What is the Total Return Index
The total return index is a type of equity index that tracks both the capital gains of a group of stocks over time, and assumes that any cash distributions, such as dividends, are reinvested back into the index. Looking at an index's total return displays a more accurate representation of the index's performance. By assuming dividends are reinvested, you effectively account for stocks in an index that do not issue dividends and instead, reinvest their earnings within the underlying company.
BREAKING DOWN Total Return Index
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%.
The Standard & Poor's 500 Index (S&P 500) 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 which assume that all coupon payments and redemptions are reinvested through the buying more bonds in the index.
Other total return indexes include the Dow Jones Industrials Total Return Index (DJITR) and the Russell 2000 Index.
Difference 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 544% through February 2018. The total return price (dividends reinvested), however, soared 931.2%.
The Dow Jones Industrial Average over the 10 years ended in March 2018 also had a price return of 98.65%, while the total return rose to 163.98%.
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 lower risk since it provides for an innate level of diversification.