What is an annualised return?

Investors are often overburdened by a variety of financial metrics when assessing the performance of their investments. One such crucial measure is annualised return. This metric goes beyond the surface-level returns and provides a more comprehensive view of an investment's performance over time. In this article, we will understand what annualised return is, how it is calculated, how it differs from absolute return, and its significance.

• Table of contents

• Understanding Annualised Return
• How is Annualised Return Calculated?
• Absolute Return vs Annualised Return
• Calculation of Mutual Funds Annual Return
• Annualised return in the context of taxes and inflation
• Applications of annualised return
• Limitations of annualised return
• How to use annualised return for investment decisions
• Common mistakes to avoid when calculating annualised return

Understanding Annualised Return

Annualised return is a measure used to express the average rate of return on an investment over a specified period, typically calculated on an annual basis. It offers a standardised way to assess and compare the performance of investments with varying timeframes.

While the absolute return provides the actual gain or loss on an investment over a specific period, the annualised return considers the compounding effect over time, offering a more accurate representation of the investment's performance.

How is Annualised Return Calculated?

Annualised return formula:

((1 + Absolute Rate of Return) ^ (365/number of days)) – 1

For example, if the NAV increases from Rs. 40 to Rs. 50 in 7 months, the Absolute Return is 25% i.e., 0.25.

Then annualised return can be calculated as:

((1 + 0.25) ^ (365/210)) – 1

i.e., 47.38%

However, this method holds good if the period of holding is exactly one year.

Also Read: Calculating mutual fund returns: Difference between CAGR, XIRR, and absolute returns

Absolute Return vs Annualised Return

Absolute return

Absolute return, commonly referred to as point-to-point returns, represent the straightforward returns on the initial investment. This calculation involves the starting value (NAV) and the concluding NAV (current NAV). The duration of holding the fund is not a critical factor in this method. Typically applied to periods of less than one year, absolute returns provide a simple measure of investment performance.

The formula for absolute return:

Absolute Return = ((Present NAV – Initial NAV)/ Initial NAV) *100

Absolute return provides a simple measure of the total percentage increase or decrease in the investment value. Whereas, annualised return, as discussed earlier, considers the compounding effect over time. It offers a more nuanced perspective on investment performance, especially when comparing investments with different holding periods.

Calculation of Mutual Funds Annual Return

The annual return of a mutual fund indicates its average yearly performance over a specific period. This calculation helps investors evaluate a fund's historical returns in a standardized way, regardless of how long they hold it.

Annualised returns on mutual funds are determined using the Compound Annual Growth Rate (CAGR). This calculation takes into account the initial investment value, the final value, and the total investment period in years.

The formula for CAGR is:

CAGR = (PV/FV)^(1/n)

Annualised returns enable comparisons of mutual funds across different time periods. They offer a clearer picture of long-term performance compared to absolute returns. Investors should remember that past returns do not indicate future potential performance.

Since market fluctuations can significantly influence annualised returns, it is advisable to assess this metric alongside other performance indicators.

Annualised return in the context of taxes and inflation

When reviewing mutual fund returns, it is important to account for the effects of taxes and inflation. The pre-tax annualised return may not reflect the actual potential gains an investor receives. Taxation policies in India, particularly changes made in 2023 and 2024, impact net returns. The removal of indexation benefits for debt funds and modifications in equity fund taxation make post-tax annualised return an essential factor.

• Inflation reduces the purchasing power of money over time.
• The real annualised return, adjusted for inflation, provides a clearer picture of an investment’s potential growth.
• Tax rules should be considered to determine the actual returns an investor may receive.

Investors should assess their after-tax and inflation-adjusted annualised returns for well-informed financial planning.

Applications of annualised return

Annualised return is a widely used measure in mutual fund analysis. It helps investors compare funds held for different durations. For example, it allows easy comparison between a fund held for three years and another held for five years.

• Comparing the performance of various fund categories.
• Evaluating a fund manager’s performance over time.
• Determining whether a fund has consistently outperformed its benchmark.
• Assessing an investment's potential long-term growth.

Financial advisors rely on annualised returns to guide investors in understanding potential investment growth and making realistic financial plans.

Limitations of annualised return

Despite being a useful measure, annualised return has limitations. It reflects past performance but does not ensure future potential returns. Since market conditions fluctuate, past returns may not accurately predict future trends.

• It does not reflect the risk level of a fund.
• It can be misleading for funds with significant volatility.
• It does not include the effect of expense ratios charged by the fund.
• It is based on historical data, whereas markets focus on future potential.

Investors should use annualised returns as part of a broader analysis and avoid relying solely on this metric for investment decisions.

Also Read: What is XIRR in mutual funds?

