Summary - Total return is a way for investors to know the difference between the price they pay for an investment and the value that investment has in their portfolio. Total return calculates a security’s performance over a given period of time and includes both the income earned through interest, dividends, coupons, and capital gain distributions as well as the capital appreciation that occurred in that time period.
Total return is typically measured over the course of one year and is expressed as a percentage of the initial amount invested. For example, a total return of 10% means that the value of the security increased by 10%. How it increased could come from several factors.
Reviewing total return is an important component of an investment strategy because it can level the playing field between two investments that have different investment objectives. For example, an aggressive growth investor may have money in a growth-oriented exchange-traded fund that has a return of 20%. Another investor may have the same amount of money in a growth and income fund that looks to add value through both dividends and capital appreciation. Because a growth and income fund will typically have less capital appreciation than exchange-traded funds looking exclusively at capital appreciation, looking exclusively at capital appreciation may not give an accurate picture of the fund’s overall value to the investor.
In this way, an investor can use total return to determine an investment’s true growth over time. Total return can also be used to analyze a company’s performance over longer time periods by looking at the average annual total returns or the cumulative total returns.
Introduction
When it comes to performance, statistics do not always tell an entire story. When a batter in baseball has a .250 batting average, it is only one measure of his performance. A .250 batting average says that for every 100 “at bats” the player has 25 hits or gets hits 25% of the time. However, that same batter may have a .350 on-base percentage which is much more indicative of his total performance. On-base percentage takes into account how many times the batter has gotten on base per plate appearance. A plate appearance includes how many times they drew a walk or were hit by a pitch. These two situations, along with any times the batter sacrifices themselves into an out to move a runner do not count as "at bats". Therefore, a .350 on-base percentage means a player reaches base 35% of the total times he comes up to bat. That’s a big difference.
In the world of investing, the difference between an investment’s capital appreciation and total return can change an investor’s outlook on an investment. For example, an investor purchases Stock A for $25 and it increases by $5 in one year. That’s a 20% return (25/5 = 20). If the same investor pays $20 per share for Stock B and it increases by $2 per year that would mean they only got a 10% return. Stock A had a better rate of return than Stock B, right? Not necessarily. What if Stock B paid out a 5% annual dividend yield? That would mean that for every share of stock, the investor-owned he would receive $1 in dividends. That dividend income adds to the total return of his investment. And that’s the focus of this article.
In this article, we'll take a close look at total return and give examples of why it's one of the more important performance metrics investors can use when comparing between two investments or when objectively analyzing the performance of their stocks against other assets. Along the way, we'll define some important related terms to help explain total return.
What is total return?
Total return is a performance metric that expresses the actual rate of return of an investment or of a portfolio over a period of time. Total return is usually expressed as a percentage and is typically measured over one year’s time.
Total return includes all the income and capital appreciation that combine to impact the total performance of stocks, mutual funds or another asset. Income includes interest paid, dividends issued, capital gains distributions and coupons. The individual components that comprise total return will be weighted differently depending on the asset classes of the securities being measured. Also, a total return needs to be evaluated in an apples-to-apples way. A fund that invests in foreign securities or emerging markets may have different net investment income and a different net expense ratio depending on many variables related to the specific country’s involved.
The fees and expenses of a mutual fund will count against a fund’s total return.
Key terms to help understand total return
- Equity Securities– these are financial assets that represent ownership of a share or shares in a business.
- Debt Securities– these are debt instruments such as investment grade government or corporate bonds, CDs or preferred stock. It can also include collateralized securities such as mortgage-backed securities and zero-coupon securities. In terms of total return, debt securities may provide interest income.
- Capital Gains Distribution– this is a taxable event that is triggered when a fund manager sells shares of an underlying security or securities inside the fund. If the asset is trading higher than when it was initially purchased, the fund must distribute at least 95% of the capital gains to shareholders of the fund.
- Dividends– these are payments made to shareholders that come from the profits of a company. A company has two options when it comes to their profit. They can keep it (ideally to reinvest it in the business) or they can distribute it to shareholders in the form of a dividend. In general, companies that issue dividends will show a lower rate of capital appreciation than companies that do not issue dividends. However, as it relates to total return, the presence of a dividend may mean a dividend-paying investment is actually better than a more aggressive growth stock.
