Average Annual Return (AAR): Definition, Calculation, Examples, and Best Mutual Fund Selection

Explore what Average Annual Return (AAR) is, how to calculate it, and how to use it for selecting the best mutual fund investments.

The Average Annual Return (AAR) measures the money made or lost by a mutual fund over a specified period, expressed as a percentage. AAR is crucial for investors to gauge the performance of their investments.

Calculating the Average Annual Return (AAR)

To calculate AAR, follow this standardized formula:

$$\text{AAR} = \left( \frac{(1 + r_1) \times (1 + r_2) \times \cdots \times (1 + r_n)^{\frac{1}{n}} - 1}{n} \right) \times 100\%$$

Where:

• \( r_i \) = return in each year
• \( n \) = total number of years

Steps for Calculation

• Determine Annual Returns: Collect the return rates for each year of investment.
• Product of Returns: Multiply these annual rates expressed as decimals (e.g., 10% => 0.10) incremented by 1.
• Nth Root Calculation: Take the nth root of the resulting product, where ’n’ is the number of years.
• Result Adjustment: Subtract 1 from the result.
• Convert to Percentage: Multiply by 100 to express the final AAR as a percentage.

Examples of AAR Calculation

Simple Example

An investor wants to determine the AAR for a mutual fund with annual returns of 8%, 12%, and -3% over 3 years.

• Annual Returns: 1.08, 1.12, 0.97
• Product of Returns: \( 1.08 \times 1.12 \times 0.97 = 1.171 \)
• Nth Root Calculation: \( 1.171^{\frac{1}{3}} = 1.054 \)
• Result Adjustment: \( 1.054 - 1 = 0.054 \)
• Convert to Percentage: \( 0.054 \times 100 = 5.4% \)

The AAR for this investment is therefore 5.4%.

Choosing the Best Mutual Fund Investment

In selecting the best mutual fund investments, consider the following criteria along with AAR:

Risk and Returns

Higher AARs typically come with increased risk. Balance the annual return with the fund’s volatility and risk profile.

Expense Ratios

Lower expense ratios mean more of the return is passed on to the investor. Compare these ratios among mutual funds.

Diversification

Assess the fund’s investment strategy for effective diversification across industries and geographies.

Historical Performance

While past performance is not indicative of future results, consistent historical returns can provide insight into a fund’s stability.

Fund Manager’s Credibility

Research the track record and experience of the fund manager. Their expertise can significantly impact performance.

Related Terms

• Compound Annual Growth Rate (CAGR): CAGR is similar to AAR but emphasizes the compound growth rate of an investment annually.
• Net Asset Value (NAV): NAV represents the per-share value of a mutual fund, integral for evaluating fund worth.
• Beta: Beta measures a fund’s volatility relative to the market, informing investment risk.

FAQs

Is AAR the same as CAGR?

No, AAR calculates an average, while CAGR considers the compounding effect of returns.

How important is AAR in mutual fund selection?

AAR is a key metric but should be assessed alongside risk, expense ratio, and other factors.

Can AAR be negative?

Yes, a negative AAR indicates that the fund has experienced a net loss over the measured period.

References

1. “Investment Analysis and Portfolio Management” by Frank K. Reilly & Keith C. Brown
2. “The Intelligent Investor” by Benjamin Graham

Summary

The Average Annual Return (AAR) is fundamental in evaluating mutual fund performance, integrating into broader considerations like risk and expense ratios. By understanding and accurately calculating AAR, investors can make informed decisions to optimize their investment portfolios.