Understanding the return of a fund Richard Carter & Roenica Botha
Understanding the return of a fund
EXECUTIVE SUMMARY: By reinvesting the income which a unit trust fund earns, investors can take advantage of the compounding effect of returns and maximise their long-term wealth creation. Richard Carter and Roenica Botha elaborate.
When we talk about a fund's performance we always assume distributions have been reinvested. But have you ever wondered how much of the performance of your fund is capital appreciation and how much is income the fund earned over the period? And what impact does reinvesting distributed income have on your long-term wealth creation?
To answer these questions it is useful to understand what a 'unit' is in a unit trust fund, and how earning and distributing income works.
What is a unit and how is it valued?
A unit represents the portion of a fund that an investor owns. Its value is calculated daily and is made up of two parts: capital and net income.
The 'capital' part is the value of the underlying shares or cash instruments the fund owns. This value is based on the price at which the underlying investments trade.
The fund earns income in the form of interest and/or dividends from its underlying investments. The fund also has expenses related to its daily management and trading. The net income (income less expenses) is accumulated daily and added to the capital value to calculate the daily unit price.
Click here to enlarge
What is an income distribution and what happens when a fund distributes?
At the fund’s income distribution date, all the net income which has accumulated since the previous distribution is added up and made available to be reinvested or paid out to investors as a ‘declared distribution’. Since the net income forms part of the total value of the fund, when it is distributed the unit price on the day after the distribution drops by the amount distributed, plus or minus any market movement of the underlying investments for the day. If the total expenses exceed the income earned, the fund will not make a distribution, but rather has to use part of the capital in the fund to pay its expenses.
In an Allan Gray retirement product or investment platform account, distributions are automatically reinvested for investors by purchasing more units in the relevant account. This means that additional units are purchased for you with the distributed amount. The value of your holding does not change but this is made up by more units in total at a lower price per unit than before the distribution. In Allan Gray unit trust accounts, you can choose to have distributions paid out – the value of your holding in a distributing fund will reduce by the amount of any distribution paid out to you.
Example
If you look at the June 2009 distribution of the Allan Gray Stable Fund as an example:
On 30 June 2009 the Stable Fund declared a distribution of 28 cents per unit. The unit price (see
Graph 1 below) on
Click here to enlarge
1 July 2009 was 17 cents lower than on the previous day. This was the result of a distribution of 28 cents and an 11 cents increase in the capital value of the underlying investments.
Now consider the account of an investor who owned 1 000 Stable Fund units. On 30 June 2009, at a unit price of R21.55, the account was worth R21 553. Reinvestment of the distribution allowed the investor to buy an additional 13 units. On 3 July 2009, at a unit price of R21.43, the 1 013 units in the account was worth R21 704. This reinvestment put the investor back in the same position as on 30 June 2009 before the distribution. The additional increase was from subsequent growth in the capital value of the underlying investments.
Despite the decrease in the unit price, by reinvesting the distribution the overall value of the investment in the Stable Fund would have increased over those specific four days.
Returns from income versus capital
Table 1 shows the Allan Gray funds’ returns since inception to 31 December 2008. The table breaks down the total returns into the portion earned from (a) capital and (b) the extra return you would have earned by reinvesting net distributed income (dividends + interest – expenses).
The table illustrates that the Equity Fund returns are largely of a capital nature, whereas the Money Market Fund only earns (interest) income.
The importance of reinvesting distributions
Column (b) in
Table 1 shows the portion of the return earned from income and the reinvestment of that income. This can be used to see the impact on the accumulated capital value if income is paid out rather than reinvested.
R1 000 invested in the Balanced Fund since its inception (1 October 1999) would have grown to R6 570 if the investor reinvested distributions. However, if the investor had distributions paid out he would end up with R4 940, 25% less.
The impact is more marked in the Stable Fund due to the higher proportion of return earned as income. Since inception (1 July 2000) an investment of R1 000 in this Fund would have grown to R3 590 with distributions reinvested. If distributions were paid out this value would be 37% less.
Click here to enlarge
In the Equity Fund, which mainly grows through capital appreciation, the difference would have been very small. Over a longer period, the impact would be more significant because of compound interest. By reinvesting the income which a fund earns, investors can take advantage of the compounding effect of returns and maximise their long-term wealth creation.
Click here to enlarge
