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What is Annualized Return in Mutual Funds? How is it calculated?

‘Return’ is the yield that an investment generates over a period of time. It is the percentage increase or decrease in the value of the investment in that period. Returns on mutual funds are expressed in 2 different ways, viz, absolute and annualized. The most popular one being the annualized return or CAGR (Compounded Annual Growth Rate).

A mutual fund fact sheet shows the fund facts and the most important to us as investors are its return. The returns are usually given for 1-month, 3-month, 6-month, 1-year, 3-year, 5- year and so on. The returns for 1 to 3 months is given in absolute basis and the returns from 1 year and above are given in absolute basis. So when you see a 5% under the 3-month column, it means the fund has given 5% in 3 months’ time. 12% annualized return in 3 years means 12% return earned every year for the past three years and not 12% total return in 3 years.

Albert Einstein hasn’t simply said that compound interest is the 8th wonder of the world. Compounding can do wonders to your money. 12% annualized return can double your money in 6 years. And 15% annualized return can double your money in less than 5 years! Below is the table that shows how long different interest rates take to double your money.

Annualized ReturnTime taken to 2x your money
5%14 years, 2 months
8%9 years, 0 months
10%7 years, 3 months
12%6 years, 1 months
15%4 years, 11 months
20%3 years, 9 months
25%3 years, 1 months

 

How to Calculate Annualized Return and Absolute Return?

Absolute Return

Absolute returns, also known as point-to-point returns, calculate the simple returns on initial investment. To calculate this return all one needs is the initial and ending NAV (present NAV). In this method, the duration of holding the fund is not important. One usually uses absolute returns to calculate returns for a period of less than one year.

Formula for absolute returns

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

Annualized Return

Annualized return is the amount of money the investment has earned for the investor per annum. CAGR is compounding of returns earned over a period of time. It provides a snapshot of the of an investment’s performance but doesn’t give investors any indication about the volatility. Using annualized return gives a clearer picture when comparing various mutual funds that have traded over different periods of time. However, this is applicable only if you re-invest your gains every year.

Formula for annualized return

Annualized return = ((1 + Absolute Rate of Return) ^ (365/no. of days)) – 1

OR

Annualized return = ((1 + Absolute Rate of Return) ^ (1/no. of years)) – 1

Example

DateFund NAVTime PeriodAbsolute ReturnsAnnualized Returns
March 28, 201830.51
February 28, 201831.021 month-1.64%-1.64%
September 29, 201728.796 month5.97%5.97%
March 31, 201725.821 year18.16%18.16%
March 31, 201620.962 years45.56%20.65%
March 31, 201521.733 years40.40%11.98%
March 31, 201310.995 years177.62%22.66%
March 31, 20089.7510 years212.92%12.08%

The above table shows the NAV of Aditya Birla Sun Life Tax Relief 96, (which has been taken only for the purpose of illustration). The returns up to 1 year are the same in the case of absolute and annualized. The returns after 1 year are different. While the absolute returns show how much the investment has grown from the initial date, annualized return show how much the fund grew annually to reach that current return. This doesn’t mean the fund grew at a certain rate every year. It’s just the average growth of the fund year on year. Annualized return normalizes the absolute return and lets you know the returns over a given period of time.

Why 1-year returns for some funds are higher than its 3 or 5-year returns?

Mutual funds returns are reported on an annualized basis. And mutual fund returns fluctuate across years. This is the reason why 1-year returns may appear higher than 3 years returns.

Let me take you through a small example.

Aditya Birla Sun Life Tax Relief 96, one of the top fund in tax saving category of mutual funds has the following returns.

1yr: 18.16% annualized return => 1 lakh invested in this fund 1 year ago has become 1.18 lakh today

3yr: 11.98% annualized return => absolute returns of 40% in 3 years => 1 lakh invested in this fund 3 years ago has become 1.40 lakh today

5yr: 22.66% annualized return => absolute returns of 177% in the last 5 years => 1 lakh invested in this fund 5 years ago has become 2.77 lakh today.

5 year 22.66% annualized return mean that money invested 5 years ago in the fund has grown 22.66% every year, not 22.66% overall but instead 177% overall. This is the principle of compounding at work growing one’s investment over the years!

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