Why Unrealized Gains Do Not Equal Returns
Have you ever looked at your brokerage or IRA account statement and discovered that the unrealized gain from one of the investments you thought was doing well is negative? Does that mean you’ve been losing money on that particular investment? Not necessarily. Here is a brief explanation of why we don’t use unrealized gains to calculate returns.
An investment’s unrealized gain is the difference between the price you paid for it (also called its cost basis) and its current market value. It is used primarily to determine how much of the investment is subject to income taxes when sold. If capital growth were the only source of returns, the unrealized gain should match the investment’s cumulative arithmetic return since purchase. This is commonly the case for non-dividend paying stocks. But many stock and especially bond mutual funds and ETFs distribute dividends, interest, and even capital gains periodically. These distributions may or may not be included in the unrealized gains depending on how they’re taxed.
Let’s take a simple example. Suppose you bought a bond mutual fund for $10,000 that distributes $100 in dividends in cash every month but has no capital growth (in other words its market value remains at $10,000 throughout the year). Since the difference between the cost basis and the market value at the end of the year (its unrealized gain) is $0, you would conclude that the investment returned $0 for the year. But the actual arithmetic return for the year was the capital gain plus the total distributions divided by the cost basis, or $0 + $1,200 divided by $10,000, which equals 12%. Quite a difference!
If you chose to have the distributions reinvested instead, at the end of the year (1) the cost basis would have increased by $1,200 since you made an additional $1,200 in purchases, and (2) the market value would also have increased by the same amount since you now owned that many more shares. The unrealized gain at that point would still have been $0 ($11,200 – $11,200). And your arithmetic return still would have been 12%.
It gets more complicated when a fund has capital gains distributions. They decrease the fund’s market value (because the fund is actually selling some of your shares and distributing the cash to you) but at the same time they increase the cost basis since the distributions have been taxed. This is quite common with bond funds, which use such distributions to try to keep the cost per share in some narrow range (typically around $10). The result over time can be a growing negative unrealized gain in the position. As indicated above this says nothing about returns but rather how much of your holding in the fund will be taxed when you liquidate it.
Note that the examples above used simple arithmetic returns to explain the difference between unrealized gains and returns. But most mutual funds and financial planners actually use the time-weighted method to calculate returns (TWR) because it more accurately reflects the returns of each purchase over time. It’s beyond the scope of this article to explain TWR, but if you’re interested in learning more about it please reach out to us.