Adjusted average total return: Meaning, Criticisms & Real-World Uses

What Is Adjusted Average Total Return?

Adjusted Average Total Return is a measure of investment performance that seeks to account for factors beyond simple percentage gains or losses, providing a more comprehensive view of an investment's true outcome. Unlike raw total return, which only reflects price appreciation plus income, an adjusted average total return incorporates elements like fees, taxes, or the impact of inflation and risk. This metric is a key component within the broader field of Investment Performance measurement, falling under Portfolio Management and quantitative analysis. By factoring in these additional variables, the adjusted average total return aims to provide a more accurate depiction of an investor's real return or a fund's actual profitability after considering specific influences. This provides a more meaningful basis for comparison between different investment vehicles or strategies.

History and Origin

The concept of adjusting investment returns for various factors evolved as financial markets grew more complex and the need for more nuanced performance evaluation became apparent. Early measures of investment performance primarily focused on nominal returns. However, as understanding of the impact of inflation, taxes, and risk factors deepened within economic theory and Portfolio Theory, the limitations of simple total return became evident. The development of standards for performance reporting, such as the Global Investment Performance Standards (GIPS), spearheaded by the CFA Institute, further emphasized the importance of fair representation and full disclosure in investment reporting⁸. These standards, which gained significant traction globally, underscore the need for consistent methodologies in calculating and presenting investment results, indirectly promoting the consideration of adjustments that make performance figures more comparable and representative of actual investor experience.

Key Takeaways

Adjusted Average Total Return goes beyond simple nominal returns by factoring in specific elements like fees, taxes, inflation, or risk.
It offers a more realistic portrayal of an investment's outcome from an investor's perspective.
This metric is crucial for comparing different investments on a level playing field, especially when varied cost structures or risk profiles are present.
Adjustments help investors understand the real purchasing power of their returns after accounting for factors such as the erosion caused by Inflation.
While providing a more insightful view, the specific adjustments made can vary, necessitating transparency in methodology.

Formula and Calculation

The specific formula for an adjusted average total return can vary significantly depending on what factors are being adjusted. There is no single universal formula, as the "adjustment" component is flexible. However, a common framework involves starting with the basic total return and then subtracting or normalizing for the chosen adjustment factors.

For example, to calculate a tax-adjusted total return:

\text{Adjusted Average Total Return} = \text{Total Return} - (\text{Total Return} \times \text{Tax Rate})

Or, for an inflation-adjusted return (real return):

\text{Real Return} = \frac{(1 + \text{Nominal Return})}{(1 + \text{Inflation Rate})} - 1

Where:

Total Return: The sum of capital appreciation and income (e.g., dividends, interest) over a period, expressed as a percentage.
Tax Rate: The applicable income or capital gains tax rate.
Nominal Return: The stated return before adjusting for inflation.
Inflation Rate: The rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.

In cases where risk is adjusted, more complex formulas like the Sharpe Ratio or Sortino Ratio are used, which normalize return by a measure of risk, such as Standard Deviation.

Interpreting the Adjusted Average Total Return

Interpreting an adjusted average total return involves understanding which factors have been accounted for and what that implies for the investment's actual benefit to the investor. For instance, an inflation-adjusted return reveals the true increase or decrease in purchasing power of an investment. If an investment generated a 5% nominal return but inflation was 3%, the real return is approximately 1.94%, indicating the actual gain in purchasing power.

Similarly, a tax-adjusted return highlights the net benefit an investor receives after accounting for their tax obligations, providing a clearer picture of their after-tax wealth accumulation. When evaluating different investment options, especially those with varying fee structures or tax implications, comparing their adjusted average total returns offers a more equitable assessment. This allows investors to make more informed decisions by moving beyond superficial nominal figures and focusing on what truly impacts their financial well-being. Furthermore, understanding these adjustments can influence decisions related to Asset Allocation and overall Diversification strategies.

Hypothetical Example

Consider an investor, Sarah, who purchased shares in a Mutual Fund for $10,000. Over one year, the fund's value increased to $10,800, and it paid out $200 in dividends.
The total return before any adjustments is:
Capital appreciation: $10,800 - $10,000 = $800
Total income (dividends): $200
Total gain: $800 + $200 = $1,000
Total Return = (\frac{$1,000}{$10,000} = 0.10 \text{ or } 10%)

Now, let's calculate an adjusted average total return. Suppose the fund charges an annual Expense Ratio of 0.5% of assets and Sarah is in a tax bracket where capital gains and qualified dividends are taxed at 15%. Also, assume annual inflation was 3%.

