Average Annual Return - Explained
What is an Average Annual Return?
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Table of ContentsWhat is an Average Annual Return?How Does Average Annual Return Work?Components of Mutual Fund AARDifference From Average Annual Rate of ReturnAcademics Research on Average Annual Return (AAR)
What is an Average Annual Return?
Average annual return (AAR) refers to a percentage utilized when reporting the historical return, like the three-, five-, and ten-year average returns of a mutual fund. The average yearly return is stated net of a fund's operating expense ratio, which doesn't include sales charges, if applicable, or even portfolio transaction brokerage commissions.
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How Does Average Annual Return Work?
When choosing a mutual fund, the AAR is a useful guide for calculating the long-term performance of a fund. However, investors should also check a fund's annual performance to fully appreciate the consistency of its yearly total returns. For instance, a five-year average yearly return of 10% seems attractive; however, supposing the annual returns (those who produced the average annual return) were +40%, +30%, -10%, +5%, and -15% (50/5= 10%), performance over the last 3 years warrants analysis of the fund's investment strategy and management.
Components of Mutual Fund AAR
Three components exist which contribute to the equity mutual fund's AAR. Share price appreciation arises from unrealized losses or gains in the underlying stocks held in a portfolio. As a stock's share price fluctuates over a year, it proportionately detracts from or contributes to the average annual return of the fund which maintains a holding in the issue. The American Funds AMCAP Fund's 2.74% holding of Oracle Corporation, one stock it's owned since 2003, has added to the portfolio's ten-year AAR of 8.15% through the 23rd of June, 2016, as the stock of the company grew from $10.88 on April 1, 2003, to about $40.83 on June 23, 2016. Capital gains distributions paid from a mutual fund arise from income generation or selling stocks from which a manager gains profit in a growth portfolio. Shareholders can choose to collect the distributions in cash or even reinvest then in the fund. Capital gains are the realized aspect of AAR. The distribution, which lessens share price by the amount of dollar paid out, stands for a taxable gain for shareholders. It is possible for a fund to have a negative AAR and also make taxable distributions. A $2.59 capital gain was paid by the Wells Fargo Discovery Fund on Dec. 11, 2015, irrespective of the fund having an average annual return of negative 1.48%. Quarterly dividends which are paid from company earnings add to the AAR of a mutual fund and also lessen the value of the net asset value of a portfolio. Like capital gains, dividend income gotten from the portfolio can either be taken in cash or reinvested. Large-cap stock funds having positive earnings usually pay dividends to institutional and individual shareholders. These quarterly distributions include the dividend yield component of the AAR of a mutual fund. The T. Rowe Price Dividend Fund a 1.23% trailing 12-month yield, a contributing factor to the fund's 1-year AAR of 5.55% through the 23rd of June, 2016.
Difference From Average Annual Rate of Return
It is easier to calculate an average annual return than it is to calculate the average annual rate of return, which utilizes and geometric average as against a regular mean. [(1+r1) x (1+r2) x (1+r3) x ... x (1+ri)] (1/n) - 1, is the formula, where "r" represents the annual rate of return and "n" represents the number of years in the period. The average annual return is occasionally termed less useful for picturing a fund's performance because returns compound as against combine. It's mandatory that investors pay attention when checking for funds to compare the same return types for each fund.