Understanding Returns in Collective Investment Schemes

Determining the return of a collective investment scheme (CIS), such as a unit trust fund or exchange traded fund (ETF), is more complex than you might think, and certainly not as straightforward as the interest-rate return on a bank deposit.

On a bank deposit, with a fixed rate of interest, the interest is either paid out to the investor (this could be monthly, quarterly or annually) or reinvested, in which case the deposit is recapitalised at the new amount. The following year’s interest will be on the new, higher capital amount, giving you compounded growth year on year.

The returns of CISs derive from the prices at which the underlying assets – mostly shares and bonds – trade on the financial markets. But they also reflect the income these assets generate: dividends in the case of shares and interest payments in the case of bonds. To understand the return of a CIS, we must look at its net asset value (NAV), yield, total return and annualised returns.

Net asset value

The NAV of a unit trust fund or ETF is calculated by subtracting the fund’s liabilities, which include the investment costs, from its assets (the total value of its holdings) and dividing that amount by the number of units or shares issued.

In a unit trust, the NAV is calculated at the end of each trading day according to the closing prices of the underlying assets. The NAV is the price at which you buy or sell units through the unit trust management company.

ETFs, on the other hand, trade on the stock exchange, and you buy or sell them at their market value in real time through a stock broker. Their NAV is also calculated at the end of each trading day. However, because they trade in real time, ETFs also depend on a fluctuating intraday, or indicative, NAV (iNAV), which is an estimate of the fair value of the fund’s assets at any given point in time and which should closely correspond to its real-time market price.

A rise in the price of the unit or share, as reflected in its NAV, gives you your return on capital. For example, if the price rises from R100 to R110, the return on capital, or gain, is 10%. This is generally the main component of a fund’s return.

Yield

Yield is a measure, expressed as a percentage of the unit or share price, of income the fund receives from dividends and interest from the underlying securities. This, the second component of return, takes the form of annual or semi-annual income distributions. Investors can choose to receive the income or to reinvest it (although some funds reinvest it automatically). Reinvesting buys more units.

Dividends and interest payments coming into the fund from the underlying securities accumulate, adding to the fund’s cash assets (hence raising its NAV). When a distribution is made to investors, the fund’s assets drop slightly, with a corresponding drop in the NAV. For investors who reinvest, the drop in NAV is offset by the additional units they receive.

Note that ETFs that pay distributions do so into the investor’s share account and it is up to the investor to reinvest this money in the same or different investment.

Total return

The NAV reflects distribution payouts that have been reinvested in the fund, as they again form part of the fund’s assets. However, it does not include distributions that have not been reinvested.

For a more comprehensive and accurate gauge of a fund’s returns, you need to consider its total return, which includes all distributions, reinvested or not. This is the return quoted in the fund’s fact sheet or minimum disclosure document.

The total return is the best figure to use for long-term investors who are relying on compounding to grow their investments. However, it may be less appropriate for investors earning an income from their investments (in other words, who don’t reinvest), such as retirees, who may do better to look at the fund’s NAV return and yield.

Annualised returns

For periods longer than a year, fund fact sheets quote an annualised return. This is an average return per year for the period – say five years. However, it is the geometric, not arithmetic average, as it takes into account compound growth. In other words, taking into account the beginning value and end value over that period, it is what an average compound rate would have delivered per year.

References:

https://www.investopedia.com/terms/n/nav_return.asp

https://www.investopedia.com/terms/t/totalreturn.asp

https://www.investopedia.com/ask/answers/090415/how-do-dividends-affect-net-asset-value-nav-mutual-funds.asp

https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/nav-return

https://www.investopedia.com/terms/a/annualized-total-return.asp