Absolute Return in Mutual Funds: Meaning and Formula

Understanding various metrics can profoundly impact the decision-making process in investments. Among these is absolute return, which remains a crucial factor for portfolio evaluation. In this blog post, we'll demystify the concept of absolute return in the context of mutual funds, guiding investors to a more nuanced understanding of their investment performance.

What is the Absolute Return in Mutual Funds?

The term absolute return refers to the total return that an investment has generated over a particular period. Unlike other return measurements, absolute return is simple—it represents the raw increase or decrease in the value of an investment without comparing it to any market benchmarks or indices. This makes it a straightforward metric for assessing a mutual fund's success.

How Does Absolute Return Work?

One must look at the actual numbers to comprehend absolute return. It focuses exclusively on an investment's gain or loss and does not consider its relative performance against other investments or benchmarks.

Absolute Return Formula and Example

Let's talk about the absolute return formula. In finance, absolute return refers to the total return an investment generates over a specific period. This measure is particularly useful as it shows the actual gain or loss, expressed as a percentage, without comparing it to other benchmarks or indices.

How It's Calculated:

To calculate the absolute return, you use a simple formula:

Absolute Return = {(Final Value - Initial Value) / Initial Value} * 100

Here's what each term means:

Initial Value: This is the amount initially invested or the asset's value when you first acquired it.
Final Value: This is the value of the investment at the end of the period you are considering.

The result from this formula is a percentage that shows how much the investment's value has gone up or down during the period you're looking at.

Example of Absolute Return Calculation

Imagine you invested Rs. 100,000 in a mutual fund. After one year, the value of your investment is Rs. 110,000. Let's apply the absolute return formula:

Initial Value: Rs. 100,000
Final Value: Rs. 110,000

Using the formula:

Absolute Return = {(Rs.11,000 - Rs.10,000) / Rs.10,000} * 100 = 10%

So, the absolute return on your investment is 10%. This means your investment grew by 10% over the year, regardless of how other investments or market indices performed.

Why Absolute Return Matters?

Absolute return is a straightforward way to see how your investments are doing on their own merits. It's especially liked by investors who want a clear picture of their investment's performance without external comparisons. It can be used for any investment, like stocks, bonds, or mutual funds, and over any period, making it quite versatile.

Also, knowing the absolute return can help you make better decisions about whether to keep holding an investment or consider selling it based on its performance over time.

Importance of Absolute Returns

For investors, the significance of absolute return can't be overstated. Here are the top important pointers to know:

Unbiased Analysis: Absolute return is ideal for investors who don't want to get bogged down by market fluctuations and focus solely on their investment's performance.
Measuring Success: It clearly shows how much their investment has grown without comparing it to other investments or benchmarks.
Transparency: Unlike relative returns, absolute return does not obscure the actual return numbers with market indices. This provides a transparent view of a mutual fund's performance.
Risk Management: Absolute return is an essential tool for risk management, as it allows investors to evaluate how much they stand to lose or gain from their investment.
Mitigate Market Volatility: Since absolute return disregards market benchmarks, investors can avoid the impact of market volatility on their investment decisions.
Long-Term Evaluation: Absolute return is useful for long-term evaluations as it focuses on an investment's actual gain or loss rather than short-term fluctuations.
Diversification: It encourages diversification by allowing investors to evaluate individual investments based on their absolute performance rather than relying on market indices.
Realistic Expectations: It helps investors set realistic expectations for their investments, as they can calculate the actual returns they can expect from a particular investment.
Simplicity: Absolute return is a simple measure of an investment's performance, making it easy for investors to understand and evaluate.
Goal-Oriented Investing: Absolute return allows investors to set specific goals for an investment and measure its performance against those goals rather than comparing it to market benchmarks.
Flexibility: Investors can use absolute return to evaluate different types of investments, such as stocks, bonds, real estate, etc., without being limited by a particular market index.
Personalised Investing: With absolute return, investors can personalise their investment strategies based on their risk tolerance and long-term financial goals.
Risk-Adjusted Returns: Absolute return considers the risk level associated with an investment, providing a more accurate measure of its performance compared to simple returns.

When to Use Absolute Return Analysis?

There are times when analysing the absolute return can be very insightful. Here are all the situations to use it:

Comparing Investments: As mentioned before, absolute return is an ideal performance measure when comparing different investments, as it eliminates the influence of market fluctuations.
Evaluating Long-Term Investments: Absolute return is useful for evaluating long-term investments such as retirement funds or college savings plans, where investors have a specific goal and want to know if their investment meets it.
Assessing the Performance of Funds: Absolute return analysis can be used to evaluate the performance of mutual funds, hedge funds, and other professionally managed portfolios.
Measuring Risk-Adjusted Returns: Since absolute return considers the risk level associated with an investment, it can provide a more accurate measure of its performance compared to simple returns. This is especially useful when comparing two investments with similar returns but different levels of risk.
Personalising Investment Strategies: With absolute return, investors can personalise their investment strategies based on their risk tolerance and long-term financial goals rather than being limited by a particular market index or benchmark.

Difference Between Absolute Return and Relative Return in Mutual Funds

While absolute return measures how much an investment has grown or shrunk in total value, relative return compares this growth to a benchmark or a sector average. Presented below are the main distinctions:

Comparison Parameter	Relative Return	Absolute Return
Definition	Measures the total growth or decline of an investment	Compares the performance of an investment to a benchmark
Market Context Consideration	Does not consider the market context	Takes into account market trends and indices
Performance Evaluation	Evaluated independently of other investments or benchmarks	Evaluated in relation to a specific benchmark or index
Objective	To achieve positive returns regardless of market conditions	To outperform a benchmark or market index
Suitability	Suitable for investors focusing on specific return targets, irrespective of market movements	Suitable for investors aiming to compare their investment’s performance against a market standard

Conclusion

For savvy investors, this metric is imperative for a holistic view of their investments' performance. Remember, while absolute return reflects the change in your investment value, it is one of many tools in your analysis toolkit. Taking a comprehensive approach to investment analysis by considering a variety of metrics is often the wisest course.

Frequently Asked Questions

1. How do absolute return funds work?

Absolute return funds aim to make positive returns by employing diverse strategies, regardless of market conditions.

2. What is the formula for return on mutual funds?

The formula for absolute return on mutual funds is [(Ending value - Beginning value) / Beginning value] * 100.

3. What is a good ROI percentage?

A good ROI percentage varies based on investment type and risk tolerance. However, a positive absolute return over time generally signifies a successful investment.

Absolute Return in Mutual Funds: Formula and How it Works