Financial reporting can be best described in a fashion similar to Winston Churchill’s description of Russia – “…a riddle wrapped in a mystery inside an enigma.” One term in particular seems to be a source of misunderstanding and confusion, and that is “Book Value”, sometimes reported as ‘Adjusted Cost Base’ in the case of mutual funds, segregated funds, or Exchange Traded Funds (ETFs).
Unless you are an author, publisher, or librarian, ‘Book Value’ is a financial term that reports a share or unit value, or dollar amount of a particular investment or security. Because it seems to relate to the amount originally invested, and because it often appears on a statement line beside ‘Market Value’, there is an assumption that there is a relationship between ‘Book’ and ‘Market’ values. There is, but it is a tax relationship, NOT a performance relationship. Too often we compare Book to Market and draw performance conclusions. And this is where the confusion lies.
At the time when money is first invested, the investment amount is equal to the Book Value. The Book Value of the entire position changes as units are bought or sold, up or down.
The Book Value also changes when a dividend or distribution is declared by the fund. Since this distribution is taxable in an open account, it is reported to the investor on a T3 form for tax purposes by the fund company. But if the distribution is reinvested, won’t that mean being taxed twice when we sell the fund? Fortunately, the answer is ‘no’. That is because the distribution has increased the Book Value, and the formula for determining the capital gain is Market Value minus Book Value, not Market Value minus Original Investment. Thus, a fund with high distributions (say, an Income Fund) will tend to have a higher Book Value than one with few distributions. Selling a high-distribution fund usually results in a relatively low capital gain, compared to a low-distribution, growth-oriented investment. That’s the tax dimension. If we compare Book Value to Market Value to get a sense of investment performance, we are looking only at that small residual capital gain or loss, and are not taking into account previous distributions we have received and paid tax on. The comparison tells us nothing about the rate of return. Book Value is really only important if we are selling a fund from an open account. It means little in an RRSP or TFSA.
Knowing your actual rate of return is the best measure of investment performance. Determining Rates of Return will be addressed in a future article.