What Is the Average Annual Return (AAR)?
Let me explain the average annual return, or AAR, directly to you—it's a percentage that reports the historical return of something like a mutual fund, often over three, five, or ten years. This figure is net of the fund's operating expense ratio, but it doesn't factor in sales charges if they apply, or any brokerage commissions from portfolio transactions.
In straightforward terms, AAR shows you the money a mutual fund has made or lost over a set period. If you're thinking about investing in a mutual fund, you'll likely check the AAR and stack it up against similar funds as part of your strategy.
Key Takeaways
- The average annual return (AAR) is a percentage that represents a mutual fund's historical average return, usually stated over three, five, and 10 years.
- Before making a mutual fund investment, investors frequently review a mutual fund's average annual return as a way to measure the fund's long-term performance.
- The three components that contribute to the average annual return of a mutual fund are share price appreciation, capital gains, and dividends.
Understanding the Average Annual Return (AAR)
When you're picking a mutual fund, the AAR serves as a solid guide to measure its long-term performance—I'll tell you straight, it's helpful, but you should also dig into the fund's yearly performance to see how consistent those total returns really are.
Take this example: a five-year AAR of 10% might seem strong, but if the yearly returns that built it were +40%, +30%, -10%, +5%, and -15%—averaging out to 10%—then the last three years suggest you need to scrutinize the fund's management and strategy closely.
Components of an Average Annual Return (AAR)
For an equity mutual fund, three main components make up the AAR: share price appreciation, capital gains, and dividends—I'll break them down for you one by one.
Share Price Appreciation
Share price appreciation comes from unrealized gains or losses in the stocks a fund holds. As a stock's price moves up or down over the year, it adds to or subtracts from the fund's AAR proportionally.
Consider the American Funds AMCAP Fund, where Netflix is the top holding at 3.7% of net assets as of February 29, 2020—it's one of 199 equities, and managers adjust holdings to hit performance goals, leading to a 10-year AAR of 11.58% through that date.
Capital Gains Distributions
Capital gains distributions from a mutual fund come from income generated or profits from selling stocks in a growth portfolio. You can take these in cash or reinvest them, and they form the realized part of the AAR—the distribution cuts the share price by the payout amount and creates a taxable gain for you.
Interestingly, a fund might distribute capital gains even with a negative AAR, like the Wells Fargo Discovery Fund that paid $2.59 on December 11, 2015, despite a negative 1.48% AAR.
Dividends
Dividends, paid quarterly from company earnings, add to a mutual fund's AAR and lower the portfolio's net asset value (NAV). You can reinvest them or take cash, just like capital gains.
Funds with large-cap stocks and positive earnings often pay dividends to shareholders, forming the dividend yield part of the AAR—for instance, the T. Rowe Price Dividend Growth Fund has a trailing 12-month yield of 1.36%, helping its three-year AAR reach 15.65% through February 29, 2020.
Special Considerations
Calculating AAR is simpler than the average annual rate of return, which uses a geometric average with the formula [(1+r1) x (1+r2) x (1+r3) x ... x (1+ri)]^(1/n) - 1, where r is the annual return and n is the number of years.
AAR can be less precise for understanding fund performance because returns compound, not just add up—so when comparing mutual funds, make sure you're looking at the same type of returns for consistency.
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