Absolute Return in Mutual Funds: An Overview
The expected rate of return is one of the most important things for anyone who wants to invest in a mutual fund. An investor will put money into a fund only if he or she believes the potential reward justifies the inherent risk. The percentage by which an investment increases in value over its initial cost is known as its rate of return, or simply its return. The rate of return illustrates how much money was made or lost on an investment during a given time frame. You can figure out your profits one of four ways:
- Absolute Returns,
- Simple Annualised Returns,
- CAGR (Compounded Annual Growth Rate),
- XIRR (for calculating SIP Returns).
Importance of NAV in Mutual Funds
The Net Asset Value, or the market value of the securities held by the scheme, is divided by the total number of units of the scheme on the stipulated date. The NAV varies on a daily basis and is calculated as –
NAV = (Assets – Liabilities) / Total number of outstanding units.
The NAV is crucial to understanding the returns on the investment.
What is Absolute Return in Mutual Funds?
An absolute return also called a total return, is a mutual fund's return on investment (ROI) over a certain amount of time. Investment quantity and maturity amount are the primary factors to think about. As for the duration of the investment, it makes no difference. Rates of change are shown in percentages, which can be used to track how an investment or portfolio is growing or shrinking.
This way of figuring out the return on investment is usually used when it has been held for less than a year.
Leverage, arbitrage, futures, derivatives, options, and alternative assets are all examples of absolute return investment techniques.
How to Calculate Absolute Return in Mutual Funds?
Absolute returns are calculated as follows –
Absolute Returns (%) = (Current Value – Principal Investment) * 100
Principal Investment
For example:
The current value of the investment is Rs. 15,000.
The principal Investment of the investment is Rs. 10,000.
The absolute return is 50% as it is (15000–10000)/10000*100
Notably, 50% of earnings could have occurred over a few months or a few years. These figures will offer no clarity regarding the period taken to earn this amount. It does not give clarity on the growth potential of the investment.
A more simplistic formula for the same is Absolute return = (Current value/initial value) – 1
Difference Between Absolute Return and Relative Return in Mutual Funds
| Absolute return | Relative Return or Alpha |
| It is a return over a period of time. | It refers to the difference between the absolute return of an investment and its benchmark over a period of time. |
| As there is no reference period, a high absolute return is not necessarily proof of the investment being good. | A high alpha is an indicator that the investment made is good. |
| An absolute return makes no such indication. | The relative return shows if the primary purpose of the mutual fund has been fulfilled i.e. if the fund has been able to outperform the benchmark. |
| The absolute return has limited use. | Relative return is a more popular measurement of the returns generated by a fund. |
Absolute Vs Annualized Return in Mutual Fund
Even though absolute returns are less cumbersome to compute, they cannot be utilized to compare the performance of different assets. But annualized returns can also be used to compare, even though they are harder to calculate. Most of the time, absolute returns are used to calculate returns over less than a year. But if the time frame is more than a year, annualized returns should be calculated. Absolute returns are used to figure out short-term changes, while annualized returns are used to figure out long-term trends.
Is CAGR a superior metric to Absolute Returns?
When investors are willing to take on more risk in exchange for the chance of making a lot of money, they might want to think about a strategy called "absolute returns." CAGR takes into account the time period during which an investment is held. This makes the picture of the investment's potential for growth that this metric paints more clear and more precise. The standard formula for determining CAGR is as follows: CAGR (%) = Absolute Returns/Investment Duration (years). In this way, not only faster but also higher returns can be considered when making an investment decision.
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Conclusion
Absolute return analysis should only be used by people willing to take calculated risks in search of both short-term and long-term returns. It's easy to compute and doesn't care much about the state of the market. A dynamic approach to risk management relies on absolute returns.
Is there any period of reference for calculating absolute return?
No, absolute return does not have a reference period.
Can an absolute return be used to compare the performance of two investments?
In general, absolute returns are not utilized to compare two investments.
For what time period is absolute return the most accurate representation of return on investment?
Regarding a one-year timeframe, absolute return provides the most precise statistics.
In what terms are returns normally computed?
Returns are often calculated in percentage terms, and the same holds true for absolute returns, CAGR, etc.