Absolute returnsAbsolute 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.
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|
Final ThoughtsLearning 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