What are absolute returns in mutual funds, and how to calculate them?

Mutual funds have become a popular investment option due to their potential for good returns. They pool money from various investors to invest in a diverse portfolio. Absolute returns refer to the actual returns that such funds generate. If you want to know more about this metric and how to calculate it, read on.

Absolute returns in mutual funds: An overview

Absolute return is a measure of a mutual fund’s market performance. It looks at the actual returns that the fund generates, regardless of market conditions.

What is an absolute return in mutual funds?

Absolute return, as mentioned before, is the actual return that a mutual fund generates over a specific period. That is, the returns from the investment irrespective of market conditions or the performance of other funds.

It measures the percentage change in the net asset value (NAV) of a mutual fund over a specified period. And it includes both capital gains and dividends. If a mutual fund’s NAV is ₹10 and increases to ₹12 after a year, the absolute return is 20%. This means that the fund has generated a profit of 20% on the initial investment.

The metric helps investors evaluate fund performance. Strategies that focus on this metric aim to generate positive returns in any market environment.

What are absolute return mutual funds?

Absolute return mutual funds are those that use this way of measuring returns. In contrast, other mutual funds seek to produce returns better than their peers, the fund category, and the market. So they rely on a relative return approach to fund investing.

With this other approach, the success of the asset is based on a comparison to a chosen benchmark a mutual fund seeks to produce returns that are better than its peers, its fund category, and the market as a whole. This type of fund management is a relative return approach. The success of the asset is often based on a comparison to a chosen benchmark.

Absolute return mutual funds, on the other hand, examine performance separately from any other performance measure. So only gains or losses on the investment are the focus.

Such mutual funds use a combination of long and short positions, derivatives, and other strategies to achieve their goals. They often have higher fees than traditional mutual funds due to their more complex investment approach.

Importance of NAV and absolute returns in mutual funds

The Net Asset Value (NAV) that the absolute return helps calculate is one of the crucial things to look at while investing in mutual funds. It represents the value of the fund divided by the number of units outstanding. By dividing the total net assets of the mutual fund by the number of units outstanding.

Here are some of the reasons why NAV is essential in mutual funds. It:

• Reflects the fund’s performance: The NAV of a mutual fund reflects the overall performance of the fund. A high NAV indicates that the fund has performed well and vice versa. Thus, investors use the NAV to evaluate its performance.
• Helps in portfolio management: The NAV helps investors manage their portfolios effectively. Investors can use the NAV to determine the value of their holdings and allocate their investments accordingly. Moreover, investors can use the NAV to assess the impact of market volatility on their portfolio and take necessary measures to mitigate the risks.
• Facilitates redemption and purchase: The NAV plays a crucial role in the purchase and redemption of mutual fund units. Investors can purchase units at the prevailing NAV, and the redemption amount is also calculated based on the NAV. Therefore, NAV is critical for investors to know the exact value of their investments.
• Transparency: NAV helps investors get a clear picture of the mutual fund holdings and their market value. It provides transparency to investors by revealing the underlying assets and their values. Hence, investors can make an informed decision based on the transparency provided by the NAV.

How to calculate absolute return in mutual funds

The formula to calculate absolute return in mutual funds is simple. It can be calculated for any time period, such as a day, a week, a month, a quarter, or a year, with this formula:

Absolute Returns = (Final NAV – Initial NAV) / Initial NAV x 100

For instance, suppose you invested ₹10,000 in a mutual fund with an initial NAV of ₹20. After a year, the NAV increases to ₹25 absolute returns would be calculated as follows:

Absolute Return = (25-20) / 20 x 100 = 25%

Therefore, your investment has grown by 25% over the one-year period.

Difference between absolute return and relative return in mutual funds

Absolute returns and relative returns are measures that help evaluate the performance of mutual funds. As discussed before, the former measures the actual returns that a mutual fund generates. On the other hand, relative returns measure the fund’s performance against a benchmark or index.

While absolute return offers an idea of how the fund has performed in absolute terms, relative returns help investors understand how the fund performs in comparison with its peers. So the relative returns are calculated differently, as follows.

Relative Returns = (Mutual Fund Returns – Benchmark Returns) / Benchmark Returns x 100

For example, if a mutual fund generates returns of 15% in a year, and the benchmark returns are 10%, the relative return would be calculated as follows:

Relative Returns = (15 – 10) / 10 x 100 = 50%

Therefore, the mutual fund has outperformed the benchmark by 50%.

Absolute vs. annualized return in mutual fund

While absolute return is a useful metric to understand fund performance, it doesn’t give you the whole long-term picture. This is where annualized returns come in.

Annualized returns take into account the time value of money. They do this by averaging out your returns over a specific period of time.

For example, if your investment returned 10% in one year and 5% in the next year, your average annual return would be 7.5%.

Annualized return is often used to compare the performance of different investments in the same time period. It’s a more accurate representation of how your investment is performing over time than absolute returns.

How to calculate annualized returns

Calculating annualized returns is slightly more complicated than calculating the absolute return. Here’s the formula you can use:

Annualized return = {[(ending value / beginning value) ^ (1 / years held)] – 1} x 100

For example, if you invest ₹10,000 in a mutual fund, and it grows to ₹12,000 over the course of two years, your annualized return would be:

Annualized return = {[(12,000 / 10,000) ^ (1 / 2)] – 1} x 100 = 9.54%

In this case, the annualized return is lower than the absolute return because the investment grew at a slower rate in the second year.

Conclusion

Absolute return is a measure of the actual returns that a mutual fund generates, irrespective of its benchmark. By contrast, relative return measures the fund’s performance against a benchmark or index. Meanwhile, because annualized returns take into account the time value of money, they offer a more accurate understanding of how the investment performs over time.

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