What is Absolute Return and How Does it Work?

Explore absolute return in mutual funds and discover how this important metric can help you make informed investment decisions.
4 mins
27 September 2023

When you invest in mutual funds, you are often keen to know how your investment is performing. One way to gauge this is by understanding absolute returns. Absolute return is a straightforward metric that indicates the actual profit or loss generated by your mutual fund investment over a specific period.

What is Absolute Return in Mutual Funds?

Absolute return, in the context of mutual funds, represents the total gain or loss on your investment without considering the time factor. It is expressed as a percentage and gives you a direct insight into your investment's performance.

How does Absolute Return work?

  • Calculating Absolute Return: To calculate the absolute return of an investment, you need to subtract the initial investment amount from the final value (including any interest, dividends, or capital gains) and then divide it by the initial investment. The result is expressed as a percentage.
  • Independence from Benchmark: Unlike relative returns, which compare an investment's performance to a benchmark index, absolute return evaluates the investment's performance solely based on the actual gains or losses. It doesn't consider whether the market as a whole is up or down.
  • Risk Management: Absolute return is often used by investors and fund managers to assess the success of an investment strategy or a fund. It allows them to focus on the specific performance of an asset or portfolio rather than being influenced by market conditions.
  • Asset Allocation: It can be a valuable tool for asset allocation in a diversified portfolio. By considering the absolute return of individual assets, investors can make informed decisions about how to balance their investments for the best overall performance.

Absolute Return Formula and Example

Calculating absolute return is quite simple. Let's say you invested Rs. 50,000 in a mutual fund on January 1, and its current value on December 31 is Rs. 60,000. To find the absolute return:

Absolute Return = [(Current Value - Initial Investment) / Initial Investment] * 100

Absolute Return = [(60,000 - 50,000) / 50,000] * 100 = 20%

So, your absolute return for the year is 20%.

Difference Between Absolute Return and Relative Return in Mutual Funds

Absolute return provides the actual gain or loss on your investment, while relative return compares your fund's performance to a benchmark index (Like Nifty). While absolute return is an exact measure, relative return gives you an idea of how well your fund performed compared to its peers or the market.

Is CAGR a Superior Metric to Absolute Returns?

CAGR stands for Compound Annual Growth Rate. It is a financial metric used to calculate the annual growth rate of an investment or asset over a specified period, while accounting for the effect of compounding. CAGR provides a smoothed-out and consistent way to measure the annualized growth rate of an investment, even if it experiences fluctuations in value during the given time frame.

To calculate CAGR, you need two data points: the initial value (usually the investment's starting value) and the final value (its ending value) over the specific period. The formula for CAGR is as follows:

CAGR = (End Value / Beginning Value) ^1 / n – 1

CAGR is particularly useful when you want to understand the average annual growth rate of an investment over several years, which helps in comparing different investment options and assessing their long-term performance. It provides a more accurate picture of how an investment has grown over time, accounting for the compounding effect, which is crucial in financial planning and decision-making.

When compared to Absolute return in case of mutual funds, CAGR is often considered a superior metric because it factors in compounding. CAGR provides a smoothed-out annualised growth rate, making it easier to compare investments with different time horizons. While absolute return is informative, CAGR gives a more comprehensive view of an investment's performance.

Concluding Note

Absolute return is a valuable metric for assessing your mutual fund's performance in a straightforward manner. However, when making investment decisions or comparing different funds, consider using CAGR or relative return for a more comprehensive evaluation. Remember that while absolute return provides insight into past performance, it is essential to consider your future financial goals and risk tolerance when investing in mutual funds.