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Understanding Total Return

Net asset value isn't the only way to measure a fund's performance, in fact total return will give you a clearer picture

Morningstar.co.uk Editors 8 July, 2013 | 7:00AM

There's a relationship between net asset value (NAV), yield and total return, but it's complicated. 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%—in fact, it can yield nothing at all—and yet its returns can still be at the top of the charts?

Before we go further, though, let's review the two key components of total return. You can earn money from your investment in two ways: income (often called yield) and capital appreciation.

Income and Capital Appreciation

Income: A fund's income payout, or yield, tends to interest those investors who need regular income, because they don't necessarily have to tap into their principal for their day-to-day living expenses. Savings accounts pay income, but so do most bonds and some stocks. If you own a fund that buys income-paying stocks or bonds, the manager passes on any income to shareholders (after taking expenses off the top, of course).

Yield can be calculated in a variety of ways. Morningstar calculates yield for the past 12 months. 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.

Capital appreciation: The second key way you can gain from a fund is through capital appreciation—that is, if one or more of your fund's holdings is selling for a higher price than it was when the manager purchased it. If the manager sells the new, pricier stock or bond, the fund clocks what is called a capital gain. And even if the manager simply hangs on to the stock or bond that has gained in value, the fund will enjoy capital appreciation; in other words, its NAV will increase. That's because the NAV is a reflection of the value of all of the securities in a fund at a given point in time.

Distributions

As counterintuitive as it may seem, looking at a fund's NAV in isolation isn't always the best way to check up on its performance. That's because the NAV is vulnerable to changes that don't necessarily affect the true value of the fund.

For example, a fund's NAV will change whenever a fund makes a payment to its shareholders, otherwise known as a distribution. If a fund with an NAV of £10 makes a £4 distribution, its NAV slips to £6.

Despite the shrunken NAV, shareholders are none the poorer. They still have £10: £6 in the fund and another £4 in cash. Unless they need the £4 in income to spend, most investors will reinvest their distributions back into the fund; 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 you reinvest your distributions.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Morningstar.co.uk Editors  analyse and report on shares, funds, market developments and good investing practice for individual investors and their advisers in the UK.

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