CAGR in Mutual Fund

CAGR is an acronym for Compound Annual Growth Rate. A quick way to gauge the increase in a business or an investment over a particular duration of time, it considers the impact of compounding, which refers to the increase that builds upon itself.

For an investor, mutual funds are an easy way to gain access to equity markets and experience capital appreciation without researching individual stocks. A mutual fund basket allocating a corpus across multiple stocks diversifies the risks for an investor. CAGR is often used in evaluating the returns from a mutual fund. Investing in mutual funds requires an in-depth understanding of CAGR in mutual fund, formula of CAGR, examples, high CAGR mutual funds, and benefits of CAGR. So, what is cagr in mutual fund?

What is CAGR?

Compound Annual Growth Rate (CAGR) is a measure of the mutual fund returns that are annualised over a specific time duration. It is a more accurate manner of calculating the growth of an investment averaged over an annual basis. CAGR is usually represented in the form of percentage.

An important metric to compare mutual funds, the CAGR can be readily used to evaluate the returns of a mutual fund on a 3-year basis, 5-year basis, 10-year basis, or since inception. You can use CAGR as a handy tool for visualising how much an investment will be worth after a given period of time. Returns on investment can be measured as an absolute increase from the initial investment. But absolute returns is a less precise way to calculate returns because it only considers the initial and the final values of an investment without taking into account the time period. It may not provide an accurate picture of how staggered the growth was. A 350% return in five years does not provide enough information to an investor for revisiting his investment decisions and revalidating his portfolio effectively. Neither does it provide a good starting point for further research. Moreover, absolute returns always represent a good performance and a mutual fund with a 350% return in 5 years may not seem to be much different from a mutual fund that has generated an absolute return of 330% in the same time period.

A CAGR effectively reduces these three-digit or four-digit absolute growth figures in manageable chunks of two-digit numbers. A mutual fund with a 15% CAGR across five years seems to be more attractive than a mutual fund with a CAGR of 11% during the same time period. This is because the 4% additional alpha represents the extra returns generated by the former mutual fund for every year in the duration. Therefore, the cagr in mutual fund is a more conservative approach of estimating portfolio returns.

How does CAGR work for mutual funds?

The CAGR is a quick estimation tool for evaluating returns from mutual funds. Consider a 3-year CAGR of 14% for an arbitrary mutual fund. What does this figure of 14% tell you? It gives some first-hand indications for the mutual fund. The first interpretation is that for a 3-year window ending today, the mutual fund gave an annualised growth of 14%. In an individual year within this 3-year window, the growth rate could have been less than or greater than 14%. So, the CAGR smoothens the crests and the troughs of the returns generated every year by painting an average picture of the increase in the value of an investment across multiple years.

However, the CAGR depicts that the growth rate annualised over 3 years has been 14%. An immediate implication is that as an investor, you should not expect a return of 14% every year from the mutual fund. So, you need to be mindful of the fact that you may not experience similar returns in the future because a CAGR is a lagging indicator. Market conditions affect a mutual fund’s CAGR. There could be a case that the economy experiences a boom in the next three years which can yield a 3-year CAGR of 18% for the same mutual fund. On the contrary, if the economy goes through a recession, the CAGR may drop to 10%. You can only draw a conclusion that since the mutual fund gave a 14% CAGR over the past 3-year period, the chances of a 14% return in a future 3-year window is more probable than other possibilities. This suggests that a CAGR is not a promise or a guarantee of future returns.

Also Read: Absolute Return in Mutual Funds

Example of CAGR in mutual funds

Suppose there are two mutual funds A and B. An investor invests Rs. 5,00,000 in mutual fund A and Rs. 2,50,000 in mutual fund B. After 5 years, mutual fund A has a final investment value of Rs. 10,00,000, whereas mutual fund B has a final investment value of Rs. 5,50,000. At first sight, it might seem that mutual fund A has generated higher returns than that of mutual fund B, and therefore should be preferred over mutual fund B. If only the increase in value is compared for both mutual funds, mutual fund A saw an increase of Rs. 5,00,000 while mutual fund B experienced an increase of Rs. 3,00,000. So, the increase in the case of mutual fund B is lower than that for mutual fund A.

However, on calculating the CAGR for both mutual funds, it is clear that mutual fund A gave a CAGR of around 15%, whereas mutual fund B generated a CAGR of around 17%. Therefore, as an investor, you should consider CAGR as the foremost measure of returns generated for a mutual fund and overlook the absolute values and returns. For comparing mutual funds, CAGR needs to be your first go-to tool.

Formula for CAGR in mutual fund

CAGR can be calculated using the following formula:

CAGR = (Final value of investment/Initial value of investment)(1/n) - 1

Where initial value of investment is the capital that has been invested at the beginning of the investment period, final value of investment is the worth of the initial investment at the end of the investment period accounting for returns, and ‘n’ is the number of years for which the amount was invested. For a mutual fund with an initial investment value of Rs. 1,00,000 and a final value of Rs. 2,50,000 in a period of six years, the CAGR can be calculated as follows:

CAGR = [(2,50,000/1,00,000)(1/6) - 1] x 100 = 16.49%

As seen from the formula, it is an easy-to-use estimator for investors to get a sense of how much returns their investments have generated for a particular time period. Using CAGR in mutual funds is a more sophisticated way of making investment decisions.

