What is the first question that you ask when investing in a mutual fund scheme?
‘Kitna returns milega?
Mutual fund return is the most important factor that investors look at while investing. And rightly so. You are after all investing your hard-earned money. So, you have every right to know what kind of mutual fund returns to expect.
But unfortunately, majority of investors fail to understand the various types of mutual fund returns. This failure is the reason why investors are often misled and mis-sold mutual fund schemes.
But we are going to change this.
There are numerous types of returns but only 3 types of mutual fund return matter to you as an investor – CAGR, XIRR & Absolute returns.
We all know that if you invest Rs 100 in a mutual fund and it becomes Rs 150, then Rs 50 is your profit or mutual fund return.
Simple! Well, not really. Mutual fund returns are a little bit more complex.
For example: If your friend, advisor or uncle tells you that this XYZ fund has given a 30% return, the question that you should be asking is – ‘What kind of mutual fund return is this? Absolute? CAGR? Or XIRR?’
Let us start with Absolute returns.
Absolute return is the most common type of mutual fund return. It is also the most mis-leading mutual fund return. This is because it does not consider the time taken to earn the return.
For example: Suppose a person tells you that they walked 20 kms. You’d think this is quite impressive. But what if this person walked 20 kms in 20 days? This means that he only walked for 1 km a day! This is way less impressive.
This is how absolute return is absolutely misleading!
Let us now compare two mutual fund schemes via absolute returns.
Suppose you have two investment opportunities.
- You can invest Rs 1 lakh in Fund A and get Rs 1.50 lakhs. Or,
- You can invest Rs 1 Lakh in Fund B and earn Rs 1.45 Lakhs.
You will obviously select Fund A. And absolute return will support your decision. Here’s how.
The formula to calculate absolute returns = (Maturity Value – Investment Value)/Investment Value.
Absolute return for Fund A = (1,50,000-1,00,000)/1,00,000 = 50%
Absolute return for Fund B = (1,45,000-1,00,000)/1,00,000 = 45%
By simply looking at absolute return, you will conclude that your decision was correct.
But what if we add an element of ‘time’ into this. Will you still choose fund A?
To answer this, we need to look at another type of mutual fund return – Compounded Annual Growth Rate (CAGR).
Compounded Annual Growth Rate (CAGR)
CAGR is the return that you earn every year. It is the most popular mutual fund return that shows you how much money you have made annually.
Let’s go back to the above example but this time we’ll add time to the equation.
In the above example: If Fund A gives 50% return in 5 years and Fund B gives 45% return in 3 years, then which fund will you invest in?
To answer this, we need to calculate CAGR.
Compounded Annual Growth Rate = (Maturity Value/Investment Value) ^(1/time) -1
CAGR for Fund A = (1,50,000/1,00,000) ^ (1/5)-1 = 8.47%
CAGR for Fund B = (1,45,000/1,00,000) ^ (1/3)–1 = 13.18%
As you can see, based on CAGR, Fund B generates higher returns than Fund A.
Now you must be thinking – Which mutual fund return is correct? Absolute return or CAGR?
The answer is both. But CAGR will give you a better picture of the actual returns that you made on an annual basis.
But even CAGR has its limitations. It only considers investments made at a particular time. Hence CAGR is perfect for lumpsum investing. But majority of investors prefer investing via systematic investment plans (SIP).
As you know, in a systematic investment plan, there is no single fixed date of investment. Calculating CAGR in case of SIP will give you the wrong picture. Here’s why calculating CAGR is useless when dealing with SIP.
Suppose you started a SIP of Rs 5,000 in a mutual fund scheme. Your SIP start date is 1st January 2020. Your SIP end date is 1st December 2020.
Your total investment over a period of 12 months is Rs 60,000. The current value of your fund is Rs 65,000.
If you calculate CAGR, then: (65,000/60,000) ^ (1/1)-1 = 8.33%.
Looking at 8.33% return, you might decide to SELL your fund. Afterall you only made Rs 5,000 in 12 months. That’s only Rs 416.67 per month!
But you would be wrong.
Did you invest the entire Rs 60,000 on 1st January 2020?
No! This is why CAGR will not work while calculating SIP returns.
This is where XIRR helps in measuring your SIP returns.
Extended Internal Rate of Return (XIRR) helps you calculate returns when there are multiple investment dates, like in the case of a SIP.
Let’s recalculate the returns that your SIP generated in the above example.
|SIP Dates||SIP amount||Months Invested For|
As you can see, in reality your returns are 15.66%! not 8.33%. This difference is because your 1st instalment had 12 months to grow. But your 5th instalment had only 7 months to grow. Similarly, the last instalment had only 1 month to grow!
XIRR helps you calculate point to point mutual fund returns. Remember, the best way to calculate your SIP returns is through XIRR.
Learning about all these mutual fund returns might be a little overwhelming. So, let’s make it easier for you to remember.
- Whenever you are analysing an investment opportunity, always use CAGR instead of absolute returns.
- Use CAGR to calculate returns on lumpsum investment
- Use XIRR to calculate returns on Systematic Investment Plan
This concludes our discussion on mutual fund returns.
But wait, there’s more.
We have learnt how to calculate an investor’s mutual fund returns. But what about the returns earned by your mutual funds?
Yes, there are other returns such as trailing returns, rolling returns, calendar returns etc which help you evaluate your mutual funds. We will cover these returns in the next article.
Now that you understand the 3 main types of mutual fund returns, the question is, ‘how will this help in managing your portfolio’?
The entire objective behind teaching you about mutual fund returns is that you can evaluate the returns you made in various schemes and get rid of poor performing funds.
These funds drag down your portfolio returns. Your goal should be to get rid of these funds ASAP.
But we agree that calculating these returns and then evaluating your funds can be tedious and time consuming.
Fortunately, there is a smarter and quicker way to evaluate your mutual fund portfolio – SmartSwitch.
And this facility is absolutely FREE! Open a RankMF account today, upload your CAS statement and evaluate your mutual fund portfolio now!