How to use annualised return for investment decisions

The primary way investors may use annualised returns is for comparison and long-term assessment:

• Comparing schemes: Annualised return expresses the performance of different mutual fund schemes over varying time periods on a common, annual basis. This may be suitable for comparing the long-term track record of, for example, two different large cap funds or two aggressive hybrid funds.
• Benchmarking performance: It may help to compare a fund's annualised return against the returns of its relevant benchmark index (e.g., Nifty 50 for a large cap fund).
• Long-term goal projection: While past returns are not a guarantee of future performance*, you may use a fund's historical annualised return as a reference point.
• Identifying compounding effects: Since CAGR incorporates the effect of compounding, it provides a more accurate view of how wealth has potentially been created over time compared to absolute returns (which do not account for the tenure of the investment).

*Past performance may or may not be sustained in future.

Common mistakes to avoid when calculating annualised return

• Misinterpreting CAGR as actual yearly return: Annualised return represents a hypothetical, constant rate of return over the entire period. It is an average that smooths out volatility. Investors should avoid the mistake of assuming that the fund delivered this exact percentage return every single year. In reality, returns may fluctuate significantly during the investment horizon.
• Ignoring the impact of IDCW payouts: The calculation of annualised return for a growth option fund is straightforward, using the initial and final NAVs. However, if the investor has opted for the IDCW (Income Distribution cum Capital Withdrawal) payout option, the IDCW amounts received must be added back to the final investment value, as they represent a distribution of the fund's capital/earnings. Failing to include these payouts will understate the true annualised return.
• Not accounting for additional investments or withdrawals: The standard CAGR formula assumes a single, one-time lump sum investment. If an investor has made multiple contributions or withdrawals during the investment tenure, the standard CAGR formula will provide an incorrect result. In such scenarios, the Extended Internal Rate of Return (XIRR) is the more precise and suitable measure for performance.
• Focusing solely on point-to-point returns: The annualised return is a point-to-point measure, meaning it is entirely dependent on the specific start date and end date chosen. If the calculation starts at a market low and ends at a market peak, the return may be artificially high.
• Comparing funds from different categories: It is a mistake to compare the annualised return of schemes with fundamentally different risk profiles, such as comparing a small cap fund with a liquid fund solely based on their returns.
• Ignoring risk and volatility: Annualised return does not communicate the volatility or risk taken to achieve that return. A fund with a relatively lower annualised return but consistently lower volatility may be more suitable for a particular investor than a fund with a higher annualised return but extreme volatility.

Conclusion

In the complex world of investments, annualised return emerges as a powerful metric that transcends the simplicity of absolute return. While absolute return offers a snapshot of the actual gain or loss, Annualised return brings time into the equation, offering investors a more comprehensive and standardised measure of performance.

FAQs

How is annualized return calculated?

Annualized return expresses investment returns over any timeframe (shorter or longer than a year) as an equivalent yearly return. It ensures a uniform basis for comparison. The formula is ((1 + Absolute Rate of Return) ^ (365/number of days)) – 1

Why is annualized return important?

Annualized return helps compare mutual fund performance across different timeframes. It shows how an investment could have potentially grown if it had expanded at a consistent rate each year. This makes it more insightful than simple returns, particularly for long-term investments.

What is a 3 year annualised return?

A 3-year annualized return shows the average yearly growth rate of an investment over three years. It reflects the hypothetical annual return if the investment had grown at a constant rate during that period, offering a clearer view of its potential growth.

What is the formula for annualised return?

Annualised return formula:
((1 + Absolute Rate of Return) ^ (365/number of days)) – 1

How do you calculate annualised return on mutual funds?

Annualized returns for mutual funds are usually determined using the Compound Annual Growth Rate (CAGR). This approach converts returns earned over a specific period into an equivalent yearly rate, offering a smoothed, year-over-year growth measure. It helps investors assess the potential average annual growth of their investment.

What is the difference between annualised total return and average return?

Annualized total return represents the compounded annual growth rate, providing a smoothed measure that accounts for fluctuations. In contrast, average return simply sums up periodic returns and divides by the number of periods, without factoring in compounding. CAGR gives a more accurate reflection of long-term potential growth.

What is a good annual rate of return for a mutual fund?

A suitable return depends on the fund category and market conditions. Equity funds, being high risk, may have the potential for higher returns in the long term, while debt funds generally offer comparatively lower return potential.

Are there any limitations to annualized return?

Annualized returns, particularly CAGR, assume a constant growth rate, which may not align with real market conditions. They do not capture volatility or the sequence of returns. While useful for comparison, they should be assessed alongside other indicators like standard deviation and the Sharpe ratio.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
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