Capital vs. Total Return: How to correctly assess your Fund’s performance

BY David Bassanese | 13 October 2015
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When comparing the performance of different investments, investors need to remain aware of an important but often easily overlooked distinction – that between the capital (or price) returns on an investment, and its “total” returns.  As this note will demonstrate, this distinction is especially important when it comes to investments that produce relatively high income compared to capital returns.

Capital vs. Total Returns

The return on an investment usually involves two elements: the capital (or price) return, and the income return.  The sum of both the capital and income return is then called the “total” return.

Total Return = Capital Return + Income Return

In the case of shares, for example, the change in the share price of a listed company over time can be considered the capital return. If a company’s share price has increased from $10 to $12 over a given year (ignoring share splits or rights issues), then the capital return would have been 20%.  If, however, the company also distributed a dividend of $1 at the start of the year, then the income return would have been 10%.  In this case, the total return from the share over this period would have been 30%.

As should be evident, looking at the performance of the share price alone would provide an incorrect picture of the total value of this investment. What’s more the misperception created by looking at the share price alone is even greater when the income returns from the investment are particularly high.

As seen in the chart below, for example, the price performance of the S&P/ASX 200 index has been sufficiently weak in recent years that the price index has yet to reclaim its previous peak level in late 2007, or just before the financial crisis.  Yet due to the steady dividend returns produced by companies in the index (depicted by the income return in the chart below), the “total” return of the S&P/ASX 200 index since mid-2007 has nonetheless been positive.

asxreturn
Past performance is not an indicator of future performance.

Equity Income ETPs

BetaShares manages a number of ETPs that aim to produce enhanced equity income returns to suit the needs of investors seeking an income stream from their investments.   The overall aim of these products, however, is still to produce decent total returns – though with the composition of these returns skewed toward income over capital.

As as specific example, let’s consider the BetaShares Australian Dividend Harvester Fund (managed fund) (ASX Code: HVST), which aims to provide investors with exposure to large-cap (typically among the top 50 by market capitalisation) Australian shares, along with a strong income stream comprising dividends and franking credits, that is at least double the yield of the broad Australian share market on an annual basis.  In addition, the Fund employs a risk management strategy which aims to reduce the volatility of equity investment returns and defend the portfolio against the risk of significant market declines.  More information on the Fund is provided here.

As seen in the chart below, the total return performance of the Fund since inception has been notably higher than its capital (or price) return alone, thanks to solid income returns.  This underlines the point that it is particularly important to not focus on unit price performance alone when the income earned from an investment is relatively high.

hvstchart
Past performance is not an indicator of future performance.

As seen in the table below, moreover, the Fund’s aim of providing around double the income returns of the broad Australian share market on an annual basis has so far been achieved. In the first eleven months since the Fund began, income returns have been 10.6% compared to only 4.9% for the S&P/ASX 50 index.

hvst
Source: BetaShares. Past performance is not an indicator of future performance.

Although the Fund’s capital returns have underperformed the market since inception, this reflected a bout of under performance earlier this year when the Fund was holding bank stocks during a particularly sharp decline in financial stocks.  Such a “stock specific” risk may be encountered by the Fund on occasion and which the broader risk management strategy does not attempt to counter.

It’s noteworthy, however, that the Fund has outperformed the S&P/ASX 50 on a capital and total return basis during the broader market sell-off over recent months – thanks to both above-market income returns and less capital loss due to the risk management strategy in place.

Dividend Reinvestment Options

As noted above, to meet the need of certain investors, equity income ETPs such as HVST aim to skew their total returns toward income relative to capital.  Should investors want to seek a somewhat different balance, however, there is always the option of reinvesting all of part of their income distributions.  In the case of HVST, for example, investors can elect to participate in the Dividend Reinvestment Plan, which automatically reinvests a level of income return – the proportion of which is at the investor’s choosing – into more units of the Fund.

6 Comments

  1. Neville  |  October 14, 2015

    I understand what you have said but why has HVST so markedly underperformed MVB (in total return terms) over the past 12 months? I reckon by about 7%!
    Cheers,
    Neville

    1. BetaShares  |  October 14, 2015

      Hi Neville,
      As you are likely aware, HVST engages in a “dividend rotation” strategy in order to rebalance to securities with high gross yield. This necessarily means that bank stocks will at times be part of the portfolio and at times not part of the portfolio. To that extent MVB is not and should not be considered a direct comparison for this fund.

      Hope that helps

  2. I am interested in your comment “Such a “stock specific” risk may be encountered by the Fund on occasion and which the broader risk management strategy does not attempt to counter”. I don’t think it was made clear such a risk existed at the time I was considering investing in HVST. I invested in December 2014 under the impression that strategies were in place that would minimise the risk of capital loss. I am now looking at about a 14% loss of capital value, and thus a negative “total return”, which is disappointing given my expectation that the risk management in place would limit such losses to a lower number.

    1. BetaShares  |  October 14, 2015

      Hi Bob,
      The risk management strategy utilised by HVST aims to reduce portfolio exposure when market volatility is above average by selling ASX SPI 200 futures. This means it will reduce portfolio exposure to falls in the market. As the portfolio typically provides exposure to large cap stocks, the correlation between HVST’s portfolio and the market is high, which is where the ‘smoother ride’ comes from. Please note that the risk management strategy aims to provide exposure to the upside potential of the market and reduce downside risk (but not eliminate it).

  3. I like the idea of HVST, capturing a potential buildup to the dividend, and extracting the franking credits can be very beneficial for some. However, the way I see it there are some drawbacks that possibly might benefit from more consideration. First, following from Bob’s message, the issue is that the fund does have a reasonable exposure to the idiosyncratic risk of the stocks that are about to go ex-div….this was the problem with the untimely fall in bank stocks whilst holding onto some of them. Short SPI futures won’t help with this and does exposure the fund to a fair amount of individual stock volatility.
    This leads to my second point. I don’t know if hedging using short SPI futures is the best way to go – for two reasons. First, the way you have set it up there is a delayed reaction to increased volatility. So, only until ‘after’ the market falls will your short futures kick in, by which time there might be a bit of a recovery (upswing) which the fund now only marginally benefits from. In other words, it suffers from the initial downturn, but only partially benefits from the upturn. Secondly, and related to this, although shorting futures may work in the current environment, with more downside risk present and what looks like a very weak recovery, the opposite is true early this year when there was a quick-paced bull market for awhile – the fund did not perform very well from what I could work out based on the information at hand. A potential danger of this smoothening effect that relies on a delayed response to increased volatility through shorting SPI is that it may not allow capital value to build up enough relative to the dividends it is chasing. Have you considered using VIX futures instead? This might be worth investigating. Cheers.

    1. BetaShares  |  November 13, 2015

      Ralf,
      Thanks so much for your considered feedback. You are absolutely right that HVST, at times, has a fairly concentrated portfolio. We have however done analysis that indicates that the historical ‘beta’ of the portfolio (i.e. the extent to which it follows the ups and downs of the broader sharemarket) is actually quite high, which is why we feel the managed risk strategy we are currently using is effective in mitigating downside risk and providing a ‘smoother ride’ for investors. The risk management strategy we are utilise has been used for a large number of years and in the portfolios of some of the largest institutional clients globally, and as such we believe it is one of the best way to reduce downside risk in portfolios. We have investigated other risk management techniques and believe the ‘Milliman Managed Risk Strategy” does the best job in achieving its objectives.

      For any future information or to discuss these issues in more depth, please go ahead and call our Client Services team on 1300 487 577 during business hours.

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