Total Return

Total return is the whole gain or loss an investment produced over a period, counting both the change in its value and the income it distributed, with the income assumed to have been reinvested. Its opposite number is the price return, which counts the value change only. The gap between the two is everything the investment paid out while you held it, and for an income-heavy holding that gap is most of the answer.

The phrase most often seen in fund documents is not "total return" on its own but "average annual total return," and the difference is the one worth clearing up. Total return is the plain measure of what an investment produced over the actual period. The average annual version converts that result into an equivalent per-year rate so periods of different lengths can be compared, which is the operation the annualized return covers. This page is about what goes into the number before anyone annualizes it.

For a registered fund the computation is prescribed, not chosen. Item 26(b)(1) of Form N-1A tells a fund to compute average annual total return for the 1-, 5- and 10-year periods by solving the formula P(1+T)ⁿ = ERV, where P is "a hypothetical initial payment of $1,000," T is the average annual total return, n is the number of years, and ERV is the ending redeemable value of that payment at the end of the period. The instructions do the rest of the work: assume the maximum sales load is deducted from the initial $1,000 payment, assume all distributions are reinvested at the price stated in the prospectus on the reinvestment dates, include all recurring fees charged to shareholder accounts, determine the ending value by assuming a complete redemption at the end of the period, and state the result to the nearest hundredth of one percent. A fund's quoted total return is therefore an after-cost figure computed on a standard set of assumptions, which is what makes two funds' numbers comparable at all.

Reinvestment is an assumption, and it is the assumption most likely to differ from what a real holder did. The computation puts every distribution straight back into the same investment. Someone who took the distributions in cash and spent them earned the income but not the compounding on it, so their own experience will fall short of the published total return even though nothing went wrong. Someone holding the investment in a taxable account paid tax on distributions along the way, which the headline figure does not reflect; Form N-1A has separate after-tax return computations precisely because the pre-tax number cannot answer that question.

What total return deliberately leaves out is as important as what it includes. It is a nominal figure, so it does not tell you what the money can buy afterwards; the inflation adjustment is a separate operation carried out by the real rate of return. It compresses the path into a single result, so a calm year and a violent one can produce the same total return. And it is a measure of one holding over one period, not of a household's experience, which depends on when money went in and came out.

Take the value at the end, add back every distribution received during the period as though it had been reinvested, and compare the result with what was put in at the start. Expressed as a percentage of the starting amount, that is the total return for the period. Nothing is annualized at this stage, and no adjustment is made for inflation or tax.

A hypothetical example. Ravi invests $10,000 in a fund at $25.00 a share, so he buys 400 shares. Over the next twelve months the share price rises to $26.00 and the fund pays distributions of $1.00 a share, which he reinvests.

The price change alone is 400 × $1.00 = $400, which on $10,000 is a price return of 4.0%. The distributions are also 400 × $1.00 = $400. His ending value is $10,800: the 400 original shares are worth $10,400, and the $400 of reinvested distributions buys about 15.4 more shares that are worth the $400 he put in. The total return for the year is $800 ÷ $10,000 = 8.0%, twice the price return, because half of what the investment produced arrived as cash rather than as a higher price.

Had Ravi taken the $400 in cash instead of reinvesting it, he would still have received the same $800 of value in that first year. The reinvestment assumption starts to matter in the second year and every year after it, because reinvested distributions go on to earn their own return.

Pros

• Counts everything the investment produced, so it does not understate a holding whose return arrives mostly as income.
• For registered funds the computation is prescribed and standardized, which makes published figures comparable across funds.
• The prescribed version is net of the maximum sales load and recurring account fees, so it reports a result an investor could plausibly have received.
• Works the same way for a stock, a bond, a fund or a whole portfolio, so one measure covers holdings that pay income very differently.

Cons

• The reinvestment assumption will not match a holder who spent the distributions, and the published figure will overstate that person's result.
• It is a pre-tax, pre-inflation number, so it overstates what the money is worth in purchasing power and after tax in a taxable account.
• One figure hides the path, so a steady result and a harrowing one can look identical.
• It measures the investment rather than the investor, and money contributed or withdrawn part way through will produce a different personal result.