Absolute Return in Mutual Funds – Meaning, Formula, Calculation Procedure
While calculating returns on investment, the calculation method to be used will depend on the investment time horizon. If the time horizon is less than a year, you may use the absolute return method to calculate. If the time horizon is more than a year, you may use the annualised returns method to calculate. This blog will focus on absolute return in mutual funds – meaning, formula, and calculation procedure.
What is an absolute return?
Absolute return is the total return earned from an investment. The absolute return doesn’t take into consideration the investment period. It also doesn’t compare the returns to a benchmark. Absolute return in mutual funds is the point-to-point returns earned from a mutual fund scheme.
How does absolute return work?
The absolute return takes into consideration the price at which the investment has been sold and the price at which the investment was bought. The difference is then divided by the purchase price. The value, when multiplied by 100, gives the absolute return percentage. Absolute return is useful when the investment time horizon is less than a year. For example, you must have seen mutual fund returns for the last one week, one month, three months, six months, year to date, one year, etc. These are all absolute returns.
What is the absolute return formula?
The formula for calculating absolute returns is as follows:
Absolute return = ((Selling price – Purchase price) / Purchase price) * 100
For example, Ajay bought 100 ABC Mutual Fund Scheme units at a net asset value (NAV) of Rs. 10. He sold the units at a NAV of Rs. 15. The absolute return will be calculated as follows:
Selling price – Purchase price = Rs. 15 – Rs. 10
= Rs. 5 profit per unit
(Profit / Purchase price) * 100 = (Rs. 5 / Rs. 10) * 100
In this case, Ajay earned an absolute return of 50%.
If Ajay’s investment tenure is less than a year, calculating the absolute return will make sense. However, if Ajay’s investment tenure is more than a year, it will make sense for Ajay to calculate the annualised returns instead of the absolute return.
What is an annualised return?
The annualised return is the amount of money your investment has earned on a per-year basis. For example, if an investment has grown from Rs. 1,00,000 to Rs. 1,50,000 in two years, the annualised return will be 22.47%. It means the investment has grown by 22.47% every year. Annualised returns are also referred to as compounded annual growth rate or CAGR. It is the most common formula used for calculating and comparing mutual fund returns.
Image: Formula to calculate annualised returns
You must have seen three-year, five-year, or ten-year mutual fund scheme returns on various AMC and other finance websites. These are all annualised returns.
Difference between absolute and annualised returns
Some of the differences between absolute and annualised returns include the following:
Investment time horizon
- Absolute returns don’t take into consideration the investment time horizon. It can be calculated using the purchase price and the sale price. However, annualised return takes into consideration the investment time horizon. It can be calculated using the purchase price, sale price, and investment time horizon.
When to use absolute and annualised return
- The absolute return should ideally be used when the investment time horizon is less than one year. For example, you can use absolute return if you want to calculate the mutual fund returns for a scheme for three months, six months, one year, or year to date.
- The annualised return should ideally be used when the investment time horizon is more than a year. For example, if you want to calculate the mutual fund returns for a scheme for three years, five years, or ten years, you can use annualised returns.
- You can use annualised returns for comparison purposes. For example, you can compare the annualised returns for a mutual fund scheme with its benchmark index. The comparison will tell you whether the mutual fund scheme has outperformed or underperformed the benchmark index.
Use annualised returns for long-term financial goals
Most people invest towards long-term financial goals such as building a fund for a child's higher education or building a retirement fund for themselves. Since these are long-term financial goals stretching over many years, you should ideally use annualised returns for calculation rather than absolute returns. Annualised returns tell you how much your money is growing every year. You can compare the actual annualised returns with the expected rate of return and assess whether the investment is performing on the expected lines. If not, you can review and take corrective action.