Other factors to consider when calculating Return on Investment

Examining the investment return characteristics of an asset or an investment portfolio is one of the essential steps in finding the ideal portfolio. The smart investor should always look for his optimal portfolio.

That's why we started this series of articles with the way in which this return is calculated. We then move on to the essential characteristics and differences between the return of the arithmetic average and the geometric average and their implications for decision making. We also cover annualized rates of return and time or money-weighted returns.

In this article, we will address other measures of return specific to certain assets, such as investment funds, and other considerations and factors such as inflation, taxes or debt, which can result in different applications and interpretations of an asset's profitability.

 

Net return and gross return

When we refer to net or gross profitability, we are taking into account the effect of management costs and other expenses related to the management and administration of an investment.

This designation is very common in investment funds, PPR, pension funds, venture capital funds and other forms of collective investment where there is a management company and which investors use to expose themselves in the market in a diversified and efficient way in different regions, sectors or themes.

These costs include:

• Investment vehicle management costs or fees;
• Custody and deposit fees;
• Taxes levied within the fund or investment vehicle.

Gross return is the return obtained by asset managers and is an important and appropriate measure to evaluate and compare their management capacity against competitors or alternative investments as it does not include management costs. These costs are normally charged as a percentage of the assets under management and depend on the amount of those assets, the type of investment class and the investor's tax status.

On the other hand, the gross return already takes into account transaction costs (such as the costs of buying and selling assets), as these costs directly contribute to the manager's performance.

We say that the return is net when it is presented after deducting these costs and management fees. The net return is the return that a particular investment (investment fund, for example) has yielded to an individual investor.

So:

• Gross return is important for the purpose of comparing managers and evaluating their management skills and attributes;
• Net return is the return obtained by the investor after deducting all costs, expenses and commissions.

 

Return before tax and after tax

Throughout these articles on calculating the return on an investment, we have assumed that the calculation is before taxes, that is, without taking into account the tax that the investor may pay and which is levied on the profitability obtained.

So, it should be noted, when we see a rate of return we must assume that it is a nominal rate and before tax.

To calculate the after-tax rate of return, we need to know what tax rate is levied on capital gains and capital income (such as interest and dividends). The truth is that these taxes can be taxed differently depending on the country or jurisdiction where the investor is located and also on the amount of income in case we assume the possibility of aggregation and the type of investor (individual or company).

Given the specificity of this subject and the diversity of situations, each investor must have a thorough knowledge of their tax situation and seek to adjust their investments accordingly in order to obtain the optimal after-tax return. Correct fiscal management can have a major impact on the final return.

Taxes are paid after capital gains have been realized and interest and dividend income distributed, so it may be important to reduce the volume of transactions and investments that provide better tax conditions.

 

Real and nominal returns

At a time of great impact of inflation, the concepts of nominal return and real return gain added meaning.

The nominal return, the most common and available by default, consists of 3 components:

• Real risk-free return or risk-free interest rate, to compensate for the investor's decision to postpone consumption;
• Inflation, to compensate for the loss of purchasing power;
• And a risk premium, to compensate for the risk taken on the investment.

If we add the real risk-free return and the risk premium, we get the real return on investment. The inflation component is the difference between the real return and the nominal return.

So, if we expect a return on investment of 5% and an inflation rate of 3%, the nominal return is equal to 8% (5% + 3%) or, more mathematically correct:

Nominal return = (1 + 5%) x (1 + 3%) – 1 = 8.2%.

Real return = 5% or, if we have the nominal return and the expected inflation rate

Actual return = (1 + 8.2%) / (1 + 3%) – 1 = 5%.

The real return is important for comparisons over time as the rate of inflation can be very variable. It is also essential when comparing returns in different countries, especially in countries with different currencies and with different levels of inflation, such as emerging countries.

If the nominal return is less than the rate of inflation, it means that the real return is negative and that we are not being compensated for the increase in the cost of living.

The fiscal component is also important in this real return concept. Taxes are levied on nominal returns which means that we may be being taxed for negative real returns.

The actual after-tax return is therefore a key metric in the sphere of the individual investor. This return is typically not presented by asset managers as its calculation depends on each individual investor and their actual tax situation.

 

Leveraged return

We have come to assume that the investor uses only equity to invest. However, we know that it is common for certain assets to resort to debt. For example, in the case of real estate investment, it is normal for the investor to resort to financial leverage, with debt often assuming more than 50% of the investment value.

It is also common to see the use of margin accounts to invest in securities such as stocks and bonds and also in investment funds and ETFs. Leverage, in this case, is up to 2 or 3 times the value of equity and even 10 times if we go for derivative financial products, such as futures.

This situation leverages the total return, but also, equally, the risk of loss.

Imagine the following scenario:

• Total investment of €10,000
• Equity €5,000
• Debt €5,000
• Investment value at the end of the period: €8,000

What is the return on investment?

In fact, the investor lost €2,000. In view of the equity invested, it reached the end of the period with only €3,000, after paying off the debt.

The net debt period return was -40%.

If we make the calculation taking into account the value of the initial and final investment, the return, that is, gross return for the investor, was -20%. This means that the use of leverage doubled the return on investment. In this case, it doubled the value of the loss.

 

Conclusion

The subject of calculating profitability seems a minor and unimportant subject, however, it can mean biased analyzes and incorrect decisions.

When analyzing your investment portfolio with your financial intermediary or analyzing assets such as investment funds, PPR or ETFs, always try to find out what type of return is presented and what assumptions are made.

 

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