Average Annual Return (AAR): Simple Definition & How to Calculate

What Is Average Annual Return (AAR)?

Average annual return (AAR) is a key measure used to evaluate how a mutual fund has performed over time. It looks at factors like share price increases, capital gains, and dividends to show the fund’s historical performance over periods such as three, five, or 10 years. Investors use AAR to compare funds and make their investment decisions. There are limitations, though, as it doesn’t account for compounding or how much the returns may fluctuate.

Analyzing the Impact of Average Annual Return (AAR) on Investments

When choosing a mutual fund, the AAR helps measure the fund's long-term performance. Investors should check the yearly performance to understand the consistency of a fund's total returns.

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

Core Components of 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.

Impact of Share Price Appreciation on AAR

Share price appreciation results from unrealized gains or losses in the underlying stocks held in a portfolio. As the share price of a stock fluctuates over a year, it proportionately contributes to or detracts from the AAR of the fund that maintains a holding in the issue.

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

Role of Capital Gains in AAR

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

A fund may have a negative AAR yet still provide distributions. The Wells Fargo Discovery Fund paid a capital gain of $2.59 on Dec. 11, 2015, despite the fund having an AAR of negative 1.48%.

Contribution of Dividends to AAR

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

Large-cap stock funds with positive earnings usually pay dividends to shareholders. These quarterly distributions comprise 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 contributing factor to the fund's three-year AAR of 15.65% through Feb. 29, 2020.

Crucial Factors When Calculating Average Annual Return (AAR)

Calculating AAR is easier than calculating the average annual rate of return, which uses a geometric mean. The formula is: [(1+r₁) x (1+r₂) x (1+r₃) x ... x (1+r_i)] ^(1/n) - 1, where r is the annual rate of return and n is the number of years in the period.

AAR can be less useful for showing fund performance as returns compound, not just add up. Compare the same return types when evaluating mutual funds.

The Bottom Line

AAR is an important metric that investors can use to check how a mutual fund has performed over time. It includes share price, capital gain, and dividend changes to give a summary of overall performance. AAR has limits because it doesn’t account for compounding or yearly fluctuations, so it might not show the full picture. Investors should also look at other metrics, like yearly returns or alternative measures, to understand fund volatility and management quality. AAR is best used as one part of a bigger evaluation when choosing mutual funds.