What is absolute return in mutual fund?
Absolute return is a type of investment return that is measured from the initial investment to the final value of the investment, regardless of the direction of the investment's performance.
How to calculate absolute return?
Absolute return is a measure of an investment's performance, which takes into account both the change in the investment's value and the time period over which that change occurred.
To calculate the absolute return, subtract the initial investment from the current investment value and then divide it by the investment's initial value and multiply by 100.
Absolute Return Formula
AR= [(Current value of investment - Initial value of investment)/ Initial value of investment]*100
Difference between Absolute & Annualised Return/CAGR
Absolute return measures total gains over a specified period, taking into account all cash flows such as initial investments and subsequent returns. In contrast, annualized return or CAGR considers average gains per year, over multiple years. An example might be an investment in the stock market that yielded a 4% return in its first year, followed by 8%, then 6%. The absolute return would represent 18% (4%+8%+6%), while the annualized return would take the average of those three numbers and rate growth at 6%.
Absolute return and XIRR
Absolute return and XIRR (Extended Internal Rate of Return) are both measures used in finance to evaluate investment performance, but they serve different purposes.
Absolute return provides a straightforward assessment of the total gain or loss on an investment over a specific time period. It is calculated by considering the difference between the ending and beginning values of an investment. For example, if an investment of ₹1,000 grows to ₹1,200, the absolute return would be 20%.
On the other hand, XIRR, or Extended Internal Rate of Return, is a method used to calculate the annualized return of an investment, taking into account the timing and size of cash flows. XIRR considers irregular intervals of cash flows and is especially useful when there are multiple investment or withdrawal transactions at different points in time. The formula for XIRR involves solving for the discount rate that equates the present value of cash inflows and outflows. It provides a smoothed, compound average annual rate of return.
Absolute return vs CAGR
CAGR provides a smoothed, compounded annual rate of return, factoring in the compounding effect over the entire investment duration.
CAGR, however, adds time to the equation. It calculates the average annual growth rate achieved over a specific period. This provides a more nuanced understanding of the investment's growth trajectory, akin to a speedometer for your portfolio.
So, the same 50% absolute return over five years translates to a steady 10% CAGR, revealing a consistent growth pattern.