PRICE RETURN INDICES EXPLAINED

A price return index (also called a price index) is a type of stock market index that measures the performance of a group of securities based only on changes in their market prices. It does not account for any dividend payments or other income distributions that investors may receive from holding those securities.

For example, if a stock within the index pays a quarterly dividend, the price return index will not reflect that income. Consequently, the performance shown by a price return index tends to be lower than that of a total return index, which does include such payouts.

Price return indices are commonly used by global equity benchmarks such as the Dow Jones Industrial Average and the standard versions of the S&P 500 and FTSE 100. They are useful for tracking the price appreciation or depreciation of securities, offering an estimate of capital gains without factoring in reinvested dividends.

How Price Return Indices Work

These indices are calculated by identifying a group of representative stocks, assigning a weight to each (either price-weighted, market capitalisation-weighted, or equal-weighted), and then tracking the combined price movements over time. Changes in the index result solely from changes in the prices of the component securities.

Benefits and Limitations

Price return indices offer a clean view of market sentiment and basic price appreciation, which is useful for technical or short-term analysis. However, they exclude significant aspects of total investment returns, particularly for income-oriented investors or long-term portfolio evaluations.

Thus, investors seeking a complete view of investment performance often turn to total return indices, which include both price movements and reinvested dividends.

Price return indices exclude dividends and other forms of income, which can make a substantial difference in long-term investment return calculations. Understanding what is omitted is crucial in selecting the appropriate index for analysis or benchmarking.

Dividends

The primary exclusion in a price return index is cash dividends. These are payments companies make to shareholders, usually from profits. For income investors in particular, dividends can comprise a large portion of total return. Over time, especially in established equity markets, compounding reinvested dividends can lead to significantly improved returns.

Stock Distributions

Price return indices typically do not adjust for special dividends, stock dividends, or capital returns either. These can alter investors' effective returns depending on their treatment in total return indices or individual portfolios. For instance, if a company issues a one-time special dividend, the stock price might drop accordingly. A price return index would register only the price decrease, without compensating for the value of that distribution.

Interest from Fixed-Income Components

In multi-asset indices (e.g., balanced funds or diversified benchmarks), the price return index also ignores coupon payments or interest income from bonds or fixed-income securities. This further limits its usefulness when considering total portfolio performance across asset classes.

Inflation Adjustment

Price return indices do not make any adjustment for inflation. As such, the purchasing power represented by the index values may decline over time, distorting perceptions of real investment growth. Investors often supplement price return indices with inflation data or look at real return indices when examining long-term value preservation.

Implications for Investors

By excluding income elements, price return indices may underreport actual investor gains, especially in dividend-rich environments or during periods of strong corporate earnings distributions. This can be misleading for benchmarking purposes or performance comparisons if not properly contextualised.

To fully understand a price return index, it’s essential to compare it with its counterpart: the total return index. The key distinction lies in the treatment of distributions.

Total Return Indices

A total return index assumes that dividends received are immediately reinvested in the index. This reinvestment introduces a compounding effect, which typically results in the total return index outperforming the price return index over extended periods.

For example, between 1990 and 2020, the S&P 500 price return index rose by approximately 800%, while its total return variant increased over 1,600%. The difference is due to the cumulative effect of reinvested dividends. Compound growth of income plays a major role in wealth accumulation, which is absent from the price return index's view.

When to Use Each Index

• Price Return Index: Best used when interested only in capital gains or comparing price momentum.
• Total Return Index: Suitable for evaluating overall investment performance, especially in long-term or retirement planning scenarios.

Analytical Considerations

Using only a price return index might lead analysts or investors to undervalue dividend-producing stocks or understate the value of long-term index investing. Financial advisors typically prefer total return indices for assessing the performance of portfolios invested in mutual funds or ETFs, as these returns better reflect the compounded effects of ownership over time.

Conclusion

In sum, while price return indices offer useful insights into price movements and market sentiment, they provide an incomplete picture for evaluating total wealth generation. For a comprehensive understanding of investment returns, particularly across longer timeframes or in income-focused strategies, total return indices are the more suitable benchmark.

Investors and analysts should carefully select the type of index that aligns with their investment goals, timeframe, and focus—understanding clearly what each index reveals and what it omits.