Continuing the theme of my June 4 column in the Tacoma News Tribune, here’s another element of evaluating investment returns that can be confusing:
In some cases, particularly with mutual funds that own bonds and pay out regular income, you could see performance reports that show investment gains while in actuality, you’ve invested more in the fund than it is currently worth.
This is sometimes a function of measuring your cost basis return. In taxable brokerage accounts (non-IRAs) your monthly statement identifies the month-end market value of a position as well as the cost basis. The basis is the total amount you have invested in the fund over time adding together the initial contribution, any subsequent contributions or withdrawals and any reinvestment of income paid out by the fund.
Here’s a simplified example of how a fund company could report positive performance while you actually have a capital loss (higher cost basis than current market value).
Imagine you make investment of $10,000 on the first day of year. You buy 1,000 shares at $10 each. The fund pays out income of $50 per month. That income is reinvested in five new shares each month, all purchased at $10. At the end of the year, you have 1,060 shares at $10 each for a total market value of $10,600.
The price return/capital appreciation of the fund for the year was zero. The share price started at $10 and ended at $10. The total return (price change plus income paid out) was 6% (you earned $600 on a $10,000 investment), in this case all income. Given this math, it’s possible for the price of the investment to go down but still have a positive total return. Imagine that the fund dropped to $9.90 per share at the end of the year. The 1,060 shares would be worth $10,494. The total return would be 4.94% (6% income return reduced by the -1% price return).
Now if this investment is in a taxable account (not a retirement account) you would also have a cost basis return that differs from the average annual return.
Going back to the example above, the fund produced a 6% return increasing in value from $10,000 to $10,600. Even though this $600 is new money to you, by reinvesting it in new shares of the fund, this amount is added to your cost basis which is now also $10,600. You are even with what you have contributed to the account. There was no growth in price per share but the fund can report a 6% total return.
Complicating this scenario is the fact that this is a taxable account. The $600 of income received was fully reinvested but you are responsible for paying tax on this income, reducing the after-tax return. This is one reason why it’s usually preferable to hold bond funds in a tax-deferred account like an IRA instead of in a taxable account.
This is also an example of how income is nice to have in a portfolio but ultimately the total return of capital appreciation plus income is more important where portfolio growth is required.
~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA