Index Return Series Paper 1:

Pranay Dureja, Senior Specialist, Nasdaq Index Research & Development

This is part 1 of a multi-part series where we will deep dive into the nuances of Index Returns. This paper will provide an overview of the three primary types of index returns and their role in determining suitability and assessing investment performance.

At a Glance:

• Index Returns are driven by 3 components: Reference Rate, Risk Premium, and Periodic Income.
• The 3 components are combined in various fashions to create Total, Price, and Excess Return Indexes, which all hold unique use cases to use inside financial products.
• The difference in performance between the Indexes is dependent on the relationship between the prevailing reference rate and periodic income being paid by the tracked assets.

Indexes are instrumental for tracking the performance of various assets, and it's essential to understand the different types of return streams that can be calculated for any given index. There are four primary types of index returns: Price Return (PR), Total Return (TR), Net Total Return (NTR), and Excess Return (ER). Each of these returns provides a unique perspective on the performance of an index, and understanding the differences between them is crucial for making informed investment decisions.

In this paper, we will explore the definitions, examples, and performance of total, price, and excess return indexes. While net total returns are important, they are generally only used as a proxy by investors to estimate an after-tax total return.

How Returns are Calculated

Before diving into the specifics of each return type, let's take a step back and understand the three components that contribute to an Index’s return profile:
 

For example, if a given company’s stock produced a loss of -10% over 1 year, its reference rate was +5%, and the stock held a dividend yield of +2%:

• The risk premium taken by investing in the stock would be -15% (i.e. a negative equity risk premium of 15%).
• Upon adding the 2% dividend (assuming no compounding), the stock would have underperformed the reference rate by 13%.

The three components stated above form the foundation for the various index return profiles, which will be examined in the following sections of this paper.

Three Types of Index Returns

When Nasdaq creates an index to track the performance of multiple assets, a choice is implicitly made around which of the above return components should be tracked by multiple versions of the index. Depending on the use case of the index and return profile desired by investors, it might be relevant to reference some or all of them. Nasdaq can create the following three types of indexes through the various combinations of return components:

Price Return Index = Reference Rate + Risk Premium

• Focus solely on the price changes of the underlying assets within the index, excluding any periodic income.

Total Return Index = Reference Rate + Risk Premium + Periodic Income

• Measure the performance of an index by considering both the price changes of the underlying assets and any periodic income generated from those assets.
• This process involves reinvesting the periodic income back into the index value, thereby allowing the index to compound.

Excess Return Index = Total (or Price) Return Index - Reference Rate

• Calculate the performance of a total or price return index above a predetermined reference rate.
• In the index industry, the reference rate is typically referred to as a Risk-Free Rate – such as SOFR, Federal Funds, or US Treasuries – unless otherwise stated in the Index Methodology.

As imaginable, these equations closely mirror the numerator of the Sharpe ratio, which measures risk adjusted return. Not only is their performance measured as such, but it also informs how the different indexes are used in the context of financial products.

The above diagram displays the relationship between the three different index return profiles. Total Return, as the name suggests, is comprised of all return components. From there, components are subtracted out to track other variations of Index Return. When periodic income is removed, a Total Return Index turns into a Price Return Index. Meanwhile, when the Reference Rate is subtracted from either variation, it becomes an Excess Return Index.

It is important to consider the inclusion of the Reference Rate in the Index to determine if an asset invests capital upfront. Doing so can determine whether an index is funded or unfunded, which is displayed in the diagram above. Understanding the nuances between the two can explain the use cases for each, which is shown in the table below:
 

To read the full paper - covering the applications and performance of different index returns - please click here.

For more information on how Nasdaq can work for you, please see below:

Nasdaq Global Indexes

Nasdaq Insurance Solutions

Global Indexes: Research Insights 
 

Disclaimer:

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED. 

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