Investors can earn returns on mutual fund investments in three different forms:
Capital appreciation (growth) occurs when fund shares rise in value. For example, you might buy shares at $20 per share and sell them a few years later at $30 per share. A fund’s share price generally rises when the combined market value of the fund’s underlying investments rises (and falls when that combined value falls).
For example, consider a bond fund. Its share price would likely rise if interest rates fell. 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. If the fund were stock-based, its value would rise when the combined value of the stocks in the portfolio increased.
Some mutual funds also make dividend* distributions to shareholders. This is especially common for income-based 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 the bonds in its 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 at 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 for a profit. If the profit is then distributed to the fund’s shareholders, it is categorized as a capital gains distribution.
To see how an investor can earn a return on a mutual fund investment, 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).
At this point, you’ve learned about some of the most popular securities - common stock, preferred stock, debt securities, and mutual funds. Investors try to earn a return on these investments, and one common way to measure that performance is total return.
Keep in mind that there are three ways to make a return or lose capital (money) on a security:
Preferred stocks, mutual funds, and some common stocks pay cash dividends to investors. Debt securities pay interest income to investors. Any security can have a capital gain or loss.
Both gains and losses can be:
Total return considers all gains and/or losses compared to the investment’s original cost. Here’s the formula:
The following video shows how to approach a total return question:
Let’s see if you can answer a total return question on your own:
An investor purchases 100 mutual fund shares at a $50 POP per share. After holding the security for six months, the investor receives two quarterly dividends of $1 per share, then liquidates the security at $55 NAV per share. What is the total return?
Can you figure it out?
Answer = 14%
Let’s establish the total return formula:
You can calculate total return using absolute numbers (for all 100 shares) or on a per share basis. Either approach works. For simplicity, we’ll calculate it on a per-share basis.
So the overall return is $7 per share ($2 dividend + $5 capital gain). The original cost was $50 per share. Now plug those values into the formula:
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