- Capital appreciation– this is the increase in share price, otherwise called an increase in net asset value (NAV).
The most commonly used formula for calculating total return is as follows:
Total Return = (P1– P0) + D/P0
P0= Initial stock price (market price)
P1= Ending stock price (market price)
D = Dividends
If an investor owns common shares in a mutual fund that are valued at $8,000 and during the year receives $200 in dividends and enjoys an additional $200 in capital appreciation. At the end of the year, his total return would be:
Total Return = (8200-8000) + 200/8000
Total Return = 200 +200/8000
Total Return = 400/8000 = 0.05 or 5%
An alternative formula for calculating total return is:
Total return = Dividend Yield + Capital Gains Yield
Total return can be more complicated particularly because a total return may take into account an adjustment for sales charges. However, investors can find total return information through a number of sources including their investment advisor or mutual fund advisor. Investors should also take time to read the prospectus and look at independent fund performance monitors to get a sense of how the fund they are considering compares to other funds.
Why is total return important?
Total return is one of the primary ways to evaluate the overall performance of an investment, particularly as it relates to a mutual fund or ETF. Total return is only a snapshot of performance. For a more accurate view, investors should compare the average annual total returns for an investment over several time periods. If an investment shows a dramatic swing in total return from one year to the next, it can be a clue to an investor that there is a lot of volatility associated with that fund. Average annual total return almost always count reinvestment of dividends and capital gains distributions but may not include the effect of sales charges. This information, however, must be included in the prospectus for the fund. The same is true of fees and expenses of the fund which do weigh negatively on a fund’s total return.
Another way total return can be used to measure performance over time is by looking at the cumulative total return. This shows how much an investment has earned over a period of time longer than one year. When using this metric, investors should be sure to note the origin date and the year-over-year difference between the total returns.
Total return can be used in conjunction with other metrics such as risk-adjusted return to determine the true value of an investment.
Can a total return be negative?
There are many reasons why an investment or portfolio may have a negative rate of return. Among these are poor performance, volatility within the sector or in the broader economy, and inflation. If an investor has shares in a mutual fund that total $15,000 at the start of the year and the shares decrease in value to 13,500 by the end of the year, the total return for that fund will be negative 10%.
Tax implications of total return
Dividends (if reinvested) are not taxed until their assets are withdrawn from the investment. However, as noted above, a capital gains distribution is a taxable event even though the distributions are reinvested in the mutual fund. In this case, the distribution is either taxed as a long-term capital gain or a short-term capital gain based on the amount of time the fund held the asset. This means that an investor that purchased shares at the beginning of the year may be charged at a long-term capital gains rate if the fund held the underlying securities in the fund for longer than a year. Conversely, if the investor has been in the fund for over a year, but the portfolio manager buys and sells a particular asset within the same calendar year, the investor will only be charged the short-term capital gains rate. Of course, since the goal of most investors is to avoid as much tax liability as possible, investors would be wise to contact the fund around October of the taxable year to find out if the fund is planning to make capital gains distributions that could lead to a taxable event. The only time a capital gains distribution is not taxable is when the fund is part of a tax-deferred account such as an IRA or 401k. Furthermore, investors can look into low-turnover funds which decrease the likelihood of a capital gains distribution.
The final word on total return
There are many ways to judge investment performance. However, the overwhelming tendency is to look only at an investment’s bottom line. Did the share price go up or did it go down? By how much? But different investments have different investment objectives and different components that go into calculating their value. For this reason, investors are advised to look at an investment’s total return to measure not only its share price performance but as an indicator of the value that a particular investment may have in their portfolio.
Total return takes into account the three ways that an investment can provide income to an investor: dividends, capital gains distributions, and capital appreciation. The weight of these components will be different depending on the asset class of the investment. For example, stocks or equity funds may have more balance between dividends and capital appreciation. By contrast bond funds will receive most of their income from dividends. Also, funds that invest in foreign securities and/or emerging markets may show a different total return depending on the state of the particular country’s economy.
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