Definition
– Average annual return (AAR) is the simple arithmetic average of a fund’s yearly total returns over a stated period (for example, 3-, 5-, or 10-year AAR). It reports, in percent, the mean yearly gain or loss investors would see if you simply added each year’s return and divided by the number of years.
Key points at a glance
– AAR typically is shown net of a fund’s operating expenses (the expense ratio).
– AAR normally excludes front- or back-end sales charges (loads) and portfolio brokerage commissions.
– AAR is a simple mean and does not reflect compounding. For compound (annualized) performance, use the geometric (time-weighted) return instead.
– Evaluate both the AAR and the individual yearly returns to judge consistency.
Why AAR matters
– Investors use AAR to compare mutual funds’ historical performance over fixed windows.
– A high AAR can be attractive, but it can mask volatility: wildly different yearly returns can produce the same AAR as a steady, moderate-earning fund.
Components that make up a mutual fund’s AAR
– Share price appreciation: changes in the market value of the stocks or other securities the fund holds — unrealized gains or losses that show up in NAV (net asset value).
– Capital gains distributions: realized profits from the manager selling holdings. These are paid to shareholders (cash or reinvested) and reduce NAV; they are typically taxable events for shareholders.
– Dividends: income paid from companies held by the fund (often quarterly). Dividends received by the fund may be distributed to shareholders or reinvested, and they also lower NAV when paid.
Important special considerations
– A fund can distribute taxable capital gains even in years when the fund’s AAR is negative, because distributions reflect realized gains during the period, not the arithmetic average of annual returns.
– Compare like with like: when comparing funds, make sure you’re comparing the same return measure (e.g., AAR vs. geometric/annualized return) and the same time window.
– Reinvestment choice matters: reported returns often assume distributions are reinvested; if you take distributions in cash, your personal results differ.
– Tax consequences and sales loads (if any) can materially change investor experience versus the published AAR.
How AAR differs from the geometric (compound) annualized return
– AAR = (r1 + r2 + … + rn) / n, where r is each year’s return (expressed as a decimal or percent).
– The geometric (annualized) return accounts for compounding: ((1+r1) × (1+r2) × … × (1+rn))^(1/n) − 1.
– Because returns compound, the geometric mean usually gives a lower (more realistic for long-term wealth accumulation) number than the arithmetic AAR when returns vary year-to-year.
Worked numeric example — arithmetic AAR vs. geometric annualized return
Suppose five yearly returns are: +40%, +30%, −10%, +5%, −15%.
1. Convert to decimals: 0.40, 0.30, −0.10, 0.05, −0.15.
2. Arithmetic AAR = (0.40 + 0.30 − 0.10 + 0.05 − 0.15) / 5 = 0.10 → 10.00%.
3. Geometric (annualized) return:
– Multiply 1 + each return: 1.4 × 1.3 × 0.9 × 1.05 × 0.85 = 1.461915 (approx).
– Take the 5th root: 1.461915^(1/5) ≈ 1.0788.
– Subtract 1 → 0.0788 ≈ 7.88%.
Interpretation: the arithmetic AAR is 10%, but because returns compound unevenly, the annualized compound return over those five years is about 7.88%. The compound figure better represents the growth rate an investor actually experienced.
Quick checklist when using AAR
– Confirm the time period (e.g., trailing 3-, 5-, 10-year).
– Verify whether returns are net of expense ratio and whether sales charges or commissions are excluded.
– Check whether distributions are assumed reinvested in the reported returns.
– Inspect yearly returns to assess consistency and volatility (don’t rely on AAR alone).
– Consider using the geometric/annualized return for long-term comparisons and planning.
– Remember tax and distribution effects — AAR does not reflect your personal after-tax return.
Sources
– Investopedia — Average Annual Return (AAR): https://www.investopedia.com/terms/a/aar.asp
– U.S. Securities and Exchange Commission (SEC) — Mutual Funds and Exchange-Traded Funds (ETFs) guide: https://www.sec.gov/reportspubs/investor-publications/investorpubsmutualfundshtm.html
– Financial Industry Regulatory Authority (FINRA) — Mutual Funds: https://www.finra.org/investors/learn-to-invest/types-investments/mutual-funds
– Vanguard Investor Education — Understanding investment returns: https://investor.vanguard.com/investing/how-to-invest/returns
Educational disclaimer
This explainer is for educational purposes only. It does not constitute investment advice or recommendations. Individual tax situations and investment goals vary; consult a qualified professional before making investment decisions.