Unit trust investing and compounding - query

bogleboogle

Hi all

I like to think I understand how compounding works re: interest (in Y2 you earn interest on the interest you earned in Y1, etc - compounding the interest), but I'm confused about how / whether this principle applies to unit trust investing (e.g. of typical S&S ISA index tracker funds). 

For an S&S ISA index tracker fund, e.g. the FTSE Global All Cap, when you invest it is my understanding that you are buying units in the tracker fund. The price of a unit is what varies and what determines the value of your holding (and is correlated to the stocks that the fund holds). 

So, if the price of a unit goes up by 10%, the value of your holdings will increase by 10%. What I don't understand is how this can be compounded because - unlike a typical savings account - the value depends on the underlying assets and varies each day and is not 'crystallised' at any point so to speak in order for the additional growth to compound on that. 

Specifically, it would be different if the amount of units you held grew, because then that could compound. 

Could someone please explain (I) whether this is a somewhat correct understanding and (II) if not, how unit trust investments can be said to benefit from compounding?

Many thanks
B

eskbanker

Investment compounding is driven by reinvesting dividends - if the acc variant of funds is chosen then this will be reflected in a higher unit value, or the inc variant will pay out the dividends and reinvestment will involve buying more units.

tacpot12

Your understanding of how compounding works with interest on savings is correct. You are earning interest on the interest (providing you leave the interest in the savings accounts). 

With unit trusts, you are correct that the price of your holding depends on the number of units held and the price per unit, which can vary. But compounding does occur with unit trusts when you appreciate the difference between accumulation units and income units. Most, but not all, unit trusts have an "accumulation" unit you can buy, and an "income" unit. 

It is also the case that most unit trusts will invest in shares that pay dividends. These dividends are used differently depending on whether you have bought accumulation units or income units. If you have bought income units, the dividend is paid to you, perhaps quarterly or half-yearly. If you have bought accumulation units, the dividends are used to buy more shares, so that the number of shares that are owned by the accumulation units will increase (and this will therefore produce more dividends in future years). The additional dividends coming into the accumulation units are then used to buy more shares so you get a compounding effect on the income coming into the accumulation shares, but you may also get a compounding of the value of the accumulation units because each year (assuming the value of the underlying shares does not change) because each year the accumulation units own more shares.

The income units don't benefit from the compounding effect of dividends being reinvested and producing even more dividends, nor does the number of shares that they own ever increase (but the value of the shares that are owned can increase so the asset value of the income units can increase over time, but will do so more slowly than the asset value of the accumulation units). This accounts for the very different prices you will pay to buy accumulation units vs. income units in the same fund. 

bowlhead99

A simple way to think of this is that the term 'compounding' means that you are getting more and more money back because you are earning money or making gains not just on your initial money but on the returns you have already made so far.

So with a bank account if you put in £100 at 10% interest and it turns into £110.... then when you go into the second year if you leave it all alone and earn the same 10% interest rate, you're not just earning another £10 off your original £100, but you're earning £1 off the £10 of returns that you earned in the first year. Overall would turn the £110 into £121. So instead of  your bank balance going £100, £110, £120, £130, £140, £150 ... it goes £100, £110, £121, £133, £146, £161... etc

With investments it is the same idea, other than the fact that the returns aren't fixed at a known regular interest rate.  Similarly if you leave your investment fund alone to accumulate its returns and get more and more valuable, you will be earning money in year 2 not just on the initial money you first put in, but also on the income and growth that was made in year 1.

For example, simplistically your tracker fund will make returns for you when:
(a) the fund receives dividends from some of the companies in which it invests, so it has cash in the bank that it could either (i) pay to you or (ii) keep in the fund and reinvest in buying more shares of companies in the index like Microsoft and Apple and Unilever etc; or
(b) some of the companies it holds will have their share prices on the stock market go up, so if you want to sell your units in the fund, the fund will sell some of the shares that it owns in Microsoft and Apple and Unilever etc, hopefully for more than they were worth when originally purchased/

The total return you'll make is a mixture of (a) and (b).  Let's say that total return is 10% a year.

So, just like the 'bank account interest' example, if your shares or units of the fund go up in value by a total of 10% a year, the value of your shares will go up 100, 110, 121, 133, 146, 161  etc etc and it is a compound return; after 5 years at 10% you are at 161 instead of 150. 

In reality, it doesn't go up smoothly so instead of going up like that it might go 100, 112, 96, 120, 140, 161... but if it makes an average annual return of 10% a year it will end up with a nice 'compounded' return and be at 161 after five years rather than the 150 it would have reached without compounding.

