November 6, 2011

## Summary

Financial success is typically discussed in terms of return, rate of return, and performance.  The compound annual growth rate (CAGR) is a good measure of an investment’s rate of return.  An investment “outperforms” or “underperforms” a market index according to the difference in CAGRs.

## Return

Investors hope to earn a profit called the return.  The two main types of return are cash distributions and capital gains.  Cash distributions include dividends and interest.  A realized capital gain(loss) is the actual return earned from an increase(decrease) in market value between times of purchase and sale.   An unrealized capital gain(loss) is an imaginary return calculated by the increase(decrease) in market value of an unsold investment.  The total return from an investment is the sum of its cash distributions, realized capital gains, and unrealized capital gains 1Significance: It’s important to know whether a market index measures the total return of the market (e.g., S&P 500 Total Return) or the price return of the market (e.g., S&P 500) 2.

## Rate of return

The rate of return is a change in value with respect to time.  Annualized return is a return, or rate of return, from any time period that’s converted to an annual value 3.  Annualization may or may not account for the effects of compounding.  Example #1:  To annualize any monthly or quarterly rate of return without concern for compounding the returns, multiply the unannualized rate of return by 12 months/year or 4 quarters/year as appropriate for the time period.  This method provides only an estimation of the annual rate of return.  Example #2:  The annual rate of return is simply the ratio of yearly return to initial investment expressed as a percentage.  Example#3:  To annualize a compounded return over several preceding years, compute the compound annual growth rate (CAGR4,5.  VIDEO: CAGR

Figure 4 illustrates the use of CAGR to describe the 5-year growth of a market Index called the S&P United States 500 Total Return 1988 (SPTR).

Each datum (blue dot) is a spot value of the Index at the end of the last trading day of the year.  Lines connecting the data form peaks and valleys on the graph to illustrate the dynamic nature of the stock market.  The dashed line represents a smoothed continuum of Index values as if the Index grew at the appropriate CAGR of 2.29%.  Significance: Net growth of value occurs when CAGR is a positive value and net loss occurs when CAGR is a negative value.

## Performance

Investment performance is best determined by comparing the investment return to an impartial standard value.  The standard value is either a numerical goal or the value of a market index.  The comparison is only meaningful when the investment return and standard return are based on the same,

• class of financial assets
• type of return (e.g., total return, price appreciation) 2
• units of return (e.g., percentage)
• time interval (e.g., annual)

Outperform” means that the investment return exceeds the standard return and “underperform” means that the investment return lags the standard return.  Investment performance is often measured by comparing the CAGR of an investment portfolio to the CAGR of an appropriate market index1.  For example, Fig. 5 shows that a Fund’s portfolio underperformed its market index.

Figure 5 compares the SPDR S&P 500 ETF Trust’s 5-year portfolio return (NAV) to the benchmark return of the S&P United States 500 Total Return 1988 (SPTR).  The 5-year returns were measured as CAGRs and performance was measured by the difference in CAGRs.

## Concluding trivia

• CAGR is a statistic that’s calculated as the geometric mean for a series of annual percentage returns.
• The graph of CAGR is an exponential curve defined by the formula Y = X(1+CAGR)N . Y is the final value, X is the initial value, CAGR is a decimal number, and N is the number of years.
• The generic rate of return (R ) applies to unannualized growth rates and financial applications such as the calculation of future values.