Total return, as informed for funds, bonds and stock, usually includes the reinvestment of all distributions. It is therefore a good measure of performance, as was explained in “Total Return to Measure Fund, Bond and Stock Performance”. Nevertheless, it does have shortcomings, mainly because of the following factors :
- It assumes distributions are reinvested immediately but doesn't consider the costs involved.
- It doesn't include the effect of taxes.
- There are no comparisons with alternative investments. Or, put in other words, total return doesn't include opportunity costs.
- It is independent of the risk that was assumed.
The purpose of this article is to discuss these factors, so that we are able to perform more educated evaluations of investments' performances than those done by simply comparing total returns.
Reinvestment Costs
Reinvesting distributions in some cases has no costs, but in others it does. When it does, it is frequently not cost effective to reinvest immediately after receipt, because fixed costs such as brokers' fees would take away much of our potential earnings. In those cases, we will probably prefer to accumulate the receipts and reinvest them only once a year or so. That reinvestment delay would reduce our returns a bit. The quantity of that reduction depends on how much of the total return is achieved through distributions, but differences between papers are rarely higher than a 5 % of their total returns, so it is not too-big a factor.
Tax Efficiency
As investors, when our earned value is turned into cash, we have to pay taxes (unless our holdings are in a tax-deferred account). The more we can postpone payment of those taxes, keeping that value in our profit-bearing portfolio, the better, because in the meantime it will be working for us earning us more money. Therefore, from a tax perspective, capital gains are more convenient than distributions, because they are realized (this is, turned into cash) later.
Total return, as informed in publications and websites, generally doesn't consider taxes. It assumes all distributions can be reinvested fully, but in reality part of them aren't, because distributions are taxed (once again, they aren't if securities are in tax-sheltered accounts). If two funds have the same total return, but one pays more of it through distributions, then that fund will actually return less than the other. There are exceptions, and some capital gains and distributions qualify for lower taxes, thus the analysis is more complex. It is out of the scope of this article to discuss taxes in detail, lets just retain that some investments are more tax efficient than others. That fact, that affects investment profits, is not reflected in total return. Therefore, when analyzing a securities' performance, besides looking at its total return, we may want to know if it is tax efficient and up to what extent.
Market Performance and Risk
Until now, we have considered performance to be the same as how much value the investment earned. Nevertheless, if we understand it in a broader sense, as the answer to how well the investment did, then we will want to incorporate into the analysis the amount of risk that was taken and the earnings of the broad market during the same period. In a sense, it is not the same "performance" to obtain a 10 % return from a conservative investment than from a high-risk one. Neither is the same to obtain such a return when comparable investments return a 2 % in average or when they return a 20 %.
Total return describes how much the investment earned but it doesn't take into account neither the general market performance nor risk. To evaluate how well an investment did, we can do more than looking at its total return. We may, for example, compare it with the return of the market (as represented by an index), analyse it in combination with proxies to risk such as volatility and beta, or look at a relative risk-adjusted metric such as Jensen's alpha. Several of those metrics are often informed in publications and informational websites, although not as often as price and total return. For more about these alterantive measures, you can read “Investment Performance Measurement: Return, Volatility, Alpha & Beta”. These indicators are used extensively in Modern Portfolio Theory (MPT).
So what do we do with this knowledge?
In order to invest, it is not mandatory to calculate reinvestment costs and tax efficiency or to follow MPT metrics. I think that many small investors, if not most, don't bother with it, and some are even unaware of their importance. Nevertheless, if you would like to improve on your financial skills, knowing the metrics will help you. A good starting point is to recognize that total return doesn't provide a full picture, even if it offers a better one compared to price increase.
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