What is the Total Return Index?
Total Return Index or TRI is a very useful equity index benchmark to captures the returns from both the movement of prices of the constituent stocks as well as from payout of its dividends and it also assumes dividends are reinvested. It is a very useful measure because it actually states what the investor is taking back or getting in return out of the investment made.
Total Return Index Formula
The total Return Index formula is represented as below –
Total Return Index Calculation
A total return index calculation can be in the form values of dollar, euros, or other currencies. To calculate the TRI first, we need to account for the dividend paid. The first step is to divide the dividends paid over some time with the same divisor, which was used to calculate the points related to the index, or this is also called the base cap of the index. It gives us the value of dividend paid out per point of the index, which is represented by the equation as below:
Indexed dividend (Dt) = Dividend Paid out / Base Cap Index
The second step is combining the dividend and price change index to adjust the price return index for the day. The below formula can be used to do so:
(Today’s PR Index +Indexed Dividend)/Previous PR Index
Lastly, the total return index is calculated by applying the adjustments to the price return index to the total return index, which accounts for the full history of payment of dividends. This value is multiplied to the earlier day’s TRI index. It can be represented as below:
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Total Return Index = Previous TRI * [1+ {(Today’s PR Index +Indexed Dividend)/Previous PR Index}-1]
So, TRI calculation involves a three-step process, which includes first, determining the dividend per index point, second, adjustment of price return index, and finally, application of the adjustment to earlier day’s TRI index level.
Example of Total Return Index
Let us consider here an example London Stock Exchange as a single unit stock, and we invest in it. This stock was purchased in the year 2000, and in 2001 a dividend of 0.02 GBP was issued for the stock. The price of the stock after the dividend was issues took it to 5 GBP. We can now imagine that whatever the dividend was issued was utilized to purchase more of the stocks of LSE at the same price band of 5 GBP. Therefore we can now purchase 0.02/5 = 0.004 shares of LSE, which takes the grand total of 1.004 shares. Thus TRI at this level can be calculated as 5*1.004= 5.02
In the second-year 2002, the stock issues a fresh dividend again where the share prices suppose is constant at 0.002 GBP. At present, we are the owners of 1.004 shares. The total dividend thus calculated is 1.004*0.02 = 0.002008 GBP. It is reinvested now in the same stock whose current price is 5.2 GBP. Now the number of shares held will become 1.008. The TRI now will thus turn out to be 5.2 * 1.008 = 5.24
We need to do the same for every period. Therefore, at the end of the cumulative number of the period, we can easily plot a graph of the TRI level or calculate the required TRI for that period using the formula mentioned above, taking into account the previous period TRI and current TRI.
Total Return Index vs. Price Return Index
- The total return index includes both the movement of prices or the capital gain/loss and the dividend received from the security. In contrast, the price return index only considers the movement of a price or the capital gain/loss and not the dividend received.
- TRI gives a more realistic picture of the return from the stock as it includes all the constituents associated with it like price change, interest, and dividend where PRI only gives a detail about the movement of prices, and this is not the real return from the stock.
- TRI is more of the latest approach as to how investors benchmark their mutual funds because it helps them to assess the fund in a better manner since the NAV of a mutual fund portrays not only the capital loss/gain in the portfolio but also the dividend received from the holdings in the portfolio. In contrast, PRI is more of the traditional approach where mutual funds were benchmark against price changes only pertaining to the number of securities that are driving a mutual fund.
- TRI is more transparent, and the credibility of the stocks or funds has increased a lot. In contrast, PRI is more of a misleading scenario because it overstates the performance of a mutual fund, which attracted a lot of investors to invest in the specific fund without understanding the real scenario.
TRI Impact on Mutual Fund Investors
Total return index usage over the Price return index can broadly affect the long term strategies of investors. It plays a crucial role in active investments in passive investments made. Taking an average count, it is seen that components of the index will earn at around 2 % dividend yearly. This return, when we take the PRI approach, is not included in the comparison of mutual funds.
Thus, in the PRI approach, the return is minimized or understated by 2% annually. With the TRI approach, investors will see that the performance of the index has gone up by 2% by taking into consideration the TRI approach rather than taking into account the PRI approach. One good thing about TRI on mutual fund investors is that the money invested will not be locked behind inaccurate benchmarks anymore.
Conclusion
The total return index is a useful benchmark when we want to find out the actual return generated for constituents of a stock or a mutual fund. It is a handy measure because it states what the investor is taking back or getting in return out of the investment made. It is the constituent of the return of an index, the paid dividends, and also the dividends which are reinvested back to the index.
In all major developed markets, all mutual funds these days are marked against the total return index, which were previously benchmarked against the price return index. Even in cases of equity find, when it comes to the growth option of the fund, it’s mandatory to consider the dividend it generated but did not distribute from its underlying companies. Thus TRI comes into a bigger picture when the actual return from the equity fund is to be computed.
Recommended Articles
This article has been a guide to the Total Return Index. Here we discuss the formula to calculate the total return index along with its example and its differences from the price return index. You can learn more from the following articles-