To get the compounding, simply leave your fund alone and don't take anything out of it. If it pays you out some dividends, invest them back in. In that sense it is like an interest-paying bank account. The bank balance goes up and if you take the interest away and spend it, it won't be able to compound, while if you leave the interest in the account it will compound, earning returns on returns.   Similarly if you leave your investment fund alone to accumulate its returns and get more and more valuable, you will be earning money in year 2 not just on the initial purchase amount but on the income and growth achieved so far.
with a bank account

Linton

Compounding does not necessarily have to be linked to dividends.  It is inherent to the nature of companies and shares. When you buy a share you buy a % of a company.  As the company generates profits the value of the shareholding increases and the company's capacity for generating more profits increases.  

If course this is a long term average effect.  For  individual companies life can be a little more exciting.

MaxiRobriguez

If it's a dividend paying company, lets say 5% dividend, your £1,000 worth of stocks pays out £50. Use the £50 to buy more stocks, and then next time the dividend is paid you get 5% of £1050, which is £52. Use that £52 to buy more stock... rinse and repeat.

If it's a growth company which doesn't pay dividends, the compounding still works but the company uses profits generated to invest in themselves, which should mean profits next year are bigger. The stock price rises in tandem.

Unit trusts are basically the same. You can have income funds, where a dividend is paid to you, or you can accumulation funds, where any dividend is retained within the fund to purchase more of the underlying asset, which raises the unit fund price.

The basic concept is, if your investment pays you money, use it to buy more investment. Over time, those extra investments you bought using money paid out by investments generates a significantly larger pot of money than you would have had it if you spent the money paid to you on a new car for example.

Another_Saver

In a savings account, you earn interest on your initial investment (call it capital, outlay or principal) and that interest accumulates automatically. With investing in that fund you mentioned, you buy the fund, in essence buying a share of the entire global stock market, and the fund itself increases in value while also paying out cash called dividends, the equivalent of interest. It's the same as if you buy a rental property, you would hope for its market value to at least keep up with inflation, the value of the property itself goes up but you don't receive that profit until cash in, i.e sell the property. Alongside this growth of your principal, you receive cash called rent. Add the two together, that's the total return.

To use a very simplified example (cutting out the academic stuff): Say between now and 2050 the world economy experiences 2% inflation, 2% real growth, and the average dividend yield over that period is 2.5% on your fund. Every year, the stocks in your fund increase in value by 4%, and this compounds. You receive 2.5% of your holding's value as dividends. The value of the dividends increases by 4% too. You can leave them in your account as cash, spend them, or use them to buy more of the fund, which is called reinvesting. If you fund is accumulating/accumulation, you won't see those dividends appear in your account, which you would if you went out and directly bought all those stocks. Instead, that fund will automatically do the reinvesting for you. So you will the value of your fund rise at 6.5% a year instead of 4%.

Thrugelmir

MaxiRobriguez said:

If it's a growth company which doesn't pay dividends, the compounding still works but the company uses profits generated to invest in themselves, which should mean profits next year are bigger. The stock price rises in tandem.

Apple's profitability has barely changed in 5 years. Investors expectations have risen though in the hope that new products and services will come good. Assumption is where many investors eventually come unstuck. Do your own research and monitor what you are invested in. 

bogleboogle

Thanks all

caper7

Thanks for asking this question because it has got me thinking and clearly I don't 100% understand Acc unit trusts either.
I have M&G recovery fund Acc.
I get a tax voucher each year detailing my dividends which I declare for income tax even though I never actually receive the money. 
It suddenly occurs to me that the number of units I have should be increasing instead, but they never have. 
Is that correct? 
If I've understood the answers above, the dividends go back into the fund rather than in an increase in units for me, allowing the fund to buy more and be more valuable and in that way increasing the value of my capital.
Is this correct? 

Linton

caper7 said:

Thanks for asking this question because it has got me thinking and clearly I don't 100% understand Acc unit trusts either.
I have M&G recovery fund Acc.
I get a tax voucher each year detailing my dividends which I declare for income tax even though I never actually receive the money. 
It suddenly occurs to me that the number of units I have should be increasing instead, but they never have. 
Is that correct? 
If I've understood the answers above, the dividends go back into the fund rather than in an increase in units for me, allowing the fund to buy more and be more valuable and in that way increasing the value of my capital.
Is this correct? 

Your description of Acc funds and dividends is correct.