What it means
Most well-known market indices, such as a stock market's headline index, track only the prices of the companies in them. That is called a price return index, and it leaves out the dividends that shareholders receive, which can be a large part of long-term gains.
A total return index adds those dividends back. Each time a company in the index pays a dividend, the index assumes that the cash is reinvested in the index on the payment date, so the income itself earns further returns from then on.
The difference can be large over time. In the short run a 2% dividend yield looks small, but compounded over many years it can account for a big share of the total gain, so comparing a fund's total return with a price-only index will make the fund look better than it really is.
For bonds, total return indices include the interest coupons as well as price changes, and for global investors they may be shown in a chosen currency, with or without currency hedging. Some versions are also shown net of withholding tax on dividends, so the details of the version must be checked.
Fund managers, pension schemes and financial planners use total return indices as benchmarks. A fund that charges fees should be compared with the total return of its benchmark, not the price index, otherwise the comparison is unfair to the fund.
An investor cannot invest directly in an index, and the calculation does not deduct the costs of trading or fund fees. The actual return from a fund tracking the index will therefore be a little lower than the index itself.
In practice
Real-world examples.
Example
A pension fund compares its share portfolio with the total return version of its benchmark. The portfolio returns 8.2% while the benchmark returns 8.5% including dividends, so the fund trailed by 0.3 percentage points, although against a price-only index showing 6.5% it would have wrongly appeared to be ahead by 1.7 points.
Example
A financial adviser shows a client how $10,000 invested 20 years ago would have grown. Using a total return index, the value is far larger than the price index shows, because twenty years of reinvested dividends are included.
Example
An exchange-traded fund provider publishes its performance against a total return index after withholding tax. This lets investors see how closely the fund follows the index once the effect of taxes on dividends is taken into account.
Formula
Calculation
Total return index (today) = Total return index (previous) x (1 + (Price change + Income) / Previous price level)
Suppose a total return index stands at 1,000 and the underlying price index stands at 5,000. Over the next quarter the price index rises to 5,100, a gain of 100 points, and the constituents pay dividends worth 50 index points. The total return for the quarter = (100 + 50) / 5,000 = 150 / 5,000 = 3.0%. The new total return index = 1,000 x 1.03 = 1,030, whereas the price index alone showed a gain of only 100 / 5,000 = 2.0%.Case study
Seen in the real world.
Marlborough Capital is an illustrative, fictional asset manager that reported a flagship equity fund's performance against a price-only index in its marketing. The fund returned 9.0% for the year and the price index returned 7.0%, so it appeared to have beaten the market by 2.0 percentage points.
The compliance team pointed out that the benchmark index paid dividends of about 2.5% a year, which were excluded from the comparison. The total return version of the index returned 7.0% + 2.5% = 9.5%, so the fund had in fact lagged by 0.5 percentage points.
Marlborough corrected its reports to use the total return index and revised its fee discussion with clients. The illustrative lesson is that choosing the wrong benchmark can turn underperformance into apparent outperformance, which is a risk to both clients and the firm's reputation.
Watch out
Common mistakes.
- Comparing a fund's total return with the price version of an index, which flatters the fund by ignoring dividends.
- Assuming that all total return indices are calculated the same way, when tax treatment and currency can differ.
- Forgetting that the index excludes fees and trading costs, so no investor can earn exactly the index return.
Questions
People also ask.
What is the difference between a price index and a total return index?
A price index tracks only changes in prices, while a total return index also includes dividends or interest, assumed reinvested.
Why do dividends matter so much over the long term?
Reinvested income buys more units that then produce their own income, so the effect compounds, and it often forms a large part of the long-run return of shares.
Which index should I use as a benchmark?
The total return version of an index that matches your investment's market, size and currency, with the same tax treatment where possible.
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