An article written by Ray Calleja: Head – Private Clients, MeDirect
In last week’s piece we explained the way the Net Asset Value (NAV) of a fund is calculated. In this week’s article we will have a look at the relationship between net asset value (NAV), yield, and total return.
There are two main components of total return. Income or yield and capital appreciation which are two ways how an investor in mutual funds can earn money.
A fund’s income pay-out, or yield, tends to interest those investors who need or want regular income, because they do not necessarily have to tap into their capital for their daily living expenses. Savings accounts and term deposit accounts pay income, but so do most bonds and some stocks. Funds whose objective is to pay steady income to their shareholders invest primarily in bonds and dividend-paying stocks such as preferred stocks and utilities’ stocks. Many such funds might have the word income in their names.
Yield can be calculated in a variety of ways. Morningstar use the following method: by taking the total income distributions over the trailing 12 months and dividing that by the sum of the previous month’s ending NAV plus any capital gains distributed over the 12-month period.
Let us take an example where a mutual fund has a current NAV of €20 per share and paid €0.10 in monthly dividends over the past 12 months. The trailing twelve-month mutual fund yield would be calculated by dividing the annual dividends paid by the NAV. Thus, the yield would be €1.20 / €20 = 0.06 or 6%.
The second main way you can gain from a mutual 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 what is now the more expensive stock or bond, the fund realises or makes 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 is because the NAV reflects the value of all the securities in a fund at a given point in time.
As we pointed out last week, looking at a fund’s NAV in isolation is not the best way to check up on its performance. That is because the NAV is vulnerable to changes that do not necessarily affect the true value of the fund. A fund’s NAV will change any time a payment or distribution is made to the shareholders. Mutual funds whose objective is income distribution, must distribute in cash any income they have received from their stocks or bonds, as well as any capital gains they have made from their holdings. In the case of accumulator funds any income generated including any capital gains will be re-invested within the fund, raising the value of your investment. A capital gain or the price return results when a fund sells a stock or bond for a higher price than when it was purchased.
Whenever a fund passes along either income or capital gains to shareholders, its NAV drops. So, if a fund with a NAV of €20 makes a €5 distribution, its NAV drops to €15. As an investor you may opt to receive the €5 in cash or have the amount re-invested back into the fund by buying new shares of the fund.
Funds usually prefer to express total returns in terms of percentages. This makes it easier to compare fund performances. As an example, if a fund appreciates 8% during a particular year and it has a 4% dividend yield, then its total return will be 12%. If a fund’s total return is less than its yield, then there has been a loss. Specifically, the net asset value has dropped. For example, suppose a fund with a 6% yield has a 2% total return. We can see that its net asset value has dropped by 4%.
Let us take one final example to include all that has been discussed above:
Trailing 12-month distribution yield: 1.19%
Sum of 12 months of distributions per share/ Month-end NAV per share – 0.2460 / €20.65 = 1.19%
Price Return: 0.73%
(Ending NAV less Beginning NAV) / Beginning NAV – (€20.65 – €20.50) / €20.50 = 0.73%
Income Return: 1.19%
Trailing 12-month distribution yield %
Total Return: 1.92%
Price Return % + Income Return % – 0.73% + 1.19% = 1.92%
The concept of total return gives investors a way to determine the real value they are receiving from their mutual funds, as well as a way to compare different funds.
So to round off what we discussed – Total Return includes all elements of return, both income and capital gains what have been realised and distributed, as well as any unrealised gains in the fund’s underlying portfolio, which are reflected in NAV changes.
When judging the overall performance of a mutual fund, always look at the fund’s total return instead of just the changes in its NAV. Distributions made by the fund may reduce the fund’s NAV but they still belong as part of the shareholder’s overall return. Viewing returns in this manner gives a more accurate depiction of a fund’s success.
The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties.
MeDirect Bank (Malta) plc, company registration number C34125, is licensed by the Malta Financial Services Authority under the Banking Act (Cap. 371) and the Investment Services Act (Cap. 370).
The financial instruments discussed may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.
If you invest in any of the products discussed you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.