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.
Table of Contents:
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. CAGR, by definition, means the annual growth of your mutual fund investment over a specified time interval. It is a valuable indicator of the overall performance of the mutual fund scheme you have invested in.
CAGR is used for expressing mutual fund performance in periods over one year. Most Asset Management Companies (AMCs) report the CAGR of their schemes for 1-year, 3-year, 5-year and since inception periods in their monthly fund factsheets and other communication to investor where performance is disclosed.
How to calculate CAGR?
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 better than calculating 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.
How does CAGR work for mutual funds?
CAGR is frequently used in fund fact sheets and performance charts to show historical performance over periods like 3 years, 5 years, and 10 years. It serves as a tool for comparison, allowing investors to see how one fund has performed against its peers or a benchmark index over the same timeframe. By presenting a single, annualised figure, it can simplify the comparison process.
For example, an investor might compare the 5-year CAGR of several large cap funds to gauge their past performance. It helps in looking at performance from a long-term perspective, smoothing out the impact of short-term market volatility.
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 the relatively high CAGR
Research: Explore mutual funds that may be suitable based on your financial goals and your ability to take risk.
Look at past CAGR: Check the historical CAGR for the funds you are considering. This data is usually available on official fund documents or websites. Focus on funds that have shown the potential for relatively strong CAGR over longer periods.
Match the fund with your time frame: If you're investing for the long-term, such as for retirement, it may be suitable to consider funds that have demonstrated potential for long-term growth based on past CAGR.
Evaluate costs: Higher fund expenses can reduce the potential for returns.
Consider speaking to a financial advisor. If you're unsure about which funds to choose, getting personalised advice from a financial professional may be helpful.
Factors influencing CAGR in mutual funds
Market environment: The broader market landscape plays a key role in shaping mutual fund performance. Elements such as economic cycles, market trends, and investor behaviour can all affect returns.
Fund management and strategy: The decisions made by the fund manager and their team, along with their experience, can influence how a fund performs.
Asset class exposure: Different types of assets carry varying levels of risk and return potential. Equity-oriented funds, for instance, tend to have a higher potential for returns but also come with higher risk.
Expense ratio: A relatively high expense ratio can reduce the net potential returns over time.
Changes in interest rates: Shifts in interest rates can influence both equity and debt funds.
Impact of inflation: Inflation gradually reduces the value of money. While it doesn’t directly factor into CAGR calculations, it is important to consider.
Consider speaking to a financial advisor. If you're unsure about which funds to choose, getting personalised advice from a financial professional may be helpful.
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.
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