 #### Mutual Funds

| Updated on July 26, 2020  Please explain the difference between CAGR and absolute returns with reference to mutual funds. Which one is better to judge the performance of a fund?

RK Gaur

CAGR is short for Compounded Annual Growth Rate. It is the annualised return earned on an investment — assuming that the returns are re-invested and compounded until the maturity of the investment.

Here’s how compounding works: 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 accrue to the investor.

The CAGR can be calculated by re-arranging the compound interest formula 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 (CAGR) and N is the number of periods.

The CAGR can also be calculated using the function RATE in Microsoft Excel.

Say, you invest ₹50,000 in a mutual fund at the beginning of the first year, hold the investment for three years, and the maturity value after three years is ₹75,000.

The CAGR, using the above formula or the RATE function in Microsoft Excel, works out to 14.5 per cent.

Absolute returns means the total returns earned on an investment over the entire period. In the above example, ₹50,000 becomes ₹75,000 over three years.

So, the investor earns ₹25,000 on his investment of ₹50,000. The absolute return is thus 50 per cent (₹25,000/₹50,000).

The absolute return does not take into account the period for which the investment is held or the compounding effect of the returns.

To judge the performance of a fund over a year or more, it is best to calculate the CAGR, since it tells you how much return you earned each year.

This measure can be compared with the returns earned on other investments.

For example, if ₹50,000 in Investment A became ₹75,000 in three years, and ₹50,000 in Investment B became ₹1 lakh in six years, the CAGR of Investment A is 14.5 per cent, while the CAGR of Investment B is 12.2 per cent. So, Investment A did better than Investment B.

But if you went by absolute returns in the above example, Investment B, with absolute returns of 100 per cent, would appear better than Investment A, with an absolute return of 50 per cent; this can be misleading.

Generally, in practice, CAGR is shown for periods of a year or more, while absolute returns are shown for periods of less than a year — say for one month, three months or six months.

In the CAGR calculation, the actual investment and its value on the calculation date are used to find the return.

Absolute returns for periods less than a year are generally not annualised, since this involves an assumption of the same returns continuing for the full year, and can be misleading.

As required by the regulator, mutual funds, in their monthly factsheets, show CAGR of their schemes for one, three, five years and since inception.

A note of caution though while interpreting the CAGR.

Compounding typically happens in cumulative financial instruments.

In mutual funds, too, the full effect of compounding can be seen when you choose the growth option or the dividend reinvestment option.

But unlike cumulative fixed-income instruments such as bank deposits, 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.

So, actual returns in mutual funds can be subdued or even negative in one year, while they could zoom up sharply in another year.

So, when you see the CAGR of a mutual fund scheme, know that it would not have been a steady, smooth annual return in the past years, nor will it be in the future.

There would have been fluctuation in the scheme’s annual return in the past, and will be there in the future, too.

The CAGR just shows the annualised return, based on the investment value and the maturity value, ignoring the volatility in between.

Also, to find annualised return on regular investments such as mutual fund SIPs (systematic investment plans), IRR (Internal Rate of Return) or XIRR (Extended IRR) are more useful than CAGR.

Published on July 26, 2020