What Is a Total Return Index?
A total return index is a type of equity index that tracks both the capital gains as well as any cash distributions, such as dividends or interest, attributed to the components of the index. A look at an index's total return displays a more accurate representation of the index's performance to shareholders.
By assuming dividends are reinvested, it effectively accounts for those stocks in an index that do not issue dividends and instead reinvest their earnings within the underlying company as retained earnings. A total return index can be contrasted with a price return or nominal index.
- A total return index computes the index value based on capital gains plus cash payments such as dividends and interest.
- A total return index, in contrast to a price index, better reflects the actual returns that an investor holding the index components would receive.
- The total return will tend to exceed the nominal return that only accounts for price increases in the assets held.
- Many popular indices compute total return, such as S&P, which produces the S&P 500 Total Return Index (SPTR).
Total Return Indexes Explained
A total return index may be deemed more accurate than other methods that do not account for the activity associated with dividends or distributions, such as those that focus purely on the annual yield.
For example, an investment may show an annual yield of 4% along with an increase in share price of 6%. While the yield is only a partial reflection of the growth experienced, the total return includes both yields and the increased value of the shares to show a growth of 10%. If the same index experienced a 4% loss instead of a 6% gain in share price, the total return would show as 0%.
Example: The S&P 500
The S&P 500 Total Return Index (SPTR) is one example of a total return index. The total return indexes follow a similar pattern in which many mutual funds operate, where all resulting cash payouts are automatically reinvested back into the fund itself. While most total return indexes refer to equity-based indexes, there are total return indexes for bonds that assume that all coupon payments and redemptions are reinvested through buying more bonds in the index.
Other total return indexes include the Dow Jones Industrials Total Return Index (DJITR) and the Russell 2000 Index.
Differences Between Price Return and Total Return Index Funds
Total returns stand in contrast to price returns, which do not take into account dividends and cash payouts. Including dividends makes a significant difference in the return of the fund, as demonstrated by two of the most prominent.
For instance, the price return for the SPDR S&P 500 ETF (SPY) since it was introduced in 1993 was 789% as of March 10, 2021. The total return price (dividends reinvested), however, is close to 1,400%. The Dow Jones Industrial Average over the 10 years ended in March 2021 had a price return of 162%, while the total return rose to 228%.
Understanding Index Funds
Index funds are a reflection of the index they are based on. For example, an index fund associated with the S&P 500 may have one of each of the securities included in the index, or may include securities that are deemed to be a representative sample of the index’s performance as a whole.
The purpose of an index fund is to mirror the activity, or growth, of the index that functions as its benchmark. In that regard, index funds only require passive management when adjustments need to be made to help the index fund keep pace with its associated index. Due to the lower management requirements, the fees associated with index funds may be lower than those that are more actively managed. Additionally, an index fund may be seen as a lower risk since it provides for an innate level of diversification.