What is the average annual return (AAR)?

Average annual return (AAR) is a percentage used when reporting historical returns, such as three, five and ten-year average returns of a mutual fund. The average annual return is shown net of a fund’s operating expense ratio. It also does not include sales charges, if applicable, or portfolio transaction brokerage fees.

In its simplest terms, average annual return (AAR) measures the money earned or lost by a mutual fund over a given period. Investors considering an investment in a mutual fund often look at the AAR and compare it to other similar mutual funds as part of their mutual fund investment strategy.

Understanding the average annual return (AAR)

When selecting a mutual fund, the average annual return is a useful guide for measuring a fund’s long-term performance. However, investors should also look at a fund’s annual performance to fully appreciate the consistency of its annual total returns.

For example, a five-year average annual return of 10% seems attractive. However, if the annual returns (those that produced the average annual return) were +40%, +30%, -10%, +5% and -15% (50 / 5 = 10%), the performance over the past three years warrants an examination of the fund’s management and investment strategy.

Components of an Average Annual Return (AAR)

There are three components that contribute to the average annual return (AAR) of an equity mutual fund: share price appreciation, capital gains and dividends.

Share price appreciation

Share price appreciation results from unrealised gains or losses in the underlying shares held in a portfolio. When the share price of a stock fluctuates over the course of a year, it contributes proportionately to the AAR of the fund that maintains a stake in the issue.

For example, the largest holding of the American Funds AMCAP fund is Netflix (NFLX), which represents 3.7% of the portfolio’s net assets as of 29 February 2020. Netflix is one of 199 stocks in the AMCAP fund. Fund managers may add or subtract assets from the fund or change the proportions of each holding as necessary to meet the fund’s performance objectives. The fund’s combined assets contributed 11.58% to the portfolio’s 10-year AAR through 29 February 2020.

Capital Gains Distributions

Capital gain distributions paid by a mutual fund result from the generation of income or the sale of shares from which a manager makes a profit in a growth portfolio. Shareholders may choose to receive the distributions in cash or reinvest them in the fund. Capital gains are the realised part of AAR. The distribution, which reduces the share price by the dollar amount paid, represents a taxable gain for shareholders.

A fund can have a negative AAR and still make taxable distributions. The Wells Fargo Discovery Fund paid a capital gain of $2.59 on 11 December 2015, despite the fund having a negative AAR of 1.48%.

Dividends

Quarterly dividends paid from corporate earnings contribute to a mutual fund’s AAR and also reduce the net asset value (NAV) of a portfolio. Like capital gains, dividend income received by the portfolio can be reinvested or taken in cash.

Large capitalisation equity funds with positive earnings typically pay dividends to individual and institutional shareholders. These quarterly distributions include the dividend yield component of a mutual fund’s AAR. The T. Rowe Price Dividend Growth Fund has a trailing 12-month yield of 1.36%, a factor that contributes to the fund’s three-year AAR of 15.65% through February 29, 2020.

Special Considerations

The calculation of the average annual return is much simpler than the average annual rate of return, which uses a geometric mean instead of a regular mean. The formula is: [(1+r1) x (1+r2) x (1+r3) x … x (1+ri)] (1/n) - 1, where r is the annual rate of return and n is the number of years in the period.

The average annual return is sometimes considered less useful in giving a picture of a fund’s performance because returns compound rather than combine. Investors should be careful when looking at mutual funds to compare the same types of returns for each fund.

Key considerations

Average annual return (AAR) is a percentage that represents the historical average return of a mutual fund, usually shown over three, five and 10 years. Before making an investment in a mutual fund, investors often look at the average annual return of a mutual fund as a way to measure the long-term performance of the fund. The three components that contribute to a mutual fund’s average annual return are share price appreciation, capital gains and dividends.