Also Read: Average Mutual Fund Return

How to calculate CAGR in mutual funds?

You can calculate the CAGR of any mutual fund by following the mentioned steps:

Find the values of the initial investment at the beginning of the period and the final investment at the end of the period.

Determine the number of years for which the amount was invested. This time period is ‘n’ in the CAGR formula.

Calculate the CAGR using the formula:
(Final value of investment/Initial value of investment)(1/n) - 1

Since CAGR is expressed in the form of a percentage, multiply the result obtained in step 3 by 100.

A point to note here is that the CAGR works for lump sum investments and can be calculated for two specific dates. It cannot be used for SIP investments where there are multiple and regular outflows and inflows for the investor. So, the CAGR cannot handle multiple inflows and outflows.

Why does the CAGR matters for mutual fund investors?

Investors can readily assess the attractiveness of a mutual fund by checking their CAGRs. CAGR helps mutual fund investors in terms of the following points:

1. Consistency

The CAGR provides investors a standardised way of evaluating mutual fund returns instead of absolute returns. Using the CAGR formula, you can start with the same initial value of investment but arrive at different figures for the final value with different CAGRs. So, a CAGR in mutual funds makes the base of comparison equal for all mutual funds that you wish to compare and evaluate.

2. Accounting for compounding

Suppose you have invested Rs. 2,00,000 in a mutual fund that generates Rs. 2,20,000 in the 1st year, Rs. 3,00,000 in the 2nd year, Rs. 4,00,000 in the 3rd year, and so on. The CAGR takes care of the fact that the year 1, year 2, and year 3 corpus is reinvested by the mutual fund till the time the investor redeems his investments. Therefore, it takes into account the effect of compounding on investment.

3. Long-term perspective

As an investor, you can get a sense of how much your current investment will be worth in the long-term using the formula of CAGR. Mutual fund information usually mentions 3-year returns, 5-year returns, 10-year returns, and returns since inception. This can provide insights on expected investment growth in the future.

Identifying mutual funds with the highest CAGR

Picking the right mutual funds with the highest CAGR can be simplified through the following process:

1. Research

You should identify and research mutual funds that fit your risk profile, investment objective, and financial goals. Mutual Fund Schemes are available in plenty and you need to shortlist a few as per your investment philosophy. You need to keep an eye on the mutual fund manager’s investing style.

2. Check historical CAGR

After choosing a few funds, you need to go to the fund house’s websites and download the fund factsheets which contain information about their historical CAGR. Avoid mutual funds that have either consistently or intermittently delivered a lower CAGR over the years. Select only those funds that have generated an above-average CAGR.

3. Consider investment horizon

If you are an investor who is entering the world of investing and have an investing horizon till your retirement, it is best for you to invest in a mutual fund that has a consistently high CAGR since inception.

4. Diversify

Till now, you must have pruned your list and left with the last remaining 3-4 mutual funds. You should not forget to diversify your investments across multiple mutual funds that provide exposure to different asset classes, industries, or themes. You can even consider a passively managed mutual fund in your portfolio. Diversification will help you evenly spread the risk associated with investing.

5. Consult a financial advisor

You need to consult a financial advisor if you are not sure about where to invest your hard-earned money. Based on his experience and your financial goals, a financial advisor will help you choose the mutual funds.

6. Keep an eye on expenses

While CAGR is the first metric to evaluate mutual funds, you should not forget the cost of investments, especially the expense ratio. Choose mutual funds that have a lower than average expense ratio.

Uses of CAGR in mutual funds

Investors can use CAGR for mutual funds in a variety of ways:

1. Performance comparison

The CAGR essentially takes into account the time value of investments and depicts the compounded annual growth rate. Comparing mutual funds using the CAGR is easier because the initial and final values of investments do not matter while evaluating two mutual funds. All that matters is the CAGR expressed in the form of percentage.

2. Long-term planning

CAGR helps you visualise the returns that could be possibly generated through a mutual fund investment. Therefore, it helps you in long-term planning for achieving your financial goals.

3. Risk assessment

CAGR can offer a glimpse into the risks associated with investing in a particular mutual fund. A mutual fund that has a fairly consistent CAGR will be less risky than a mutual fund whose CAGR fluctuates often. A mutual fund with a sustained CAGR indicates a stable growth trajectory that may be suited for risk-averse investors.

4. Performance evaluation

CAGR serves as a guiding light for evaluating the performance of mutual funds based on their past returns. Investors can compare the CAGR for mutual funds against the underlying indices or category averages to identify low-performing or high-performing funds. This aids in the subsequent decision-making for an investor.

Conclusion

The concept of CAGR is the first qualifying parameter while evaluating mutual funds. It gives you a dipstick sense of the growth path for a mutual fund. While it relies on historical data, it can help you forecast potential returns from your investments. CAGR works for investments through the lump sum mode but does not serve the purpose for investments through SIP mode. Remember to shortlist mutual funds with a consistently high CAGR and then carry out your own research.

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