TOTAL RETURN VS PRICE RETURN INDICES: WHAT MATTERS MOST

What Is a Price Return Index?

A price return index (PRI), also known as a price index, is a type of financial market index that reflects only the capital gains (or losses) of the underlying securities. It measures the change in the prices of its constituent stocks over time but does not account for any cash dividends or other distributions that an investor might receive.

For example, the widely followed S&P 500 Index is generally quoted as a price return index unless otherwise stated. That means the published index value reflects the market capitalisation-weighted average of the prices of the 500 largest publicly traded US companies, without incorporating any dividends investors receive along the way.

Key Characteristics of Price Return Indices

• Excludes dividends: Only price movements are captured.
• Capital performance: Measures the "growth in value" based purely on price appreciation or depreciation.
• Common for benchmarking: Frequently used for media references and as general barometers of market trends.

Because they exclude dividend reinvestments, price return indices typically understate an investor's true return if dividends are reinvested—commonly the case in long-term investing or in retirement and pension funds. The compounding power of dividends can significantly enhance returns, but you wouldn’t see this effect in a price return index.

Illustrative Example

Imagine investing in a stock index fund tracking a price return version of the FTSE 100. If that index rose by 5% over one year, the 5% reflects only the share prices increases. However, if the component companies also paid an average dividend yield of 3%, your actual investment returns could be closer to 8%—but that figure would not be visible in a price return index.

Consequently, using a price return index to evaluate a portfolio's long-term performance or to compare against an actively managed fund may give an incomplete picture of returns.

Common Price Return Indices

• S&P 500 (commonly referenced version)
• Dow Jones Industrial Average (DJIA)
• FTSE 100 (default format)
• NASDAQ Composite

Each of these indices provides a snapshot of market performance based solely on share prices, not accounting for any income returned to shareholders via dividends.

Why Use a Price Return Index?

Despite its limitations, there are several reasons why price return indices remain widely used:

• Historical consistency: Many have decades of data in their price return form, allowing for long-term trend analysis.
• Simplicity: Easier for casual investors and media to understand and report.
• Benchmarking price change: Useful for investors focused on trading or strategies that do not hinge on dividend income.

Nonetheless, for a more comprehensive understanding of total wealth creation, another type of index must be considered: the total return index.

Why Total Return Indices Matter

A total return index (TRI) goes a step further than its price-only counterpart. It includes both the price appreciation and the income from dividends that are assumed to be reinvested when they are paid out. As such, it provides a more accurate reflection of the investor’s total accumulated wealth over time.

This approach aligns more closely with how long-term investors experience returns—especially those who reinvest dividends. Total return indices more accurately account for the effects of compounding, since reinvested dividends can generate their own dividend income and capital appreciation.

How It Works

When a company pays a dividend, the cash received by the shareholder is, in the context of a total return index, assumed to be reinvested into the index at prevailing prices. The continued reinvestment leads to a snowball effect, particularly evident over long periods—enhancing wealth buildup through compound interest principles.

For instance, an index might rise 5% in price over the year, but with a 3% dividend yield fully reinvested, the total return could be close to 8%. This compounding continues over years, leading to a significant divergence between price-only and total return benchmarks.

Comparative Analysis: Price vs Total Return

• Total return: Paints a complete picture of performance (price changes + dividends).
• Better for benchmarking: Crucial for assessing fund managers and investment products with similar strategies.
• Dividends matter: Especially relevant in low-growth or high-dividend environments.

Case Study: From 1988 through the end of 2023, the S&P 500 showed an average price return of around 8% annually. However, in total return terms—factoring in dividends and reinvestment—that number increased to about 10%, significantly altering portfolio growth estimates.

Where It’s Commonly Used

• In portfolio analysis and reporting tools
• In total return mutual funds and ETFs
• By pension funds and institutional investors

Total return indices are used in professional investment performance reporting. Leading platforms like Bloomberg or Morningstar often compare funds against total return indices to ensure apples-to-apples benchmarking—especially if a fund reinvests income.

Moreover, in passive investing, exchange-traded funds (ETFs) that track total return indices may deliver higher long-term performance than those benchmarked against price-only versions.

Considering Tax and Distribution Effects

While total return indices provide a fuller performance view, they do assume dividend reinvestments are tax-free and frictionless—an idealised assumption. In reality, taxes, fees, and timing of reinvestment may impact actual returns. However, despite these nuances, they remain more accurate than price-only indices for approximating investor experience.

In retirement planning, for example, income generated from dividends plays a vital role. Ignoring dividends in benchmarking can lead to underappreciating a portfolio’s sustainability or long-term viability. Thus, total return indices help formulate more realistic projections.

Which Index to Use and When

The appropriateness of using a price return or total return index depends primarily on the purpose of analysis. Recognising the differences helps investors interpret market data, compare financial products, and set realistic expectations.

When to Use a Price Return Index

• Short-term trading strategies: Where dividends are negligible or irrelevant.
• Headline comparisons: Media often reports the S&P 500 price return for simplicity.
• Price-focused derivatives: Options and futures contracts typically reference price indices.

However, in all these cases, the investor must be aware that apparent underperformance of dividend-paying investments may simply reflect the limits of price return indexing.

When to Use a Total Return Index

• Long-term investment analysis: Especially when evaluating mutual funds, ETFs, or pensions.
• Performance comparisons: Ensures consistency if an investment product internally reinvests income.
• Wealth accumulation goals: Particularly relevant for retirement or college savings strategies.

For instance, comparing an equity income fund against a price return benchmark could erroneously suggest outperformance or underperformance, depending on the period. A total return index gives a truer sense of the manager's skill and the fund’s actual returns.

Global Perspectives

Total and price return indices are both published by most index providers globally. Here are examples from some of the major index families:

• MSCI: Offers both price and total return indices in USD, GBP, and other currencies.
• FTSE Russell: Explicitly distinguishes total return indices (TR) from PR formats.
• S&P Dow Jones: Offers Total Return Indices that accompany all their major benchmarks.

Most reputable investment funds disclose the benchmark format they use. Investors should always check whether comparisons are made against a price or total return index to avoid misleading conclusions.

Practical Takeaways

• Understand what your index benchmark includes and excludes.
• For portfolio analysis, favour total return indices when possible.
• Always match the benchmark to the fund behaviour (i.e. dividend-paying vs dividend-reinvesting).

In sum, both price return and total return indices serve essential roles in investing and financial benchmarking. Knowing when and why to use one over the other allows for more informed decision-making and fairer performance evaluation. Ultimately, for most long-term goals, a total return index provides the truer picture of financial health and investment growth.