Why do we need a total return index?

5 mins read
Total return index is an important index for the shareholders as it helps to show the dividend impact on the returns. This helps them to take a more informed decisions.

Investors use several indexes to determine the returns on mutual funds to decide whether or not to invest. The total return index or TRI is a useful equity index benchmark that captures the returns from the movement of the prices of the constituent stocks and their payout dividends. We will discuss how it works, its use, features, and benefits. 

Let’s understand first: ‘what is total return index?’

What is a total return index?

While investing, we often compare a stock’s past performance to understand its future performance. The total return index is created to measure both capital appreciation and dividend returns. It shows the impact dividend payouts have on an investor’s returns.

The total return index considers that dividends were reinvested. Using the total return index allows users to include every part of the return, not just price movement. It tracks capital gains and any cash distributions like dividends or interests in measuring the index’s performance. Hence, it offers a more holistic picture to shareholders. 

Assuming dividends were reinvested, the total return index effectively considers all stocks that don’t payout dividends but reinvest to the underlying company. 

Formula to measure total return index 

The below formula represents the total return index.

Total Return Index = Previous TR * [1+(Today’s PR Index +Indexed Dividend/Previous PR Index-1)]

Calculating the total return index involves three steps.

  • Determining the dividend per index point 
  • Adjusting the price return index 
  • Applying adjustment of the previous day’s total return index

The steps are explained below in detail.

The total return index calculator considers dividend payouts, so we first need to divide the dividends paid over time by the same divisor, which is the base cap of the index. It calculates the value of the bonus per point of the index. We use the following formula to calculate dividends.

Indexed dividend (Dt) = dividend Paid out / Base Cap Index 

The second step is to combine the dividend with the price change index to get the adjusted price return value of the index for the day. 

(Today’s PR Index +Indexed Dividend)/Previous PR Index

At the final step of measuring the total return index, we adjust the price return index to the total return index, which accounts for the complete history of dividend payments. The value is multiplied by the previous day’s TRI index to calculate the day’s total return index. 

Total Return Index = Previous TRI * [1+ {(Today’s PR Index +Indexed Dividend)/Previous PR Index}-1]   

Let’s understand the total return index formula with an example.

Suppose we bought some shares in the BSE in 2020. In 2021, the company announced a dividend of Rs 0.02. After the dividend stock price increases to Rs 5. Assuming that the bonus is reinvested in buying more stocks at the prevailing price level, we can buy 0.02/5 or 0.004 stocks. The total stocks we own now is 1.004. According to the formula above, TRI at this point is 5*1.004= 5.02.

In 2022, the company announced a dividend at a fixed rate of 0.02. The total dividend amount on 1.004 share is Rs 1.004*0.02 = 0.002008. The dividend is reinvested at the current market price of 5.2. So, we can now own 1.008 shares. The TRI at the current level is 5.2 * 1.008 = 5.24

The exact process will repeat for every period until the end of the investment period. At the end of the cumulative period, we can plot these values and easily calculate the required TRI. 

The S&P 500 total return index (SPTR) is the most popular total return index. The TRI value is critical as it doesn’t penalise some stocks for how they handle their cash allocation. 

Total return index vs price return index 

Total Return Index  Price Return Index
It considers both the price movement and the dividend received from the security, considering the dividend is reinvested.  The price return index only considers the price movement or capital gain/loss.
TRI gives a more realistic picture since it includes price change, dividends, and interest.   It only considers the price movement, which is not the actual return from the stock.
TRI is more transparent and credible. It is the latest measure used by mutual fund inventors to benchmark the returns from the fund.  The price return index is misleading as it overestimates the mutual fund’s performance.
TRI is a better measure of NAV since it doesn’t only calculate capital gain/loss but also dividends. The price return index is a more traditional approach.

Total return index vs total return strategy

The total return strategy is an entirely different concept. It is a popular retirement investment strategy. The total return or income strategy focuses on increasing the investor’s income.  

Following the total return strategy, investors and fund managers invest in high dividend-yielding stocks and fixed-income instruments like bonds to generate consistent income. It is an effective investment strategy for retirement income because it focuses on preserving the capital and growing the capital base in the future.

Why retail investors should care for total return index

TR index is helpful for retail investors to compare their returns on mutual fund investments against the returns of a fund manager with indices like the S&P 500. Using the TR index to evaluate performance between different investment opportunities is a more accurate measure of return on investments.

Using the total return index over the price return index will significantly affect the investor’s long-term strategy. They can measure the difference in performance more accurately using TRI than the price return index.

TR index is a more helpful benchmark in finding the actual returns generated by the stocks in a mutual fund. In all the major developed markets, TRI is more widely used to calculate returns on mutual funds over the traditional price return indices. Even when measuring the growth generated by equity stocks, it is mandatory to consider reinvested dividends. Hence, TRI helps get the bigger picture while calculating the returns from equity funds.