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Rate of return



Mutual Funds and exchange-traded funds (ETFs) hold portfolios of various companies' stock shares. When the companies pay a dividend, and when the fund trades shares, dividends and capital gains are distributed to the mutual fund shareholders. Mutual funds trade at the net asset value of the stock shares.

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Total returns

Mutual funds report total returns based on reinvestment factors. Reinvestment factors are based on total distributions (dividends plus capital gains) during each period.

  • {\rm Year\; 1\; Reinvestment\; Factor\;} = \frac{{\rm Year\; 1\; Total\; Distribution}}{{\rm Year\; 1\; Share\; Price\;}}+1.


  • {\rm Year\; 2\; Reinvestment\; Factor\;} = \frac{{\rm Year\; 2\; Total\; Distribution} \times {\rm Year\; 1\; Reinvestment\; Factor\;}}{{\rm Year\; 2\; Share\; Price\;}}+1.


  • {\rm Year\; 3\; Reinvestment\; Factor\;} = \frac{{\rm Year\; 3\; Total\; Distribution} \times {\rm Year\; 2\; Reinvestment\; Factor\;}}{{\rm Year\; 3\; Share\; Price\;}}+1.


  • {\rm Year\; 4\; Reinvestment\; Factor\;} = \frac{{\rm Year\; 4\; Total\; Distribution} \times {\rm Year\; 3\; Reinvestment\; Factor\;}}{{\rm Year\; 4\; Share\; Price\;}}+1.


  • {\rm Year\; 5\; Reinvestment\; Factor\;} = \frac{{\rm Year\; 5\; Total\; Distribution} \times {\rm Year\; 4\; Reinvestment\; Factor\;}}{{\rm Year\; 5\; Share\; Price\;}}+1.


Total Return = ((Final Price x Last Reinvestment Factor) - Beginning Price) / Beginning Price

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Average annual return (geometric)

Average Annual Return (geometric)

= \left[ {\left(1 + \frac{{\rm Cumulative\; Return}}{100}\right)}^{{\rm Time\; in\; years}^{-1}} - 1 \right] \times 100

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Example

Example: Mutual Fund with low volatility and a regular annual dividend, reinvested at year-end share price, initial share value $100
End of: Year 1 Year 2 Year 3 Year 4 Year 5
Dividend $5 $5 $5 $5 $5
Capital Gain Distribution $2
Total Distribution $5 $5 $7 $5 $5
Share Price $98 $101 $102 $99 $101
Shares Purchased 0.05102 0.04950 0.06863 0.05051 0.04950
Shares Owned 1.05102 1.10053 1.16915 1.21966 1.26916
Reinvestment Factor 1.05102 1.05203 1.07220 1.05415 1.05219


  • Total Return = (($101 x 1.05219) - $100) / $100 = 6.27% (net of expenses)
  • Average Annual Return (geometric) = (((28.19)/100)+1) ^ (1/5)) – 1) x 100 = 5.09%

Using a Holding Period Return calculation, after 5 years, an investor who reinvested owned 1.26916 share valued at $101 per share ($128.19 in value). ($128.19-$100)/$100/5 = 5.638% yield. An investor who did not reinvest received a total of $27 in dividends and $1 in capital gain. ($27+$1)/$100/5 = 5.600% return.

Mutual funds include capital gains as well as dividends in their return calculations. Since the market price of a mutual fund share is based on net asset value, a capital gain distribution is offset by an equal decrease in mutual fund share value/price. From the shareholder's perspective, a capital gain distribution is not a net gain in assets, but it is a realized capital gain.

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Summary: overall rate of return

Rate of Return and Return on Investment indicate cash flow from an investment to the investor over a specified period of time, usually a year.

ROI is a measure of investment profitability, not a measure of investment size. While compound interest and dividend reinvestment can increase the size of the investment (thus potentially yielding a higher dollar return to the investor), Return on Investment is a percentage return based on capital invested.

In general, the higher the investment risk, the greater the potential investment return, and the greater the potential investment loss.

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References

  1. ^ Damato,Karen. Doing the Math: Tech Investors' Road to Recovery is Long. Wall Street Journal, pp.C1-C19, May 18, 2001

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See also

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Further reading

  • A. A. Groppelli and Ehsan Nikbakht. Barron’s Finance, 4th Edition. New York: Barron’s Educational Series, Inc., 2000. ISBN 0-7641-1275-9
  • Zvi Bodie, Alex Kane and Alan J. Marcus. Essentials of Investments, 5th Edition. New York: McGraw-Hill/Irwin, 2004. ISBN 0-07-251077-3
  • Richard A. Brealey, Stewart C. Myers and Franklin Allen. Principals of Corporate Finance, 8th Edition. McGraw-Hill/Irwin, 2006
  • Walter B. Meigs and Robert F. Meigs. Financial Accounting, 4th Edition. New York: McGraw-Hill Book Company, 1970. ISBN 0-07-041534-X
  • Bruce J. Feibel. Investment Performance Measurement. New York: Wiley, 2003. ISBN 0471268496



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