Many individuals opt for mutual funds investment as a common long-term wealth accumulation strategy. The primary objective of investment in mutual funds is to earn significant returns and build a wealthy investment portfolio. However, a thorough grasp of how mutual fund returns are calculated is necessary to evaluate these investments’ efficiency and profitability.
Mutual Fund returns give you important information about how your investment has grown or declined over time. These returns can be computed in various ways, such as CAGR, XIRR, absolute returns, etc.
In this article, we will walk you through the intricacies of calculating mutual fund returns, especially the Compounded Annualised Growth Rate (CAGR), the most commonly used method to calculate mutual fund returns.
[Read: The SMART Way to Calculate the Return You Need And Invest Wisely for Your Goals]
Whether you are a novice investor seeking to grasp the basics or an experienced investor looking for advanced insights, this page provides a comprehensive understanding of mutual fund returns via the CAGR method.
What is CAGR in mutual funds?
CAGR, which stands for Compounded Annual Growth Rate, gives you the amount by which your investment has grown over a particular time period. To calculate lumpsum investment with an investment period of over one year, you can use Compounded Annual Growth Rate (CAGR).
Whereas, you can use absolute returns and simple annualised returns when the investment period is less than one year.
The formula for computing mutual fund returns through CAGR is:
CAGR = {[(Current NAV / Initial NAV) ^ (1 / Number of years)] – 1} × 100
Here, CAGR = Compounded Annual Growth Rate
Current NAV = Value on the day of redemption
Initial Value = Value at the time of investment
N = Number of years
To calculate the compounded annual growth rate (CAGR) for a lump sum investment, let us understand with an example:
If an investor invests Rs 1 lakh in a mutual fund scheme in the year 2018 with an initial NAV of Rs 20, and after five years in 2023, the NAV has increased to Rs 70.
CAGR = {[(Rs 70 / Rs 20) ^ (1 / 5)] – 1} × 100
CAGR ≈ 14.87%
Alternatively, if you prefer using MS excel as a tool to compute CAGR for mutual funds, you can use the RRI function (an automated CAGR formula):
=RRI (Nper, PV, IV)
Here; Nper = Time in periods (calculated in months)
PV = Present Value (ending value)
IV = Initial Value (beginning value)
This will give you the CAGR, which you can format as a percentage to obtain the result.
Calculating CAGR helps you determine the average annual growth rate of your investment, providing a standardized measure to compare investment performance over time. Moreover, it also takes into account the interest that has grown on your principal amount as well as the interest earned on the interest itself.
Although your investment may generate different returns at different market phases, CAGR provides you with the average annual growth rate, a smooth representation of the fund’s performance over multiple years.
How CAGR in mutual funds work?
The mathematical formula for CAGR indicates what an investment yields on an annually compounded basis. CAGR is an important way to compute returns on your investments since it is able to use the time value of money.
When compared with absolute returns, it provides you with a more accurate view of how profitable a mutual fund scheme can be for investment. Further, CAGR allows you to determine how volatile your returns can be over a certain time period.
When do you use CAGR method?
CAGR is commonly used when evaluating mutual funds with regular cash flows. It assumes a constant rate of growth over a specific period, making it ideal for comparing funds that have a consistent investment pattern. CAGR provides a simplified measure of the average annual return over a specified time period, making it useful for long-term investment analysis.
However, when you continue to invest for a longer duration by making multiple instalments over irregular intervals, then CAGR becomes irrelevant. So, in cases like SIPs (Systematic Investment Plan), the returns are calculated using another tool, which is XIRR or Extended Internal Rate of Return.
CAGR vs. XIRR: Which Metric is Better for Comparing Mutual Fund Returns
Both CAGR and XIRR are useful tools for analysing the performance of mutual funds. However, XIRR is typically regarded as the more suitable method for calculating returns in the case of SIPs. This is due to the possibility of erratic cash flows since SIPs require investing a specific sum of money at predetermined times.
[Read: What is XIRR in Mutual Funds? And How to Calculate it?]
XIRR represents the actual returns of an SIP in mutual funds more accurately by taking into account the precise date and quantity of each cash flow. Contrarily, CAGR assumes that the rate of return would be constant during the investing term, which may not truly reflect the returns of a SIP in mutual funds.
In conclusion, although XIRR and CAGR are crucial tools for estimating mutual fund returns, their functions differ. While CAGR is appropriate for mutual fund investments with regular cash flows, XIRR is good for those with irregular cash flows.
By understanding the strengths and limitations of each method, investors can make better-informed decisions and accurately calculate returns on their mutual funds.
[Read: Are Your Equity Mutual Funds Generating Alpha Returns?]
To conclude…
Whether you are investing in mutual funds through a lump sum, SIP or a combination of the two routes, every investor is aiming to invest in mutual funds that generate expected returns. However, when determining mutual fund returns, you must consider the economic conditions and the current market performance.
Since there are various methods for computing past returns of mutual funds, it’s critical to select one that matches the mutual fund scheme’s investment style and cash flow behaviour.
This article first appeared on PersonalFN here
