Understanding how your mutual fund investments grow over time is key to making informed financial decisions. The Compound Annual Growth Rate (CAGR) is one of the reliable ways to measure this potential growth. Whether you’re new to mutual funds or just want to make sense of “average returns”, learning about CAGR can help you evaluate and compare the performance of different investments with clarity and confidence.
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What is CAGR in mutual funds?
Compounded Annual Growth Rate (CAGR) is a measure of how much your investments have grown every year during a specific time period. It represents the annualised rate of return that would take your investment from its starting value to its ending value, assuming it grew at a steady rate each year. Since investment returns can vary significantly from one year to another, CAGR helps smooth out these fluctuations and presents the growth as a single annual rate.
indicator of the overall performance of the mutual fund scheme you have invested in.
CAGR is used for expressing mutual fund performance for periods exceeding one year. Most Asset Management Companies (AMCs) report the CAGR of their schemes for 1-year, 3-year, 5-year ,10-year and since inception periods in their factsheets and other performance-related communication to investors.
How does CAGR work for mutual funds?
CAGR can be easier to understand with a simple illustration. Suppose a mutual fund investment grows from ₹1 lakh to ₹1.76 lakh over five years. The 5-year CAGR would be approximately 12%. However, the fund’s actual yearly returns may have varied significantly. CAGR smoothens out volatility to express growth at a fixed annual rate.
This can aid the comparison of different mutual funds as it gives at-a-glance information on how each investment grew. For example, an investor might compare the 5-year CAGR of several large cap funds to gauge their past performance.
Example for illustrative purpose only. Past performance may or may not be sustained in future.
What is compounding and how does it relate to CAGR?
Compounding in mutual funds is the process by which the returns earned on your investment are reinvested and start generating returns of their own. In simple terms, your investment earns returns, and those returns earn more returns over time. This creates a snowball effect that has the potential to significantly increase investment growth over time. The longer you remain invested, the more powerful the impact of compounding becomes.
While compounding describes the process of earning returns on both the original investment and the accumulated returns, CAGR measures the annualised rate at which that growth has occurred over a specific period, assuming that returns were reinvested. In this way, CAGR helps quantify the effect of compounding by expressing investment growth as a single annual rate.
CAGR formula and how to calculate it
Follow these steps to calculate CAGR:
Step 1: Determine the starting value of the investment. It would be the initial investment if you want to calculate CAGR from the start of the investment.
Step 2: Find out the final value of the investment for the time period.
Step 3: Work out the tenure over which the growth occurred.
Step 4: Use the CAGR formula: [(Final Value / Starting Value) ^ (1/Tenure)] – 1.
Step 5: Multiply the value with 100 to express the CAGR value in percentage.
You can also use a CAGR calculator to get these estimates in seconds. All you need to do is enter the initial value, final value and investment tenure to calculate the year-on-year growth, assuming returns were reinvested.
3 things you must know about compound annual growth rate
After understanding ‘what is CAGR’, here are three other important things you must know about it:
Indicates overall performance: CAGR enables you to gain insights into the long-term performance of the mutual fund. You can easily compare different schemes by comparing their CAGRs since it tells you how consistently an investment has grown over time.
CAGR is more representative than absolute returns: Absolute returns do not consider the tenure of the investment and may give you an incomplete view of the fund performance. CAGR helps you understand how your investment has grown each year since funds grow at different rates each year.
Not applicable to SIPs, STPs and SWPs: You will have to use other performance indicators for Systematic Investment Plans (SIPs), Systematic Transfer Plans (STPs) and Systematic Withdrawal Plans (SWPs) instead of CAGR in mutual fund, meaning CAGR is only applicable for schemes with point-to-point returns and considers the compounding effect where the growth each year affects the base value for following years.
Why CAGR matters for mutual fund investors
CAGR provides a simplified view of returns over periods longer than one year. It shows an annualised growth rate for a lump sum investment, helping to make long-term performance data easier to understand.
Here is why CAGR can be relevant:
- Helps with comparison: Supports comparison between different mutual fund schemes or with market benchmarks like the Nifty 50.
- Highlights long-term performance: CAGR reduces the impact of short-term ups and downs in the market.
- Includes compounding effects: It shows how the value of an investment can potentially grow when realised returns start earning potential returns.
Identifying mutual funds with high CAGR
A high CAGR can indicate that a mutual fund has delivered strong growth over a period of time. Here are some steps to identify a suitable fund based on its CAGR:
• Start with your goals and risk appetite: Shortlist funds that align with your financial goals, investment horizon and ability to take risk.
• Review historical CAGR: Check the fund’s CAGR over different periods, such as 3 years, 5 years and 10 years. Consistent performance across market cycles may be more meaningful than a high CAGR over a single period.
• Compare with peers and benchmarks: A fund’s CAGR should be evaluated relative to similar funds and its benchmark index. This can provide a better understanding of its performance.
• Assess risk-adjusted returns: A high CAGR achieved by taking significantly higher risk may not be suitable for all investors. Consider risk measures and the fund’s performance during market downturns.
• Evaluate costs: Expense ratios and other costs can impact the returns investors ultimately receive. Lower costs can help improve long-term outcomes.
• Check portfolio and fund strategy: Understand where the fund invests and whether its investment approach matches your expectations and goals.
However, the fund with the highest CAGR is not necessarily the best choice for every investor. Past performance does not guarantee future returns, and factors such as risk, volatility and investment objectives should also be considered before making a decision.
Factors influencing CAGR in mutual funds
A mutual fund’s CAGR can be influenced by a range of factors, from market conditions and fund strategy to costs and interest rates.
• Market environment: The broader market landscape plays a key role in shaping mutual fund performance. Factors such as economic cycles, market trends and investor sentiment can all impact returns.
