The importance of total returns

By Matt Quinn, CFA®                                                 October 2018

We often get questions from clients about why the price of an investment looks to have declined significantly from one day to the next.  Conversely, we find that clients have a keen interest in dividends and generating income from their investment portfolios.  What do these concepts have to do with each other?  We believe they are both important components of an investment’s total return.

While we certainly recognize the importance of dividends in their contribution to long term returns, they can also be a significant drag on price appreciation.  Conversely, focusing on price movements alone for investments that pay regular and/or higher distributions doesn’t provide good insight into changes in an investment’s underlying value.  We instead urge investors to consider the concept of total return, which captures price return, and also includes interest, capital gains, dividends, or distributions realized over time.

First, a little background on how investments like stocks, mutual funds, and exchange traded funds are priced.  When the board of directors or the managers for one of these types of investments announces a dividend payment, they provide information on when the dividend will be recorded and paid as well as an ex-dividend date.  These days are often separate and distinct from one another.  The record date refers to the trading date that the dividend will become effective.  Since many of these investments frequently change ownership, the owner of record gains the right to receive this dividend on the record date even if they subsequently sell the investment.  In exchange for ownership of this dividend, the price of the investment is adjusted down by the amount of the dividend as of that record date and trading will open the next day at this adjusted closing price[1].  Thus, there is no “free lunch” for investors that emphasize dividend paying investments.  For investments that have a high payout ratio relative to the investments price or net asset value, this can look like a significant negative change to someone that just tracks the investment’s price through accounting software.  This confusion is further confounded by the fact that the dividend may not actually be paid out for several trading days – the so called ex-dividend date.

Tracking price information for investments doesn’t always give a clear picture of underlying value. Dividends do matter, not only in the pricing of securities, but also for the total return of an investment.  Based on nearly a century of data for the S&P 500 Index, about 40% of total returns have come from dividend payments and 60% from price appreciation.  Dividends were particularly important during the so-called “lost decade” from 2000 through 2009 when price returns were negative for stock investors and the only source of return for stock investors was the dividend payments they received.  Reinvesting those dividends is an even more significant driver of longer term returns for investors, but that is a topic we will explore further some other day.  This is also true for bond investors, where the distribution or “yield” is often the only source of return over longer periods of time.

Focusing on just price appreciation or current yield alone can increase risk and lead to unintended consequences for investors.  Higher yielding investments often use leverage, which can make their prices more sensitive to changes in credit or lending conditions as well as fluctuations in interest rates.  Lower yielding investments are more dependent on appreciation potential and may experience more price volatility as a result.  We prefer to take a more diversified approach when constructing portfolios, making sure we rebalance risk in portfolios over time.  When changes in prices or yields diverge from fundamentals, we look for opportunities to generate total returns for our investors.  We also prefer to compound returns by reinvesting dividends in a diverse set of investment strategies over different stages of the market cycle and try to do so as tax efficiently as possible.  After all, dividends and capital gains are taxed at different rates, and even the taxable nature of each needs to be considered within a portfolio.

If you have further questions or would like to talk through either total return or income-oriented investment strategies, we would love to start a conversation!

 

[1] Pricing services often provide adjusted closing prices, which smooth out historical data used on popular Internet sites such as Yahoo Finance.  Tracking investments through accounting software like Quicken does not account for these adjustments and instead uses actual historical transaction pricing.

 

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