It is a difficult concept at times but it is not 'automatically' bad. ETF manager decisions must be made to successfully operate a managed distribution policy. Typically, an executive committee will forecast the portfolio's anticipated income and capital gains for the upcoming year and make regular monthly or quarterly distributions based on that estimate. But forecasts can be wrong and estimates can be off. This is especially true in the short term. In any given period, a fund may not have generated enough income or capital gains to meet the distribution. So, in this case, some of the distribution may be made up of return of capital. Throughout the calendar year, funds estimate the breakdown of their distributions, but these are only estimates. If an investor sees return of capital was employed at an ETF, this isn't necessarily always bad news. Although investors should avoid funds with consistent use of destructive return of capital, to dismiss an ETF from investment consideration simply because it has distributed return of capital is unwise. First, it could be that the fund is simply passing through return of capital from its underlying holdings. Second, a fund may have unrealized capital gains in the portfolio, and the portfolio manager doesn't want to sell a holding just to meet a distribution commitment. This is constructive return of capital because the portfolio manager is, theoretically at least, continuing to invest for a fund's total return, instead of just for a distribution rate. In a third scenario, a fund may have hit a rough patch, but management doesn't want to reduce the distribution. Distribution reductions typically result in a share price decline, so ETFs are usually averse to reducing them unless there is a clear and compelling reason to do so. This is why we don't always lambaste a fund for using destructive return of capital infrequently. However, consistent use of destructive return of capital is a huge red flag, especially if the return of capital comprises the bulk of a distribution. So, we like to watch unit values as well as distributions. As noted in a prior question, if a fund has a large component of ROC but its unit value does not decline, this is much less of a concer,
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