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Difference Between Annualized and Absolute Returns in Mutual Funds

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A mutual fund is an investment instrument that pools investors’ money to invest in a range of securities based on a carefully devised asset allocation strategy. The fund is managed by a seasoned finance professional or an asset management company (fund house), and the gains from these funds are distributed proportionately among the investors.

One of the primary metrics of the performance of a mutual fund is the return it yields, which is also used to compare its performance against its peers and other Investment Plans. However, you can also find two distinct ways of calculating the returns in mutual funds, namely absolute returns and annualized returns.

We will explore all the key aspects of absolute and annualized returns in mutual funds, their implications, calculations, key points of difference, and more.

What is Absolute Return?

Absolute return, expressed in percentage, assesses the growth of an investment without considering the period. It can be understood as the total return yielded from an investment and how much the investment has increased or decreased.

For instance, if the value of your investment increased from AED 100,000 to AED 150,000 in two years, the following calculation would be made to calculate the absolute return –

Absolute Return = (Present Value - Initial Value) / Initial Value * 100

In this specific case, the return would be calculated like this = (1,50,000 - 1,00,000) / 1,00,000 *100, i.e., 50%

This indicates that the value of the mutual fund increased by 50% over the specified period.

What is Annualized Return?

The annualized return measures the rate of growth or appreciation of an investment during a certain period. The compounded annual growth rate (CAGR) is the most commonly used type of rate to account for the effect of compounding. Annualized returns tend to conceal the volatility of the fund and are typically used when the investment tenure is greater than 1 year.

For instance –

If the initial value of your mutual fund is AED 100,000 and it increases to AED 200,000 in 5 years, the annualized return will be calculated as follows –

Annualized return = {[(Present NAV / Initial NAV) ^ (1 / number of years)] −1} × 100

Substituting the values in the given formula, the annualized return would turn out to be 14.87%. This means that your investment increased at a rate of 14.87% per year during the last 5 years.

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Differences Between Absolute Returns and Annualized Returns

Tabled below are the key differences between annualized and absolute returns –

Absolute Return

Annualized Return

Measures the overall performance of a fund

Commonly known as the CAGR (compound annual growth rate), it measures the fund performance over 1-year periods

Absolute return does not consider the period of investment

Annualized return considers the effect of time and gives a compounded annual return rate

Absolute return does not take into account the effect of compounding and that the profits from the fund are being reinvested.

Annualized return assumes that the profits generated from the fund are being reinvested and considers the effect of compounding

Comparison of different mutual funds becomes difficult using absolute return as it can be affected by extreme returns over the years

Comparison of different mutual funds becomes easier as we get an annual return rate using annualized return

An absolute return is comparatively simpler to calculate

Annualized returns are relatively more difficult to calculate due to their complex formula

Formula

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

Formula

Annualized Return = { [(Present NAV / Initial NAV) ^ (1 / number of years)] −1} × 100

Key Takeaways

There are two different ways to calculate the returns on a mutual fund. Absolute returns measure an investment's performance in terms of how much money you made or lost on the initial investment. Annualized return, on the other hand, demonstrates how long-term investments with varied return rates build value on a yearly basis.

For this reason, annualized returns are better for comparing mutual funds when the returns are extremely dispersed. However, to get an estimate of the growth of your funds, you can use absolute returns as well.

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