Definition and Examples of Total Return Index
The total return index is an index created to track the increase in capital and dividend returns. The index reinvests all dividends. Using the total return is a way to include every part of the return, not just price movements. Total return indices are used to show the impact of dividends on investor returns. Let’s explore how they work and the difference between total return indices and total return investment strategies.
How the Total Return Index Works
Total return indices work by reinvesting dividends when they are paid. Let’s look at an example. You buy one share of a total return index at a price of $50 on January 1st. The index offers annual distributions of $4, paid out as $1 each quarter. By December, the stock price has risen 20% to $60. The price return is 20%. However, since the index paid you $4 in dividends and you reinvested it, achieving an additional value of $1, your initial investment is now worth $65. While the price return is 20%, the total return is 30%.
Total Return Index vs. Total Return Strategy
The total return strategy, or income investing, is a popular retirement investment strategy that shares some elements with total return indices but is a completely different concept. The total return strategy focuses on increasing income for investors. Investors or fund managers following a total return strategy concentrate on high-dividend stocks and fixed-income instruments like bonds. This is an effective retirement strategy because it generates income for investors to live on while preserving and ideally increasing capital for years to come.
What This Means for Individual Investors
Total return indices are an effective means for individual investors to compare their investment returns and potential returns from investment managers with indices like the S&P 500. The Financial Industry Regulatory Authority (FINRA) recommends using total return to evaluate investment performance across different investment opportunities because it is the most accurate measure of investment return.
It is also important to include dividends when comparing performance even when neither of the options is high-yield. From 1970 to 2020, 84% of the total return of the S&P 500 came from reinvested dividends, according to Hartford Funds. Investors should keep this performance in mind when choosing between high or low yield investments, and when deciding whether to reinvest dividends.
Key Takeaways
Total return is an investment return that includes both price appreciation and dividends. Total return indices use dividends paid to shareholders to purchase stocks. Approximately 85% of the total return in the S&P 500 from 1970 to 2020 came from reinvesting dividends.
Source: https://www.thebalancemoney.com/what-is-a-total-return-index-5217456
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