• Fund management and strategy: The investment decisions made by the fund manager, including stock selection, asset allocation and risk management, can significantly impact fund performance.
• Asset class exposure: Different types of assets carry varying levels of risk and return potential. Equity-oriented funds, for instance, tend to have higher potential for returns but also come with higher risk than debt-oriented funds.
• Expense ratio: Fund expenses are deducted from returns. Over the long term, a higher expense ratio can have an impact on CAGR.
• Changes in interest rates: Changes in interest rates: Shifts in interest rates can influence both equity and debt funds.
• Impact of inflation: While inflation is not factored into CAGR calculations, it affects the real purchasing power of investment returns.
• Investment horizon: The period over which a fund is evaluated can influence its CAGR. Longer time horizons typically provide a more comprehensive view of performance across different market conditions.
If you’re unsure about evaluating mutual funds or interpreting performance metrics, consider seeking guidance from a financial advisor.
How to use CAGR for mutual fund comparison
Using CAGR for mutual fund comparison involves comparing the annualised growth rates of similar funds over the same time horizon and then evaluating the results alongside other performance and risk-related factors. Here are some considerations.
- Compare funds over the same investment period.
- Evaluate funds within the same category.
- Review multiple time horizons instead of relying on a single period.
- Consider the fund’s risk profile alongside its CAGR.
- Examine consistency of performance across market cycles.
For example, if two mutual funds have delivered a CAGR of 10% and 12% respectively over five years, the higher CAGR indicates that the second fund generated a higher annualised growth rate during that period. However, the comparison may not provide a complete picture. Factors such as volatility, portfolio composition, market conditions, and investment strategy will also need to be considered.
Example for illustrative purposes only.
Difference between absolute returns and CAGR in mutual funds
Absolute return measures the total percentage gain or loss on an investment between two points in time. It does not consider the duration of the investment. As a result, it is generally more useful for evaluating performance over shorter periods.
CAGR, on the other hand, measures the annualised rate at which an investment has grown over a specific period, assuming the growth occurred at a consistent rate. It accounts for the investment tenure and helps standardise comparisons across different time horizons.
Here’s a detailed look at the differences between the two measures:
| Parameter | Absolute return | CAGR |
| Measurement | Total percentage change in investment value | Annualised growth rate over a period |
| Considers time period | No | Yes |
| Common use | Short-term performance evaluation | Medium- to long-term performance evaluation |
| Comparison across different tenures | Limited | More suitable |
CAGR vs XIRR – Which should you use and when?
Both CAGR and XIRR are used to measure investment returns, but they serve different purposes. CAGR is more suitable when there is a single investment amount at the beginning and a single redemption amount at the end (such as with a lumpsum investment).
XIRR, on the other hand, is more suitable when there are multiple cash flows occurring at different points in time. This is common with Systematic Investment Plans or SIPs, Systematic Transfer Plans (STP), or investments where additional contributions and withdrawals are made periodically. Since XIRR takes the timing and amount of each cash flow into account, it provides a more accurate picture of the actual returns earned by the investor.
| Basis | CAGR | XIRR |
| Suitable for | Lumpsum investments | SIPs and multiple cash flows |
| Considers timing of cash flows | No | Yes |
| Calculation complexity | Simple | More complex |
Fund houses typically publish CAGR returns for standard periods (1-year, 3-year, 5-year, etc.) in their factsheets and disclosures. SIP investors, however, often look at XIRR to understand the return on their actual investment journey.
Limitations of CAGR
While CAGR is a useful tool, it has certain limitations that investors should be aware of.
- It masks volatility: CAGR provides an average growth rate and does not reflect the journey of the investment. A fund with very volatile returns can have the same CAGR as a fund with relatively steady returns.
- It is a historical measure: Past performance, as indicated by CAGR, does not guarantee future results. Market conditions and other factors can change, impacting a fund’s future potential for returns.
- Suitability for lumpsum: CAGR is most appropriate for assessing a single, lumpsum investment. For investments made through a Systematic Investment Plan (SIP), where multiple investments are made over time, other metrics like XIRR (Extended Internal Rate of Return) may provide a more representative picture of performance.
Conclusion
CAGR is a useful tool for evaluating the historical returns of a mutual fund. However, it’s important to remember that it represents a historical average and does not guarantee future performance. It is just one of several metrics to consider when assessing a fund. Investors should also take into account the fund’s risk level, expense ratio, investment strategy, and their own personal financial goals. For a more complete picture, it may be suitable to compare the CAGR of a fund with its benchmark index and other funds within the same category. Consulting with a financial advisor may also be a suitable step to ensure your investment decisions align with your long-term objectives.
FAQs:
What is a good CAGR for a mutual fund?
What may be considered a suitable CAGR depends on the asset class of the fund and the length of your investment period.
Is the CAGR calculator free for use?
Yes, most CAGR calculators offered by mutual fund platforms and financial websites in India are available for free. These tools allow you to estimate the compound annual growth rate of your investment by entering the initial value, final value, and the investment period.
Does CAGR reflect investment risks?
No, CAGR does not indicate the risk involved in an investment. It represents an average annual return over a period and does not capture the ups and downs in the investment’s value. As a result, it may give the impression of relatively steady growth, which may not reflect actual performance. Other risk-related metrics should also be considered.
Can CAGR be used for SIP?
CAGR can provide a broad view of returns, but it may not be the most suitable metric for SIPs. Since SIPs involve regular investments made at different times, a more appropriate measure is XIRR (extended internal rate of return), which takes into account the timing and size of each installment.
Is higher CAGR better?
While a higher CAGR shows that a fund has delivered a relatively stronger average annual return over time, it should not be assessed in isolation. It is important to compare it with the fund’s benchmark and peer group. You should also consider the fund’s risk level, return consistency, and your investment goals.
