Mutual Funds

| Updated on March 10, 2018

Can you explain how compounding works in mutual funds? Even if we invest in a mutual fund via SIP for 10 years, wouldn’t the final figure be low if the net asset value (NAV) is going down at the time of redeeming?

Ananth Rajagopal

Compounding in mutual funds is theoretically similar to how it is in other financial instruments. An investment earns return for one period, the aggregate amount (investment plus first period’s return) earns return in the next period, this aggregate amount (original investment plus return of two periods) earns return in the next period, and so on.

This continues until maturity or redemption of the investment at which point the original amount invested plus the cumulative returns over the periods accrues to the investor.

The formula for compounding is A = P(1+R)^N where A is the cumulative amount on maturity or redemption, P is the original investment, R is the rate of return and N is the number of periods. The compounded amount can be calculated using the function FV (future value) in Microsoft Excel.

Say, you invest ₹60,000 in a mutual fund at the beginning of the first year, hold the investment for 10 years and the annualised return is 12 per cent; the compounded sum after 10 years will be ₹1.86 lakh.

Now, say, you invest ₹60,000 at the beginning of each year in a mutual fund for 10 years, and the fund gives annualised return of 12 per cent.

The ₹60,000 invested at the start of the first year compounds for 10 years, the ₹60,000 invested at the start of the second year compounds for nine years, and so on. At the end of 10 years, the compounded amount will be ₹11.79 lakh against total investment of ₹6 lakh.

The logic is similar in monthly SIP investments, where each investment compounds for the remaining periods until maturity. Instead of ₹60,000 annually for 10 years, say, you invest ₹5,000 each month for 120 months, and the annualised return is 12 per cent.

Each SIP instalment will compound on a monthly basis at 1 per cent (12 per cent divided by 12 months) and the cumulative value on maturity after 120 months will ₹11.61 lakh against total investment of ₹6 lakh.

Compounding happens in cumulative financial instruments, in which returns are reinvested until maturity or redemption instead of being paid out. In mutual funds too, the full benefit of compounding takes place when you choose the growth option or the dividend reinvestment option.

Unlike fixed income instruments such as bank deposits though, the annualised returns on mutual funds are not known at the time of investment. Mutual fund investments, being market linked, are subject to volatility in returns.

Returns may be subdued or even negative in one year, while they could zoom up sharply in another year — this is especially true in the case of equity oriented mutual funds whose net asset values (NAV) gyrate with the movement of stocks in their portfolios.

So yes, if the market and by extension mutual fund NAVs crash at the time of intended redemption, an investor could suffer losses.

That said, historical data shows that while well-run equity oriented mutual funds in India have suffered losses in the short run, they have tended to eventually recover, move higher and deliver inflation beating annualised returns in the long run.

For instance, over the past five years which saw many ups and downs, the average annualised return was about 14 per cent in large-cap equity funds and 17 per cent in multi-cap equity funds.

The expectation is that, given the growth prospects of the Indian economy and stock-picking skills of skilled fund managers, well-run equity funds should continue to deliver well in the long run, lead to good wealth compounding for investors.

This is a key reason why equity mutual fund investments are recommended for the long term instead of the short run.