Spelling Out Different Index-Calculation Methods

Question: I notice that the indexes used to benchmark the performance of stocks, mutual funds, and exchange-traded funds on Morningstar.com have the letters TR, NR, or PR after the name. What do these letters mean?

Answer: The letters you mention refer to how the index's performance was calculated, with different indexes using different methods for various reasons.

The reason indexes are often used as benchmarks, of course, is that they are built to represent the performance of a given area of the market by tracking the performance of a group of securities in that area. The S&P 500 is commonly used to gauge the performance of the largest U.S. companies, the MSCI EAFE is used to gauge the performance of large companies in developed nations outside the U.S., the Barclays Aggregate Bond Index is used to gauge the U.S. investment-grade bond market, and so on.

One of the most common ways of tracking an index's performance is to look at its total return during a given time period. This method, abbreviated as "TR" on Morningstar.com, incorporates all sources of return for securities in the index. That includes both price appreciation--gains or losses as a result of a security's price going up or down--as well as dividends and interest received from those securities. The total-return approach also reinvests any dividends and interest back into the index.

Another popular method used to calculate index performance is based solely on changes to the prices of the underlying securities, and this approach is abbreviated as "PR" by Morningstar. The PR method ignores any interest or dividends generated by the index's constituents and, thus, represents a pure look at price movements within a given area of the market.

Understanding Total Return
In some cases TR is preferred over PR because it better represents what many investors actually experience when owning a stock or index-based fund or ETF. In particular, the TR approach makes the most sense as a benchmark for investors who reinvest dividends and interest. But not all investors do this. Some, for example, rely on the dividends and interest payments generated by their portfolios to help pay their living expenses and therefore don't reinvest them. For these investors, the total-return approach may overstate performance.

In fact, data show that income historically has been a much larger driver of investor total returns than some people realize. To cite one example, let's look at the S&P 500's performance in 2011. Market-watchers may recall that stocks were essentially flat that year, and from a price standpoint they were exactly flat--the index started the year at 1,257 and ended it at the same level: 1,257. But because of dividends paid out by the index's holdings, the index's total return was 2.1%, meaning that investors who owned the many mutual funds and ETFs tracking the S&P 500 saw a total return of around 2%. Not great, but it sure beats getting nothing at all.

Research by Ibbotson Associates has found that since 1926 the S&P 500 (including its earlier incarnation) returned 9.98% per year on average (through Sept. 30), but only 5.72% (or 57%) of that amount came from appreciation in stock prices, with income accounting for the rest. In more recent years capital appreciation has played a larger role in total return. During the past decade the index has averaged a total return of 7.57%, with 5.38% (71%) coming from capital appreciation (through Oct. 24).

A Complication for Foreign-Stock Indexes
One complication that arises when calculating indexes that track foreign stocks involves how foreign dividends are taxed. As discussed in this Short Answer article, some foreign nations withhold taxes on dividends paid out by companies within their jurisdiction. That means that investors owning funds and ETFs that hold these foreign stocks may not receive all of the income these companies pay out. That's why some indexes that track foreign securities use what's called a net dividend approach, which is based on reinvestment of the net dividends paid to U.S. investors. This approach is abbreviated as "NR" on Morningstar.com. MSCI, which runs many widely used foreign-stock indexes, uses the NR approach in addition to one that calculates reinvestment of gross dividends--what the index's constituents pay out with no taxes withheld--and calls this latter approach gross return or "GR."

To see examples of indexes using the TR, PR, or NR approaches, take a look at Morningstar.com's Index Performance page.

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