Investors can earn returns on mutual fund investments in three different ways:
Capital appreciation (growth) happens when the fund’s share price increases. For example, you might buy shares at $20 per share and sell them a few years later at $30. A mutual fund’s share price generally rises when the combined market value of the securities in the portfolio rises (and falls when that value falls).
A bond fund is a useful example. Its share price will often rise when interest rates fall. As we learned in the bond fundamentals unit, debt securities have an inverse relationship with interest rates. So, when interest rates decline, the bonds in the fund tend to increase in value, which can increase the fund’s overall value. For a stock fund, the share price tends to rise when the stocks in the portfolio rise in value.
Some mutual funds also make dividend* distributions to shareholders. This is especially common for income-focused funds that invest in fixed-income securities (e.g., preferred stock and bonds). When a fund receives income from its investments (for example, a bond fund receiving interest payments from bonds in the portfolio), most or all of that income is usually distributed to shareholders.
*Income payments from mutual funds are considered dividends, even if the income originates as interest. For example, a bond fund holding debt securities receives interest from the investments in the portfolio. When the interest is re-distributed to the bond fund’s shareholders, it is considered a dividend distribution.
Mutual funds can also make capital gains distributions to shareholders. This type of distribution occurs when the fund sells a security for more than it paid (a gain) and then distributes at least a portion of that gain. For example, assume a bond fund sells a debt security in its portfolio at a profit. If the profit is then distributed to the fund’s shareholders, it’s categorized as a capital gains distribution.
To see how an investor can earn a return from all three sources, consider this example:
An investor purchases ABC Growth Stock Fund shares at an initial price per share of $50. They hold the investment for one year, then sell the shares at $55. Over the year, the investor received quarterly dividends of $1 per share and a one-time capital gains distribution of $3 per share.
In this scenario, the investor earned three forms of return (on a per share basis):
The total $12 ($5 + $4 + $3) represents a return of 24%* ($12 total returns / $50 original investment).
*This is the total return calculation, which will be covered in a future chapter.
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