Returns

Investors can make returns on mutual fund investments in three different forms:

• Capital appreciation (growth)
• Dividend distributions
• Capital gains distributions

Capital appreciation (growth) occurs when fund shares rise in value. For example, shares are purchased at $20 per share, then sold at $30 a few years later. Share prices rise when the collective value of the investments in the fund rise, and vice versa. Using a bond fund as an example, its share price would likely rise if interest rates fell. As we learned in the bond fundamentals unit, debt securities maintain an inverse relationship with interest rates. Therefore, a bond fund would likely experience an increase in overall value when interest rates decline. If the fund were stock-based, its value would rise when the collective value of the stocks in the portfolio increased.

Some mutual funds also make dividend* distributions to shareholders. This is especially true for income-based funds investing in fixed-income securities (e.g., preferred stock and bonds). When a fund receives income from its investments (e.g., a bond fund receiving interest payments from the bonds in the portfolio), most or all of the 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 at a gain, then distributes at least a portion of the gain. For example, assume a bond fund liquidates a debt security in its portfolio for a profit. If the profit is then distributed to the fund’s shareholders, it is categorized as a capital gains distribution.

To fully illustrate how an investor can make a return on a mutual fund investment, let’s explore 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 made three forms of return (on a per share basis):

• $5 capital gain (bought shares at $50, sold at $55)
• $4 in dividend distributions ($1 quarterly dividend x 4 quarters)
• $3 in capital gains distributions

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.