Investors would want to periodically check how much their investment has grown or how much a potential investment would give. With technological advancements, one can easily use online calculators to estimate their returns. However, having the knowledge on calculating mutual fund returns would come in handy. This article covers absolute return, and annualized return, and how to calculate them.
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What is an Absolute Return?
Absolute return is the return from an investment over a specific period of time. Expressed as a percentage, it measures the total appreciation or depreciation in the value of the asset. It can be positive or negative and measures the total gain or loss from the investment.
In the case of mutual funds, absolute returns (point to point return) are total returns from a mutual fund. It is the return of the mutual fund without comparing it to any benchmark index. When the fund managers talk about maximizing the return of a mutual fund, they mean the absolute return.
How Does Absolute Return Work?
This return works based on the current value of investment and initial investment amount. It is the difference between the current value and the initial value of an investment upon the initial value of the investment. For computing returns over a term that is less than a year, this return is generally used. In the case of mutual fund investments, all that is required is the beginning value NAV and the ending value NAV (present NAV). The duration of the investment in the fund is irrelevant while computing these returns.
What is the Absolute Return Formula?
Absolute return is simple and easy to calculate. One needs only two values to estimate this return from an investment. They are the current value of the investment and initial investment. Below is the formula to estimate the absolute return:
Absolute return = ((Current value of the investment – Initial investment) / Initial investment) * 100
Let’s take an example of an investor Ms Vani Kumar who invested INR 1,50,000 in a mutual fund. The current value of the investment is INR 2,50,000. The absolute return for Ms Vani Kumar can be estimated using the above formula:
Absolute return = (250000-150000)/150000) *100
Absolute return = 66.66%
From her investment in a mutual fund, Ms Kumar has earned a return of 66.66%. However, this return doesn’t take into account the time period of the investment. Ms Kumar would’ve made this return in 5 years or 15 years. One cannot infer this from point to point returns. Hence mutual funds usually calculate annualized returns for any time period greater than one year.
What is an Annualized Return?
Annualized return is the geometric mean average return the investment has earned every year over a given period of time. It gives only a snapshot of an asset’s performance over a given period of time and doesn’t show the volatility and price fluctuations.
Though it is difficult to compute annualized return when compared to absolute return, it can be easily compared to other similar investments to make an investment decision. To calculate the annualized return, one would need the absolute return and the investment horizon. Below is the formula for annualized return:
Annualized return = ((1+Absolute return) ^ (1/n)) – 1
In the above example, let’s assume Ms Vani Kumar’s investment horizon is four years. We can calculate the annualized return for her using the absolute return.
Annualized return = ((1+66.66%)^(1/4))-1
Annualized return = 13.62%
This means, on average, Ms Vani Kumar’s investment has given a 13.62% return every year for four years.
What is the difference between Absolute and Annualised returns?
Absolute return measures the performance of an investment regardless of the time period. It is expressed in terms of percentage and INR. On the other hand, the annualised return is the average return of an investment over a period of time. It is expressed as a percentage.
Absolute returns are easy to calculate. It takes the beginning value or initial investment and the end value to calculate the return from the investment. The annualised return, on the other hand, is slightly difficult to calculate. It takes the absolute return and adds 1 to it. Then the nth root of it is taken where n is the time period, and finally, one is subtracted to obtain the annualised multiplier. In other words, it shows the return from an investment over a period of time.
Though it is easy to calculate, it gets challenging to compare the absolute return from 2 investments. The time period of the return is unknown, hence making it difficult for comparison. On the other hand, one can compare the annualised return of two investments and can choose the one with a higher annualised return.
Let’s take the example of investing INR 1,000 for three years. At the end of 3 years, the investment grew to INR 1,500. The absolute return from this investment is 50%. On the other hand, the annualised return is 14.47%. This means the investment grew 14.47% per annum for three years.
What is the Importance of Absolute and Annualised returns?
The absolute return method is a simple way to determine mutual fund returns. It measures the change in the value of the investment over a period of time. If the mutual fund investment duration is for a short period (less than one year), then this return approach is suitable.
When calculating returns for a long investment duration, using this return might give inaccurate results. For example, if an investment of INR 50,000 grows to INR 75,000 in three years, the point to point return then will be 50%. The return obtained in each of these five years, however, might be actually lesser.
Annualized return is the geometric average return the investment has earned every year during the investment duration. Annualized return determines the average rate at which the fund’s value has increased yearly to achieve its current value. Whereas absolute return shows how much the investment has grown from its starting value.
When the investment duration is greater than one year, it is preferable to estimate returns using annualised return technique. Due to market fluctuations, performance in a particular year might differ considerably from the previous year. As a result, the annualised return technique makes it easier to compare the performance of various mutual funds across different periods.
You may also like to read about the Absolute Return vs CAGR