Mutual Funds - Returns
Stock Total Return
We begin our illustration with a share of XYZ Company that is bought for $30 at the beginning of the year. During the year, its price fluctuates, but it closes the year at $33, which represents a nice percentage return on the investment of 10% ($3/$30).
But the deal gets even better, because XYZ paid an annual dividend of $1 per share. This dividend equals an additional 3.3% return ($1/$30). Adding together the capital appreciation (price increase) of 10% and the income return (dividend) of 3.3% gives us a one-year total return for XYZ Company stock of 13.3%. However, remember that unless you sell XYZ stock, the price appreciation gain remains in the stock price, or is unrealized.
Fund Total Return
With mutual funds, explaining total return is a bit more complicated. We begin with a share of the ABC Fund, which is purchased at its net asset value (price) of $16 per share. A fund's NAV is derived by dividing the value of its portfolio securities (the fund's assets), less any accrued fees and expenses (the fund's liabilities), by the number of fund shares outstanding. Here's an illustration of the computation of net asset value for the ABC Fund:
The fund's cash and cash equivalents = $200,000
The fund's stock holdings at market prices:
10,000 shares of Company X @ $50 = $500,000
20,000 shares of Company Y @ $30 = $600,000
50,000 shares of Company Z @ $8 = $400,000
Total market value of stock holdings = $1,500,000
The fund's total assets = $1,700,000
Less the fund's liabilities = $100,000
The fund's total net assets = $1,600,000
The fund's total shares outstanding: 100,000
The fund's NAV: $16 ($1,600,000/100,000)
Remember that mutual funds are priced once a day, at the end of the day. Unlike stocks, where prices are moved by the supply and demand forces of the marketplace, fund prices are determined by the value of the underlying securities in the fund.
In our example, ABC is a hybrid stock/bond fund with a growth-income orientation. Apart from capital gains, its individual portfolio holdings will generate dividends and interest. By law, mutual funds must distribute these to the fund's shareholders. ABC's income distribution (its dividends to shareholders) for the year amounted to $1 per share. In addition, the fund's trading activities (the buying and selling of securities) generated a realized capital gain of $3 per share that ABC also distributed to its shareholders.
The ABC Fund passed along all the earnings and capital appreciation it generated - $4 ($1 in dividend distributions and $3 in a capital gains distribution) to its shareholders for a total return of 25% ($4/$16). Here again, unlike a stock, by paying out all its capital gains, the ABC Fund's price, or NAV, remains at or close to $16. In this scenario, if a fund investor only focused on the movement in ABC's NAV, the results would not look very good. It's even possible for a fund's NAV to decline, but still have good income/capital gain distributions, which will be reflected in a positive total return.
Obviously, a fund's NAV does not tell the whole mutual fund performance story, but its total return does. It captures a fund's changes in NAV, its income distribution and capital gains distribution, which, as a whole, are the true test of fund's return on investment.