Difference Between Annual Return And Absolute Return

The key difference between annual return and absolute return lies in the way they are calculated. Annual return is a percentage increase or decrease in the value of an investment over a one-year period, whereas absolute return measures the actual gain or loss, regardless of the time period. 

This article covers: 

• What Is Absolute Return In Mutual Fund
• What Is Annualised Returns In Mutual Funds
• Absolute Vs Annualized Return
• Annual Return vs Absolute Return- Quick Summary
• Annual Return vs Absolute Return- Frequently Asked Questions

What is Absolute Return in Mutual Funds?

Absolute return is a measure of the actual profit or loss generated by a mutual fund, independent of market performance. It is calculated by subtracting the initial investment amount from the final investment value and considering all dividends and capital gains earned during the investment period.

In contrast to relative return, which compares a fund’s performance to a benchmark index or other funds, absolute return focuses solely on the fund’s actual returns. This makes it a useful tool for investors who prioritize capital preservation and steady, positive returns over market outperformance.

Here is an example to help illustrate the concept of absolute return in mutual funds:

Let’s say you invest Rs. 10,000 in a mutual fund at the beginning of the year. Over the course of the year, the fund generates a return of 8%, which includes both capital gains and dividends. At the end of the year, your investment is worth Rs. 10,800.

Absolute Return Formula = (Final investment value – Initial investment) / Initial investment

= (Rs. 10,800 – Rs. 10,000) / Rs. 10,000

= 0.08 or 8%

In this case, the absolute return on your investment in the mutual fund is 8%. This means that you earned a total return of Rs. 800 on your initial investment of Rs. 10,000, regardless of how the broader market performed during the investment period.

Here are some key points to keep in mind when understanding absolute return in mutual funds:

• Therefore, absolute return is measured in actual rupee terms and is unaffected by market fluctuations or other external factors.
• Mutual funds that aim to generate absolute returns typically invest in a diversified portfolio of stocks, bonds, and other securities with the goal of achieving consistent returns over time.
• Because absolute return funds prioritize capital preservation, they tend to have lower risk profiles than other types of funds. However, this also means that their returns may be lower in bull markets or during periods of high market volatility.
• Investors who are considering investing in absolute return mutual funds should carefully evaluate the fund’s track record, investment strategy, and fees before making a decision.
• It is also important to clearly understand the fund’s performance objectives and risk tolerance.

Here are some examples of absolute return mutual funds in India and their historical returns:

(Note: Data is as of February 28, 2023)

What Is Annualized Returns in Mutual Funds

Annualized return, also known as compound annual growth rate (CAGR), is a measure of the average rate of return generated by a mutual fund over a specific period of time. It represents the annualized rate of growth that an investment has achieved over the investment period, assuming that the rate of return remains constant over time.

To calculate the annualized return of a mutual fund, you need to know the fund’s total return and the time period over which the return was generated. Here’s how to calculate annualized return:

Annualized return = ((1 + Total return) ^ (1 / Investment period in years)) – 1

For example, if a mutual fund has generated a total return of 20% over a three-year period, its annualized return would be calculated as follows:

Annualized return = ((1 + 0.20) ^ (1 / 3)) – 1

= 6.22%

This means that the fund generated an average annual return of 6.22% over the three-year period.

Here are some key points to keep in mind when understanding annualized return in mutual funds:

• Annualized return takes into account the compounding effect of returns over time. This means that even small changes in return can significantly impact the fund’s overall performance over the long term.
• Unlike absolute return, which measures the actual profit or loss generated by a fund, annualized return provides a more standardized measure of performance that can be compared across different time periods and investment strategies.
• When evaluating the performance of mutual funds, it is important to consider both the annualized return and the risk associated with the fund’s investment strategy.

Here are some examples of mutual funds in India and their annualized returns over different time periods:

(Note: Data is as of February 28, 2023)

Absolute Return vs Annualized Return

The biggest difference between absolute and annualized returns is that absolute return is the actual percentage change in the value of an investment over a certain period, whereas annualized return is the average rate of return per year over the same period, taking compounding into account. 

Let’s look at more distinctions between absolute and annualized returns.

1. Time Period: Absolute return measures the percentage change in the value of an investment over a specific time period, while annual return calculates the average rate of return per year over the same period.

2. Compounding: Absolute return does not consider the effect of compounding, whereas annual return considers the effect of compounding on investment returns.

3. Volatility: Absolute return does not account for the volatility of the investment over the time period, while annual return considers the volatility of the investment, as it is calculated on an annual basis.

4. Investment Horizon: Absolute return is useful for measuring the performance of an investment over a short time period, while the annual return is more suitable for evaluating the long-term performance of an investment.

5. Comparison: Absolute return is useful for comparing the returns of different investments over a specific period, while the annual return is more useful for comparing the returns of investments over different time periods.

Here’s an example to help illustrate the difference between absolute return and annualized return:

Suppose you invested Rs. 10,000 in a mutual fund, and the fund generated the following returns over a three-year period:

Year 1: 20%

Year 2: -10%

Year 3: 30%

The absolute return for this investment would be calculated as follows:

Absolute return = ((Ending value – Beginning value) / Beginning value) x 100

Absolute return = ((Rs. 12,600 – Rs. 10,000) / Rs. 10,000) x 100

= 26%

This means that the investment generated a total profit of 26% over the three-year period.

The annualized return for this investment would be calculated as follows:

Annualized return = ((1 + Total return) ^ (1 / Investment period in years)) – 1

Annualized return = ((1 + 0.26) ^ (1 / 3)) – 1

= 7.46%

This means that the investment generated an average annual return of 7.46% over the three-year period.

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Annual Return vs Absolute Return- Quick Summary

• Absolute return is the actual percentage change in the value of an investment over a specific time period, without taking into account the effect of compounding.
• Annualized return is the average rate of return per year over a specific time period, taking into account the effect of compounding on the investment returns.
• Absolute return measures the total gain or loss of an investment, while annual return measures performance over a year.
• Annualized return is calculated as the average annual return over a specified period, and it is useful for comparing mutual funds with different investment horizons.
• Evaluate mutual funds based on both their absolute and annualized returns, as well as other factors such as fees, management style, and investment strategy.

Annual Return vs Absolute Return- FAQs

1. What are the 3 types of return?

The three types of return are:

• Absolute return: the actual profit or loss earned on an investment over a period of time.
• Annualized return: the average rate of return earned per year on an investment over a specific time period.
• Relative return: the return earned by an investment compared to a benchmark, such as a market index.

2. What is the formula for absolute return?

A: The formula for absolute return is:

Absolute return = (Current value of investment – Initial value of investment)/initial investment

3. How do you calculate annualized return from absolute return?

A: To calculate annualized return from absolute return, you need to know the time period of the investment. The formula is:

Annualized return = ((1 + Absolute return)^(1/Time period)) – 1

4. Is absolute return fixed income?

A: No, absolute return is not fixed income. Absolute return is a type of investment strategy that aims to achieve a positive return regardless of market conditions. It can be used in various asset classes, including stocks, bonds, commodities, and alternative investments.

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