Fund ABCs: Understanding Fund Total Return

Morningstar was founded in 1984 to help investors make better decisions. We provide a wealth of free fund data and analysis at Morningstar.co.uk to help you do just that, and we are now introducing our Fund ABCs series to help educate investors about fund investing. We will be posting new articles periodically, progressing from the most basic concepts through more complex topics such as fund evaluation and portfolio building. This is the third article in the series, “Understanding Fund Total Return”. As always, we welcome your feedback.

In this course

1 Two Sources of Returns
2 How Distributions Affect Fund Prices
3 Where Does Yield Fit In?
4 Putting it all Together: Total Returns

Two Source of Returns
There are two sources of potential returns from any fund investment. One source is yield: income paid out by the securities held by the fund. Yield can come from dividends paid by equity shares, coupons paid by fixed-interest securities, or rents from property. The other source of potential returns is capital appreciation—which is simply the amount by which the value of a security has increased (or decreased) since it was purchased for the fund.

To take an example, say your fund manager buys 10 shares of XYZ Co. for £10 per share for a total investment of £100. Now, further assume the shares pay a dividend of 75p per year and that the shares have increased in value to £15 a share at the end of 1 year. The share’s yield over this period is equal to 75p X 10 shares, or £7.50, which is a return of 7.5%. The capital return is equal to the increase in the share price divided by the initial share price, or £5/£10, which is equal to 50%.

Whilst it is useful to know the component of the return you are earning on an investment, what really matters is how much money you made (or lost) from both sources. The measure that describes this (the one that you see cited on all the fund performance pages at Morningstar.co.uk) is Fund Total Return.

There's a relationship between net asset value (NAV—we are using single-priced OEICs here for the sake of simplicity, but the same principles hold true for dual-priced unit trusts), yield, and fund total return, but it's complicated. Each represents something a little different than the other, and often, the terms yield and return are used interchangeably. Did you know that a fund's NAV can fall and you can still make money? Or that a fund can yield less than 1%--actually, it can yield nothing at all--and can still be a chart-topping performer? If you remember nothing else from this course, remember this: When it comes to measuring performance, neither NAV nor yield will do. Total return is the number to watch.

How Distributions Affect Fund Prices
A change in a fund's NAV gives an incomplete picture of the total return the fund has generated. Watching a fund's NAV is like watching a television with shaky transmission--sometimes you get an accurate picture, and sometimes you don't. With funds, interference occurs whenever a fund makes a payment to its shareholders, otherwise known as a distribution. Whenever a fund passes along income to shareholders, its NAV drops. If a fund with an NAV of £10 makes a £1 distribution, its NAV slips to £9. Despite the shrunken NAV, shareholders are none the poorer. They still have £10--£9 in the fund and £1 in cash. Unless they need the income, many investors reinvest their distributions; in other words, they instruct the fund company to use that cash to buy new shares of the fund. Most total return numbers reported in newspapers or on the Web, including those used by Morningstar, assume that distributions are reinvested.

Where Does Yield Fit In for Funds?
Yield represents income that a fund distributes to its shareholders. Income comes from dividend-paying stocks and bonds owned by the fund. A fund's yield is therefore only the income component of its total return. That's why a fund can have a yield of 0%, meaning that it makes no income payments to shareholders, and still have a positive fund total return from capital appreciation. Yield can be calculated in a variety of ways, and many fund houses in the UK opt for different measures, leading to a considerable degree of investor confusion. To help eliminate these issues, Morningstar calculates yield on a trailing-12-month basis. In other words, we add up all of a fund's income payments over the past year and divide the total by the most recent month-end NAV.

Putting it All Together: Total Returns
Fund total return encompasses everything we have discussed thus far: changes in NAV caused by appreciation or depreciation of the underlying portfolio, payment of any income (yield), and reinvestment of all distributions.

((Ending position - beginning position)/Beginning position) X 100 = Total Return

Here's how it works.
Say you buy 10 shares of Fund A at £20 per share.

After a few months, the fund's NAV rises to £22. The fund also earns £5 in income per share during this period, which it distributes As a result, the fund's NAV falls to £17 when it pays the distribution.

Your distribution of £50 (£5 x 10 shares) is used to buy 2.94 more shares at the new £17 price.

Finally, say the fund's NAV rises again, this time to £18 per share. If you used only your NAV to calculate return, your shares would be worth the fund's final £18 NAV times your initial 10 shares, or £180. That's an NAV loss of £2 per share, or 10% on your original investment. But that figure would be inaccurate, because you need to factor in the income distribution that you reinvested. Add that back in and you'll find your investment is actually worth that £180 plus the £52.92 your two new shares are worth, for a grand total of £232.92. Your fund total return is really 16.5%. Not too shabby.

Key Tip: Many funds in the UK offer at least two different share classes. Income shares pay out any income generated by the fund’s securities to the investors. Investors then have the choice of retaining that income or reinvesting it in the fund. Accumulation shares simply retain income within the fund and use it to fund investments. Only income shares are subject to fluctuations in their NAVs in the manner described above.