Annual Return Versus Absolute Return

mutual fund

Investing in mutual funds can be a powerful tool for growing your wealth. However, navigating the world of financial terms and figures can be daunting, especially when it comes to understanding different ways to measure your returns.

Two key terms you will encounter while researching mutual funds are “absolute returns” and “annualised returns”, and while they sound similar, their meanings and uses differ significantly. Understanding these differences is crucial for making informed investment decisions.

What are absolute returns in mutual funds?

Absolute returns represent the total percentage change in the value of your mutual fund investment over a specific period without considering the effect of compounding. The formula for calculating absolute returns is straightforward:

Absolute Returns = [(Present NAV – Initial NAV)/ Initial NAV] × 100

While absolute returns are simpler to understand, it may be less accurate than its counterpart due to its ineligibility to factor in the compounding effect on returns.

For instance, you invest Rs. 10,000 in a mutual fund, and after two years, its NAV (net asset value) rises to Rs. 12,000. Your absolute return is simply the total percentage change in your investment, calculated as follows:

In this case, your absolute returns would be [(12,000 – 10,000) / 10,000] × 100 = 20%. So, your investment grew by 20% over those two years.

What are annualised returns in mutual funds?

In contrast, annualised returns provide the average rate of return per year over a specific period, accounting for the compounding effect on investment returns. The calculation involves the formula:

Annualised Returns = [(1 + Absolute Rate of Return) ^ (1/no. of years)] – 1

Though more complex than absolute return, the annualised return is generally considered more accurate as it incorporates the impact of compounding.

Say, for example, if your SIP yielded a 20% absolute return in year one and 15% in year two, the annualised return would be [(1 + 0.20) (1 + 0.15)] ^ (1/2) – 1 * 100 ≈ 17.3%. This factors in compounding, which means your earnings generate further earnings over time.

Difference between absolute returns and annualised returns

   FeatureAbsolute returnsAnnualised returns
DefinitionTotal percentage change over a specific periodAverage rate of return per year
Calculation(Present NAV – Initial NAV)/Initial NAV x 100(Present NAV/Initial NAV) ^ (1/no. of years) – 1
AccuracyLess accurate (ignores compounding)More accurate (considers compounding)
SimplicityEasier to understandMore complex to understand
UsefulnessComparing performance over different time periodsForecasting future returns
LimitationsDoesn’t consider riskCan be misleading for short periods

Which is a better choice for you?

The choice between absolute and annualised returns depends on your investment goals. If you seek overall growth, absolute returns can be a suitable choice. However, annualised returns provide a more insightful metric if you want to assess the performance of your investments.

Most online platforms offer a mutual fund SIP calculator allowing you to play around with absolute and annualised returns based on your desired investment amount and tenure. This can be a fantastic tool for visualising your future corpus and understanding how small, regular investments can snowball over time.