When it comes to investments, one would like to understand how their investments grew, and at what pace, over different time periods. There are many metrics that can be used to calculate the rate of return on investments, but the most common one amongst them is CAGR.
What is CAGR in Mutual Funds?
The full form of CAGR in Mutual Funds terminology is Compounded Annual Growth Rate. It is the annualised growth rate of mutual fund investments over a specific period of time. It measures the growth of mutual fund investments during a given time interval, and while calculating such returns, CAGR also considers the compounding effect of returns on investments. Thus, it considers the time value of money, the overall investment period, and the returns reinvested into the investment portfolio. In other words, it is a measure of how much your investments have grown during a given interval of time. Many investors also calculate the annualised return to compare the investment performance of different funds. However, it does not consider the time value of money, and thus it will generally calculate higher returns, which may also lead to higher expectations amongst potential investors.
Measuring investment performance is always beneficial for investors, as it gives them confidence and conviction to stay invested. Further, in case of underperformance, the investor can take remedial action. One can use several metrics to calculate the rate of return on investments, including absolute returns, annualised returns, CAGR, IRR, etc. CAGR is the most commonly used method to measure investment performance. One may use the concept of CAGR to calculate mutual fund returns and investment performance more effectively.
Calculation of CAGR
1. Take the Net Asset Value (NAV) of the fund at the end of the investment period.
2. Fetch the NAV of the fund at the beginning of the investment period.
3. Calculate the CAGR as per the formula:
CAGR= (NAV at the end/ NAV at the beginning) ^ (1/ No. of years) - 1
For example, the current fund NAV is Rs. 160, which was Rs. 100 4 years ago. As per CAGR calculation, one can calculate CAGR to be 12.47%. As against the CAGR calculation, the absolute returns from mutual fund investments are 60%, and annualised returns are 15.00%. In contrast, the CAGR returns of 12.47% are more reflective of the economic effect of the investments since the returns are also measured on the returns reinvested in the investment portfolio.
Limitations of CAGR
While CAGR is useful for comparing the investment performance of different mutual fund schemes, it also has certain limitations, which are as below:
1. CAGR does not reflect the volatility of the returns: Since CAGR calculates a smoothed rate of growth over a period, it ignores volatility and implies that the growth during that time was steady. Hence, CAGR may leave a wrong impression on investors of having steady returns across the investment period.
2. Another limitation when assessing investments with CAGR is that investors cannot assume the same rate of return will occur in the future. Like every other statistical ratio for calculating investment performance, past returns calculated through the CAGR method are not guaranteed for the future.
3. CAGR is not effective for calculating returns from investments with a holding period of less than one year.
4. CAGR is not practical for calculating returns from investments with regular cash flows. The CAGR method may be more apt to calculate returns from lump sum investments; there may be other preferred methods for SIP investments.
While CAGR measures investment performance, investors must note that they should not search for an answer to “what is a good CAGR for the mutual fund”. The CAGR performance of a mutual fund scheme must be seen relative to the performance of peer schemes and benchmark returns. One can use the CAGR calculations and review the investment performance of different mutual fund schemes to make an informed decision in a better manner.
Difference between CAGR and Absolute Return
Absolute return refers to the profits generated by the mutual fund during a period and may be calculated by merely dividing the fund appreciation with the actual investment cost. For example, if the fund has appreciated by 50% over the last four years, the absolute returns will be 50%, while the CAGR of the investments is calculated as 10.67%.
As such, CAGR is preferred over absolute returns when it comes to calculating mutual fund returns. This is because absolute returns fail to appreciate the investment period as well as the returns reinvested into the investment portfolio and calculate the returns only over the actual investment amount.
The absolute returns may be highly misleading for the investors, as the investment period gets longer.
Difference between CAGR and Annualised Return
Annualised return refers to the simple annual returns generated by a mutual fund scheme during the investment period. It may be dividing the absolute returns with the investment period. For example, if the fund has appreciated by 50% over the last four years, the annualised returns will be 12.5%. However, such returns fail to appreciate the returns generated on the existing returns that are reinvested.
As such, it shows higher returns to the investors, which may be misleading. On the other hand, the CAGR of such investments is 10.67%, which is reflective of the actual investments, including the reinvested returns. Thus, CAGR is preferred over annualised returns as well.
Difference between IRR and CAGR
While CAGR is preferred to calculate returns between two time periods, IRR (Internal Rate of Return) is advisable when the investor has made multiple investments across different periods.
This is because CAGR considers only one investment amount, while IRR carries the ability to calculate the returns through various investment amounts made at different periods. Thus, CAGR may be suitable for calculating returns for lump sum investments, while IRR may be suitable for calculating SIP returns.
CAGR is a well-accepted measure of mutual fund performance, widely used by mutual fund houses as well for investment periods of more than one year. As such, one may make use of the CAGR formula and review the fund performance in a better manner.
Disclaimer:
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
The calculation of CAGR provided in this article is for illustration purpose only and not an indication of the performance of any schemes. Actual returns may vary.