Every January some investors open their year-end statement to discover that the market value of their portfolio is ominously hovering around book value – and yet, the same portfolio statement could show a positive return.
It’s a riddle that causes even seasoned investors to scratch their heads. After all, book value is prominently displayed on statements and seems like an obvious goalpost for judging performance. Indeed, the book value of your portfolio (and of the individual holdings within it) is important. However, it is wise to understand what book value measures: taxes, not returns.
What is the Book Value?
Any investment (company stock, bond, fund unit, or even a physical asset like a piece of art) has a book value. At the time of purchase, book value simply records how much it costs to acquire the asset. For most investments in your portfolio, though, that is likely not the whole story. Things like subsequent contributions (buying more of the same stock or fund at a later date), withdrawals (selling shares or units) and reinvested distributions can all cause book value to change over an investor’s holding period.
What Causes Book Value to Change?
Many stocks and funds make regular payments in the form of distributions. This gives investors two choices, called “holding strategies”, to pick from: take each distribution in cash, or reinvest it back into the fund or stock. What investors sometimes don’t realize, though, is that choosing the latter strategy (called a dividend re-investment plan, or DRIP) is equivalent to making small, incremental buys of the investment each time it pays a distribution. This causes the investor’s book value to jump by the distribution amount each time one is paid to reflect this new purchase.
How Can Book Value Mislead an Investor?
To demonstrate, let’s use the CWB McLean & Partners Tactical Monthly Income (TMI) pool which pays monthly distributions. As the pool realizes capital gains or receives dividends and interest income from its holdings, cash accumulates within the pool. This causes the price of the fund units (called their NAVPS, or net asset value per share) to rise. When the fund finally releases this accumulated cash to unitholders at the end of each month, NAVPS falls by the distribution amount:
This process can be confusing for investors in two ways. First, the deflation in the pool’s NAVPS after a distribution can make it seem like money has been lost. In reality, total market value does not change: after a distribution is reinvested, an investor simply owns more fund units - each at the new, slightly lower NAVPS - totaling the same market value overall.
The second source of confusion comes from the fact that due to distributions, book value continues to rise over an investor’s holding period:
Tactical Monthly Pool - Growth of $100,000 Over 3-year Period
Source: CIBC Mellon
The chart above shows an investor who purchased $100,000 worth of TMI at the end of October, 2016. Over the next three years, not only did TMI grow in value, but the investor also continued to receive monthly distributions. Had the investor taken these distributions in cash, the book value would have stayed flat at $100,000. Instead, the investor re-invested each monthly distribution and saw book value grow from $100,000 to $113,316 by October, 2019.
Seeing his or her statement (example linked) at the end of this three-year period, the investor might notice that TMI’s market value ($114,822) has barely crept above the book value ($113,316) and conclude that the fund has performed poorly. This would be incorrect and highlights why investors should never rely on book value to ascertain performance:
Performance calculations show total return.
Why Does Book Value Matter?
If book value is an unreliable goalpost for measuring performance, why does it matter? The answer is: taxes.
In non-registered accounts, distributions are taxed as income regardless of whether they are collected in cash or reinvested. With cash distributions, the process is simple: book value stays unchanged and taxes are paid on the cash deposited in the investor’s account. For reinvested distributions, since no cash appears, investors can think of each subsequent bump in book value as a “receipt” reflecting the income they will be taxed on during that tax year.
This mechanism helps to avoid double-taxation. Had book value stayed flat, our TMI investor would owe capital gains taxes on $14,822 ($114,822 current market value - $100,000 original book value) when it came time to sell. Since book value grew to reflect reinvestments, the investor will only pay capital gains tax on the portion where tax is yet to be paid: $1,506 ($114,822 current market value - $113,316 current book value).
Still Have Questions?
We hope that this acts as a valuable reference for your year-end statements, and helps eliminate some of the confusion around book value. Should you have any more questions please reach out to your dedicated Client Portfolio Manager or Client Service Associate at CWB McLean & Partners or fill out the form below.