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 later in this unit.

Total return

At this point, you’ve learned about some of the most popular securities - common stock, preferred stock, debt securities, and mutual funds. Investors hope to make as much of a return as possible on these investments, which can be measured by total return. Keep in mind that there are three ways to make a return or lose capital (money) on a security:

• Dividends
• Interest
• Capital gains and/or losses

Preferred stocks, mutual funds, and some common stocks pay cash dividends to investors. Debt securities pay interest income to investors. Any security can obtain a capital gain or loss. Capital gains occur when an investment’s market value grows above its cost, which can be realized or unrealized. Realized gains occur when an investment is sold and the profit is “locked in,” while unrealized gains occur when an investment increases in value but is not yet sold. Capital losses occur when an investment’s market value falls below its cost. Like capital gains, capital losses can also be realized or unrealized.

Total return considers all possible returns and/or losses compared to the investment’s original cost. Here’s the formula:

$$\text{Total\hspace{0.33em}return}=\frac{\text{All gains and/or losses}}{\text{Original cost}}$$

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?