Absolute returns represent the actual percentage change in an investment's value during a defined period, disregarding compounding effects. On the other hand, annualised returns are the average yearly rate of return over a specific duration, factoring in the impact of compounding on investment yields.
What is an absolute return in mutual funds?
The real profit or loss produced by a mutual fund, regardless of market performance, is measured by its absolute return. It is computed by deducting the total amount invested at the beginning of the investment period from the total amount invested at the conclusion, taking into account all dividends and capital gains.
Absolute return only considers a fund's actual returns, as opposed to relative return, which assesses a fund's performance in relation to other funds or a benchmark index. This makes absolute return a valuable tool for investors who value capital preservation and consistent, positive returns over outperforming the market.
Formula for absolute return
The formula for absolute returns is given as:
Absolute Return = [(Final investment value – Initial investment) / Initial investment] x 100
Let’s try to understand it with an example. Assume for a moment that you start the year with a mutual fund investment of Rs. 10,000. The fund yields an 8% annual return that consists of dividends and capital gains over time. The value of your investment at year's end is Rs. 10,800.
Absolute return = [(10,800 – 10,000) / (10,000)] * 100
= 0.08*100 or 8%
In this instance, your mutual fund investment gives an absolute return of 8%. This indicates that, regardless of how the overall market performed over the investing period, you received a total return of Rs. 800 on your initial investment of Rs. 10,000.
Also read: What is SIP investment
What are mutual fund annualised returns?
The average rate of return produced by a mutual fund over a certain period is measured by the annualised return, commonly referred to as the compound annual growth rate (CAGR). Assuming that the rate of return stays constant throughout, it shows the annualised rate of increase that an investment has attained during the investment period.
Formula to calculate the annualised returns
A mutual fund's annualised return can be computed by taking the entire return of the fund and dividing it by the period over which the return was generated. This is how annualised returns are calculated.
Annualised Return = (1 + T) ^ (1 / N) – 1
Where:
T represents total returns
N represents years of investment (period)
For instance, the annualised return of a mutual fund with a three-year 20% total return would be determined as follows:
Annualised Return = (1 + 0.20) ^ (1 / 3) – 1 = 6.26%
This indicates that during the course of the three years, the fund produced an average yearly return of 6.26%.
When analysing annualised returns in mutual funds, bear the following points in mind:
- The compounding effect of returns over time is considered in the annualised return calculation. This implies that over time, even minor variations in return can have a big impact on the fund's total performance.
- While absolute return assesses the real profit or loss made by a fund, annualised return offers a more consistent performance metric that may be used to compare investments made over a range of time periods and methods.
- The annualised return and the risk related to the fund's investing strategy should both be taken into account when assessing the performance of mutual funds.
Difference between absolute return vs annualised return
The principal difference between absolute vs annualised returns is that the former denotes the net percentage change in the investment’s value over a predefined period. Conversely, annualised return is the average return rate per annum over the same period after considering the concept of compounding.
More distinctions between annual returns vs absolute returns:
- Volatility: Absolute return has no relation to the investment’s volatility over a certain period. The annual return is calculated after considering the investment’s volatility since it is calculable on an annual basis.
- Compounding: Absolute returns do not take into account the effects of compounding. Annual returns consider the effects of compounding on an investment’s returns.
- Time period: The absolute return gauges the change in investment value in percentages over a pre-defined period. The annual return is calculated based on the average return rate per year during the same period.
- Comparison: Absolute returns are useful for comparing the returns from separate investments over a given period, whereas the annual return can be more useful for comparing the returns given by multiple investments over different periods.
- Investment horizon: Absolute returns help measure an investment’s performance over short periods. On the other hand, annual returns are more suitable to evaluate an investment’s long-term performance.
High-return mutual fund categories for smart investing
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Example of absolute return vs annual return
To help you understand the distinction between absolute return and annualised return, consider the following example:
Let's say you put Rs. 10,000 into a mutual fund, and after three years, its value stood at Rs. 12,600.
This is how the investment's absolute return would be determined:
Absolute return = ((Final value - Initial value) / Initial value) x 100
((Rs. 12,600 – Rs. 10,000) / Rs. 10,000) x 100 = 26 %
This indicates that over the three years, the investment provided an absolute return (total return) of 26%.
The following formula can then be used to determine this investment's yearly return:
Annualised return = (1 + T) ^ (1 / N) – 1
Return on annualised capital = [(1 + 0.26) ^ (1 / 3)] – 1 = 8%
This indicates that during the course of the three years, the investment yielded an average yearly return of 8%.
Which is better - Absolute return vs annual return?
Depending on your objectives, there are several metrics to choose from. Absolute return is a useful indicator to utilise if you are worried about the overall growth of your investment. However, the yearly return is a more useful indicator for examining how your investment is doing in relation to other assets.
As an illustration
Assume you are competing in a race. Regardless of the time it takes you to run that distance, your absolute return is the distance you have covered. Your yearly return is a measurement of your pace over one year. In this case, which is more significant?
The answer depends on your objectives. If you hope to win the race, you must concentrate on your total return. However, if you wish to increase your running speed, you should concentrate on your annual return. When evaluating the performance of your investments, it's critical to consider both absolute return and yearly return. This can help you make smarter investing decisions by providing you with a comprehensive view of how your investments are doing.
Summary
Annual and absolute returns are essential metrics for evaluating the success of investments. Although absolute return represents the total returns on your investment, annualised return (also called CAGR) offers a standardised statistic for contrasting various investments, which makes it a more helpful tool for evaluating performance over the long run. Before making a decision, investors should weigh both metrics to have a thorough knowledge of an investment's performance and take into account variables like risk tolerance and investing objectives.
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