What Is the Average Annual Return (AAR)?

The average annual return (AAR) measures the money made or lost by a mutual fund over a specific period. It is stated net of a fund's Operating Expense Ratio (OER), but excludes sales charges and, if applicable, brokerage commissions. Investors usually review a mutual fund's AAR before making an investment to measure the fund's long-term performance.

Formula for the Average Annual Return (AAR)

The formula for the AAR is: 

AAR =  [ (1+ R1) x (1+ R2) x (1+R3) x ... x (1+ Rn)] (1/n)  - 1,

where,

R1 = Return in Period 1

R2 = Return in Period 2

R3 = Return in Period 3

Rn= Return in Period n

n = Number of the years in period

Why Does the Average Annual Return (AAR) Matter?

AAR is a tool used by investors when they are choosing a mutual fund so that the long-term performance of the fund can be calculated. Even so, investors should check a fund's annual performance to understand its annual returns' regularity fully. For example, a 5-year return of 15% sounds appealing. But, if the yearly returns were +50%, 45%,30%,-25% and -25%, the performance over the last two years would indicate negative growth and would prompt a thorough investigation of the mutual fund's investment strategy and management.

Components of an Average Annual Return (AAR)

There are three main components that contribute to the average annual return of a mutual fund: share price appreciation, dividends and capital gains.

Share price appreciation results from unrealized gains or losses in the stocks held in a portfolio. When the share price appreciates or depreciates, it greatly affects the AAR of the mutual fund.

Dividends paid from a company's earnings impact the AAR and reduce the net value of the portfolio. The dividends can be cashed in or reinvested in the fund.

Capital gains are the realized part of the AAR and are paid from a mutual fund that arises from income generation. Stocks can also be sold so a manager can realize a profit from the portfolio. Like dividends, capital gains can be cashed out or reinvested in the fund.