks in the background, a pattern known as NAV erosion. A high headline distribution rate can hide the fact that you're really just getting your own money handed back to you.
How to Read the Result
| Condition | Result |
|---|---|
| Underlying return < distribution rate | Erosion (NAV declining) |
| Underlying return = distribution rate | Holding steady |
| Underlying return > distribution rate | Growing |
The annual NAV change rate is roughly (underlying annual return - annual distribution rate). If the underlying gains 5% but the distribution rate is 10%, NAV drops about 5% a year. This shows up often in covered-call style monthly income ETFs, so don't judge a fund on distribution rate alone, always weigh it against the underlying's actual performance.
Frequently Asked Questions
If the underlying return is lower than the distribution rate, the shortfall is pulled from NAV, causing erosion. That's when NAV declines.
No. If the underlying rises more than the distribution rate, NAV can hold or grow. It's a problem only when returns fall short of the payout.
Generally as ordinary income or qualified dividends, though some payouts may be return of capital. Check your 1099-DIV for the exact classification.
* A simplified model excluding fees and taxes; actual NAV moves with real market performance and is for reference only.