Adjusted for Expense Ratio:
Expense deduction: $10,000 * 0.005 = $50
Net gain after expenses: $1,000 - $50 = $950
Expense-Adjusted Return = (\frac{$950}{$10,000} = 0.095 \text{ or } 9.5%)
Adjusted for Taxes (on the 10% total return):
Taxable gain: $1,000
Tax liability: $1,000 * 0.15 = $150
Net gain after taxes: $1,000 - $150 = $850
Tax-Adjusted Return = (\frac{$850}{$10,000} = 0.085 \text{ or } 8.5%)
Adjusted for Inflation (using the original 10% nominal total return):
Real Return = (\frac{(1 + 0.10)}{(1 + 0.03)} - 1 = \frac{1.10}{1.03} - 1 \approx 1.06796 - 1 = 0.06796 \text{ or } 6.8%)

This example illustrates how different adjustments provide varying perspectives on the actual return Sarah realized. The 10% nominal return becomes 9.5% after expenses, 8.5% after taxes, and approximately 6.8% after accounting for inflation, demonstrating the importance of looking beyond just the initial total return.

Practical Applications

Adjusted average total return metrics are widely used across the financial industry by investors, analysts, and regulatory bodies to gain a more accurate understanding of performance. For individual investors, it helps in selecting appropriate investment products, such as mutual funds or exchange-traded funds, by allowing for comparisons that factor in fees or the erosion of purchasing power. Financial advisors use these metrics to demonstrate the real impact of investment strategies on a client's wealth over time.

In institutional investing, portfolio managers utilize adjusted returns to assess the effectiveness of their strategies, particularly when aiming to achieve specific real return targets or when managing against inflation-linked liabilities. Regulators and standard-setting bodies like the CFA Institute, through their Global Investment Performance Standards, promote the use of fair and full disclosure in performance reporting, often encompassing adjusted returns to ensure comparability and prevent misleading statements to prospective clients⁷. Furthermore, an understanding of how returns are adjusted can help investors avoid pitfalls, such as focusing solely on headline returns without considering underlying costs or the impact of market fluctuations and emotional responses, often referred to as "breakevenitis" as highlighted by some fund managers.⁶

Limitations and Criticisms

Despite their benefits, adjusted average total return measures have limitations. The primary criticism often revolves around the subjectivity and variability of the "adjustment" itself. Different methodologies for accounting for risk, inflation, or taxes can lead to different adjusted returns for the same investment, making cross-comparison difficult if the methodologies are not transparently disclosed. For instance, risk adjustment methods like the Sharpe Ratio rely on Standard Deviation as a measure of Volatility, which may not fully capture all types of Market Risk or downside risk.

Another limitation is that while historical adjustments provide valuable context, they do not guarantee future performance. An investment that performed well on an adjusted basis in the past may not continue to do so. Furthermore, the selection of a specific Benchmark Index for comparison, especially in risk-adjusted metrics, can influence the perceived effectiveness of an investment. Investors must exercise due diligence and understand the assumptions and methodologies behind any reported adjusted average total return to make truly informed decisions.

Adjusted Average Total Return vs. Morningstar Rating

While both Adjusted Average Total Return and the Morningstar Rating aim to provide more insightful views of investment performance than simple total return, they serve different purposes and operate on distinct methodologies.

The Morningstar Rating, often referred to as the "star rating," is a quantitative, backward-looking measure that evaluates mutual funds and exchange-traded funds based on their past performance, specifically their risk-adjusted returns, relative to similar funds within their respective Morningstar Categories. Morningstar calculates a Morningstar Risk-Adjusted Return (MRAR) for each fund, which penalizes funds for excessive downside volatility³, ⁴, ⁵. The rating ranges from one to five stars, with five stars indicating the best risk-adjusted performance within its peer group. The overall Morningstar Rating is a weighted average of the fund's three-, five-, and 10-year risk-adjusted ratings, if available¹, ².

In contrast, Adjusted Average Total Return is a broader concept that refers to any total return figure that has been modified to account for specific factors chosen by the analyst or investor, such as inflation, taxes, or fees. It can be a custom calculation tailored to specific needs or a standardized calculation used by a firm. The confusion often arises because the Morningstar Rating is an application of an adjusted return concept (specifically, risk-adjusted). However, "Adjusted Average Total Return" itself is a general term for any return that has undergone such a modification, whereas the Morningstar Rating is a proprietary rating system based on a particular risk-adjusted return methodology.

FAQs

Why is an adjusted average total return important?

An adjusted average total return is important because it provides a more realistic picture of an investment's performance by taking into account factors like fees, taxes, or the eroding effect of Inflation. It helps investors understand their true gains or losses in purchasing power and allows for fairer comparisons between different investment options.

What factors can be used to adjust total return?

Common factors used to adjust total return include fees and expenses (like Expense Ratios in mutual funds), taxes (on income or capital gains), and inflation. Returns can also be adjusted for risk, using metrics that penalize for volatility or downside deviation.

Is an adjusted average total return always better than a simple total return?

An adjusted average total return is not necessarily "better" in absolute terms, but it is generally considered more meaningful for making informed investment decisions. A simple total return provides a headline number, but the adjusted version gives a deeper insight into the net financial impact on the investor, after considering relevant costs or market conditions.

Does an adjusted average total return predict future performance?

No. Like all historical performance measures, an adjusted average total return reflects past results and does not guarantee or indicate future performance. It provides valuable context for how an investment has performed under specific conditions and after certain deductions, but investment outcomes are subject to future market conditions and other variables. The principle of Compounding demonstrates how even small adjustments to returns can have a significant impact over long periods.