The average annual return (AAR) is a pivotal metric that investors use to assess the historical performance of mutual funds over specific timeframes, typically three, five, and ten years. This comprehensive guide explores the intricacies of AAR, its components, and its significance in making informed investment decisions.
Understanding the average annual return (AAR)
The average annual return (AAR) is a vital measure that investors utilize to evaluate the historical performance of mutual funds. It provides valuable insights into a fund’s average returns over predefined periods, typically spanning three, five, and ten years. AAR takes into account a fund’s operating expenses but excludes sales charges and brokerage commissions, offering a net return perspective.
Investors consider AAR a key factor when making informed investment decisions, as it helps gauge a fund’s long-term performance. However, to form a comprehensive view of a fund’s consistency, investors should also delve into its annual returns.
For instance, imagine a mutual fund with a five-year AAR of 10%. On the surface, this may appear attractive. However, a closer examination of the yearly returns that contributed to this average (e.g., +40%, +30%, -10%, +5%, and -15%) is essential to assess the fund’s management and investment strategy over the past three years.
Components of an average annual return (AAR)
The average annual return (AAR) of an equity mutual fund is shaped by three key components:
Share price appreciation
Share price appreciation stems from unrealized gains or losses in the underlying stocks held within a portfolio. As the share price of individual stocks fluctuates throughout the year, it significantly influences the AAR of the fund.
For instance, consider the American Funds AMCAP Fund, which boasts Netflix as a top holding, constituting 3.7% of its net assets as of Feb. 29, 2020. The fund’s combined assets, including Netflix and other equities, contributed to its impressive 10-year AAR of 11.58% through that date.
Capital gains distributions
Capital gains distributions in a mutual fund occur when the fund generates income or realizes profits from selling stocks within a growth portfolio. Shareholders have the option to receive these distributions in cash or reinvest them in the fund.
It’s noteworthy that a fund can exhibit a negative AAR and still distribute taxable capital gains. For instance, the Wells Fargo Discovery Fund paid a capital gain of $2.59 on Dec. 11, 2015, despite having a negative AAR of -1.48%.
Quarterly dividends paid from a mutual fund are derived from company earnings and contribute to the fund’s AAR while reducing the portfolio’s net asset value (NAV). Similar to capital gains, investors can choose to reinvest dividends or receive them in cash.
Large-cap stock funds with positive earnings typically pay dividends to individual and institutional shareholders. These quarterly distributions form the dividend yield component of a mutual fund’s AAR. For example, the T. Rowe Price Dividend Growth Fund features a trailing 12-month yield of 1.36%, contributing to its three-year AAR of 15.65% through Feb. 29, 2020.
Calculating an average annual return is relatively straightforward compared to the average annual rate of return, which employs a geometric average instead of a simple mean. The formula for the average annual return is [(1+r1) x (1+r2) x (1+r3) x … x (1+ri)] (1/n) – 1, where r represents the annual rate of return, and n is the number of years in the period.
It’s important to note that the average annual return may be considered less comprehensive in providing a complete picture of a fund’s performance because returns compound rather than combine. Investors should closely scrutinize mutual funds and ensure they are evaluating the same types of returns for each fund.
Pros and cons of using average annual return (AAR)
Here is a list of the benefits and drawbacks of using the average annual return (AAR) in your investment analysis:
- Provides a historical overview of a mutual fund’s performance.
- Enables investors to assess long-term consistency.
- Accounts for operating expenses, offering a net return perspective.
- Helps investors make informed investment decisions based on a fund’s historical performance.
- Does not include sales charges and brokerage commissions.
- Annual variations may mask underlying fund volatility.
- Investors should consider other performance indicators for a comprehensive analysis.
Frequently asked questions
What factors contribute to a mutual fund’s average annual return (AAR)?
A mutual fund’s AAR is influenced by three main factors: share price appreciation, capital gains distributions, and dividends received from its holdings.
Is AAR the only metric investors should consider when evaluating a mutual fund?
No, while AAR provides valuable insights into long-term performance, investors should also assess other factors such as risk, expense ratios, and the fund’s investment objectives to make well-rounded investment decisions.
Why does AAR not account for sales charges and brokerage commissions?
AAR focuses on a fund’s net returns by factoring in operating expenses while excluding upfront sales charges and brokerage commissions, which can vary among investors.
How can I interpret variations in annual returns when evaluating a mutual fund?
While AAR offers an average perspective, analyzing annual returns can reveal the fund’s consistency. Significant variations in yearly returns may indicate periods of higher volatility or specific challenges faced by the fund.
Should I solely rely on AAR when choosing a mutual fund?
No, it’s advisable to use AAR in conjunction with other performance indicators and conduct thorough research on the fund’s historical data, investment strategy, and risk factors for a comprehensive assessment.
- The average annual return (AAR) is a crucial metric for evaluating mutual fund performance over specific timeframes.
- It factors in operating expenses while excluding sales charges and brokerage commissions, providing a net return perspective.
- Investors use AAR to assess a fund’s long-term performance and make informed investment decisions.
- AAR comprises three main components: share price appreciation, capital gains distributions, and dividends.
- Annual variations in returns should be considered alongside AAR for a comprehensive fund analysis.
- While useful, AAR should not be the sole metric considered; investors should explore other performance indicators and conduct thorough research.