When you hear that the returns of a mutual fund for the past five years are 11%, what does it mean? Does it imply that if you had invested five years ago, you would have received a total return of 11%? And would you have received the same returns on both a Systematic Investment Plan (SIP) and a one-time investment?
If you find mutual fund returns confusing, you’re not alone. Many people are intimidated by terms like CAGR, Absolute Returns, and XIRR. This blog will demystify these terms and explain the different types of mutual fund returns.
Disclaimer: Mutual fund investments are subject to market risks. Please read all scheme-related documents carefully before investing. Past performance is not indicative of future results.
Understanding Mutual Fund Returns
Mutual fund returns, whether it’s CAGR or XIRR, tell us about the historical performance of the fund. They give us an insight into how the fund has performed over a specific period. However, they do not predict future returns.
To simplify this explanation, let’s take the example of a hypothetical fund called “ABC Growth Fund.”
What is CAGR?
CAGR stands for Compounded Annual Growth Rate. It is the most commonly used return type to discuss the performance of any fund. CAGR tells you about the compounded growth rate of your mutual fund investments.
Example of CAGR
Let’s take the example of Mr. Ravi, a software engineer, who invested ₹1 Lakh for five years in ABC Growth Fund in 2016. On 1st January 2016, he invested at an NAV of ₹25 and was allotted 4000 units. At the end of five years, on 1st January 2021, he redeemed his investments and received ₹1,60,000. His investment increased by ₹60,000.
To calculate the CAGR, we need the Initial Investment Value (IV), Final Investment Value (FV), and the period of investment (n).
CAGR = ((Initial Investment Value / Final Investment Value)^(1/n)) – 1
For Mr. Ravi, it will be calculated as follows:
CAGR = ((1,00,000 / 1,60,000)^(1/5)) – 1
So, Mr. Ravi received an average annual return of 8.78%.
Yearly Performance of Mr. Ravi’s Investment
| Year | Value of Investment | Annual Return |
|---|---|---|
| 2016 | ₹1,00,000 | 0% |
| 2017 | ₹1,10,000 | 10% |
| 2018 | ₹1,20,000 | 9.09% |
| 2019 | ₹1,30,000 | 8.33% |
| 2020 | ₹1,40,000 | 7.69% |
| 2021 | ₹1,60,000 | 14.29% |
As seen in the table, the investment value fluctuated annually. CAGR does not show the clear picture of these ups and downs but gives an overall growth rate.
Limitations of CAGR
- Does Not Reflect Volatility: CAGR might make it seem like the investment grows at a fixed rate every year, but the reality is different.
- Not Ideal for SIP Investments: CAGR is ideal for one-time lump sum investments but not for SIPs. For SIPs, each installment is a new investment, and CAGR cannot account for different investment periods.
What is XIRR?
XIRR, or Extended Internal Rate of Return, is the solution for calculating returns from SIP investments. It takes into account the different cash inflows and outflows, making it suitable for SIPs where each installment is invested for different durations.
Example of XIRR
Let’s take the example of Mr. Ravi again, but this time he started a ₹5,000 monthly SIP in ABC Growth Fund on 1st January 2016 for five years.
In this scenario, Ravi would be investing at different prices every month, and each investment will remain invested for different durations.
With XIRR, CAGR is calculated for every installment, and then the overall Compounded Annual Growth Rate is taken out after adding them all together.
SIP Investment of Mr. Ravi
| Date | Amount Invested | NAV | Units Allotted |
|---|---|---|---|
| Jan 2016 | ₹5,000 | ₹25 | 200 |
| Feb 2016 | ₹5,000 | ₹26 | 192.31 |
| Mar 2016 | ₹5,000 | ₹27 | 185.19 |
After five years, Mr. Ravi’s total investment was ₹3,00,000, and the value of his investment was ₹3,75,000.
Using XIRR calculation, his annual return was 10.33%.
Absolute Returns
Absolute returns or Total returns show how much you have gained or lost in your investment. It is the simplest way to calculate returns, ideal for investments held for a year or less.
Example of Absolute Returns
At the end of 2019, the value of Mr. Ravi’s investment was ₹1,43,600. After a year, it increased to ₹1,51,000.
The formula to calculate Absolute Returns is:
Absolute Returns = ((Final Value – Initial Value) / Initial Value) × 100
For Mr. Ravi, it will be:
Absolute Returns = ((1,51,000 – 1,43,600) / 1,43,600) × 100 = 5.15%
| Year | Initial Value | Final Value | Absolute Return |
|---|---|---|---|
| 2019 | ₹1,43,600 | ₹1,51,000 | 5.15% |
That’s a Wrap!
Understanding mutual fund returns can be challenging, but it is crucial for making informed investment decisions.
- CAGR is best for one-time lump sum investments, providing an overall growth rate.
- XIRR is ideal for SIP investments, considering different investment durations.
- Absolute Returns are useful for short-term investments, giving a straightforward gain or loss percentage.
Next time you hear about mutual fund returns, remember these distinctions and evaluate the performance based on your investment type. By doing so, you can make better decisions and potentially achieve your financial goals.