What Is a Total Return Index?
Let me explain what a total return index is: it captures both capital gains and reinvested cash distributions like dividends and interest, giving you a more complete measure of performance than a simple price index. This approach provides a transparent view of growth for shareholders and even accounts for stocks that don't pay dividends by reflecting reinvested earnings within companies. In this piece, I'll contrast it with a price return index and use examples like the S&P 500 Total Return Index to show the key differences.
Key Takeaways
- A total return index reflects both capital gains and reinvested dividends or interest, offering a truer picture of investment performance.
- In contrast to price indices, total return indices show higher returns as they incorporate cash distributions.
- The S&P 500 Total Return Index (SPTR) includes dividends, unlike the standard S&P Index (SPX).
- The major difference between price return and total return indices is the inclusion of dividends and cash payouts in the latter.
- Index funds aim to replicate the behavior of a particular index, usually with passive management and lower fees.
Understanding How Total Return Indexes Work
You should know that a total return index is often seen as more accurate than methods that ignore dividends or distributions, such as those focusing only on annual yield. For instance, if an investment has a 4% annual yield and a 6% share price increase, the yield alone doesn't tell the full story, but the total return combines them to show 10% growth. If the share price dropped 4% instead, the total return would be zero.
Example of a Total Return Index: The S&P 500
Take the S&P 500 Total Return Index (SPTR) as an example—it's a total return index that differs from the standard S&P Index (SPX) by including dividend gains. These indexes operate like many mutual funds, automatically reinvesting all cash payouts back into the fund. While most are equity-based, there are also bond indexes that reinvest coupon payments and redemptions. Other examples include the Dow Jones Industrials Total Return Index (DJITR) and the Russell 2000 Index.
Comparing Price Return vs. Total Return Index Funds
Total returns differ from price returns, which don't account for dividends and cash payouts, and including those dividends can make a big difference in the fund's return. Look at the SPDR S&P 500 ETF (SPY): its price return since 1993 was 789% as of March 10, 2021, but the total return with reinvested dividends is nearly 1,400%. Similarly, the Dow Jones Industrial Average over the 10 years ending March 2021 had a price return of 162%, but the total return was 228%.
An Overview of How Index Funds Work
Index funds simply mirror the index they track—for example, an S&P 500 index fund might hold one of each security in the index or a representative sample. The goal is to match the index's activity and growth. These funds require only passive management to stay in line with the index, which keeps fees lower than actively managed funds. Plus, they offer built-in diversification, making them lower risk in that sense.
The Bottom Line
In summary, a total return index gives you a comprehensive view of investment performance by including capital gains, dividends, and interest payouts, making it more reflective of real investor returns than a price index that only tracks price changes. Examples like the S&P 500 Total Return Index illustrate this. When you compare price and total return figures, the inclusion of dividends and interest reveals much higher returns, offering a more accurate picture of what you might actually get from an investment.
