November 15, 2011
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In a slowing economy, an increasing portion of asset returns comes from income rather than from capital gains. Consequently, investors are attracted to income-producing assets.
Performance information conveyed on return charts from many financial sources is misleading, however, because it is based solely on price return, ignoring dividends. Investors reading these charts will be unfairly biased against income-producing assets.
Financial advisors should educate their clients about total return and stay vigilant about qualifying performance charts when making investment comparisons.
Misleading performance charts
Incorrect performance information is reported daily by numerous financial tools and websites, as was documented in a recent paper. Measuring performance with price return - the return calculated simply by using the asset price at the beginning and at the end of the period – is misleading.
Suppose an advisor wants to compare VTI (an ETF tracking the total US equity market) and VBMFX (a mutual fund tracking the total US bond market) over a period of 10 years ending Oct 31, 2011. The following charts are snapshots from Yahoo Finance and Google Finance, however similar charts were observed on Marketwatch, Bloomberg and other sites.
The returns on the charts imply that VTI (+27.62%) outperformed VBMFX (+6.99%) by a wide margin. This is incorrect. These returns are price returns, measuring how much the assets appreciated in price but ignoring other sources of return, such as dividends.
What happens when we include income from dividends? The results are shown in the following table (total return numbers obtained from the website of Vanguard, the provider of VTI and VBMFX):
Over 10 years, the regular income from bonds compounds to a significant amount. The above performance charts are misleading in two ways:
- They underestimate the return earned by investors in either VTI or VBMFX
- They penalize VBMFX against VTI
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