Security Market Index

A security market index represents a given security market, market segment, or asset class, usually constructed as portfolios of marketable securities, known as constituent securities.  Indexes help investors track performance and risk, benchmark active managers, and invest in broad markets at low costs.

An index may have two versions: a price return index, which tracks only the price of constituent securities, and a total return index, which accounts for reinvestment of interest, dividends, and other distributions.

Question

Assuming an index is made up of dividend-paying stocks, what type of index would likely post higher long-term returns?

1. Price return index.
2. Total return index.
3. Neither, price and total returns should be exactly equal.

Solution

The correct answer is B.

A total return index includes both the capital gains (price appreciation) and the reinvestment of dividends paid by the stocks in the index. Over the long term, reinvested dividends can significantly boost returns, especially for dividend-paying stocks.

A price return index, on the other hand, only reflects the changes in the prices of the stocks and does not account for the dividends paid out.

Since the total return index captures both price gains and dividends, it would typically post higher long-term returns compared to a price return index.