Difference Between Absolute Return and CAGR

Absolute return measures the total gain or loss of an investment over a specific period. In contrast, CAGR shows the average annual growth rate, offering a smoother view of performance over time.
Difference Between Absolute Return and CAGR
3 min
09-September-2024

Absolute return and compound annual growth rate (CAGR) are essential metrics for evaluating investment performance. While absolute return measures the total percentage change in an investment's value over a specific period, CAGR calculates the average annual growth rate, accounting for compounding effects. Absolute return is ideal for short-term comparisons, while CAGR is more suitable for long-term analysis and comparing investments with varying durations.

To gain a comprehensive understanding of an investment's performance, it is crucial to consider both absolute return and CAGR. In this article, we will delve into the distinctions between these metrics, their calculation methods, and their significance in investment decision-making.

What are Absolute Returns in a Mutual Fund? 

Absolute returns refer to the total returns provided by a particular mutual fund scheme on the initial investment amount, expressed in percentage terms. Absolute returns depict the initial investment's increased or decreased monetary value over a specific period.

Absolute returns do not factor in the tenure of the investment but focus on two factors: the initial investment (principal amount) and the final amount (maturity amount). Furthermore, absolute returns do not compare the returns to any benchmark or index and can be positive or negative.

The formula for absolute returns is:

Absolute Returns (in %): [(Current investment value/Initial investment amount)] x 100

What is compound annual growth rate (CAGR)?

The CAGR refers to the rate of return for an investment made in a mutual fund scheme over a specific period, depicted in percentage terms. CAGR provides an assumptive growth rate at which your initial investment will grow on an annually compounded basis, given that the profits are reinvested.

Since CAGR provides the rate of return on an annually compounded basis, it is also known as annualised return. Hence, there is no difference between annualised returns and CAGR. CAGR is useful for investors as it provides a year-by-year rate of growth for a mutual fund investment, showing the maths behind the investment reaching its current value.

The formula for Compounded Annual Growth Rate (CAGR) is:

CAGR (in %):  [(Ending value/ Beginning value) ^ (1/n) – 1] x 100

Here, n is the tenure of investment in years.

Difference between Absolute Return and CAGR

Now that you have understood the basic definitions and formulas of absolute returns and CAGR, the next factor in absolute return vs CAGR is to understand the detailed side-by-side difference. Here is the difference between absolute return vs CAGR:

Particulars

Absolute Returns

CAGR

Aim

To show the absolute or total returns from the initial investment value to the current value, irrespective of the holding period.

To show the annualised returns on the principal investment for a specific holding period through an annualised compounded rate, assuming profits are reinvested.

Formula

[(Current investment value/Initial investment amount)] x 100

[(Ending value/ Beginning value) ^ (1/n) – 1] x 100

Benchmark Comparison

No comparison to benchmark/index

Often compared to benchmark/index

Suitability

Better suited to calculate returns for holding periods less than a year.

Better suited to calculate returns for holding periods over one year.

 

Use annual returns for long-term financial goals

Annualised returns are a cornerstone of long-term financial planning. When pursuing objectives such as retirement, education funding, or wealth accumulation, understanding the average annual growth rate of investments is paramount. By analysing annualised returns, investors can effectively gauge the performance of their portfolios over time, accounting for compounding effects.

The uses of CAGR

Compound Annual Growth Rate (CAGR) offers several advantages. It standardises the evaluation of investment success by providing a comparable metric based on average annual growth rather than absolute figures. CAGR facilitates long-term planning by projecting future values and aiding investors in making informed decisions. Additionally, CAGR can be used to assess investment risk. A consistently positive CAGR over time indicates steady, reliable growth, making it appealing to risk-averse investors.

Example for Absolute Return and CAGR

For a better understanding of absolute returns and CAGR, here is a detailed example:

You invested Rs. 20,000 in a mutual fund scheme, and its current value after five years is Rs. 35,000.

Absolute Returns (in %):  [(Current investment value/Initial investment amount)]x100

= [(35,000 - 20,000) / 20,000] x 100

= [(15,000) / 20,000] x 100

= 75%

So, the absolute return on your investment over five years is 75%.

CAGR (in %):  [(Ending value/ Beginning value) ^ (1/n)] – 1

= [(35,000 - 20,000) ^ (1/5) - 1] x 100

= [(1.75) ^ (0.2) - 1] x 100

= [1.1487 - 1] x 100

= 14.87%

  • Absolute Return indicates that your investment grew by 75% in rupee terms over the five years, increasing by Rs. 15,000.
  • A CAGR of approximately 14.87% indicates that your investment has grown at a constant rate each year.

CAGR Vs Absolute Return – Which is Better?

Having understood everything about absolute returns and CAGR, you know that CAGR and annualised returns are the same, and there is no difference between CAGR and annualised returns. However, both absolute returns and CAGR are beneficial in determining a mutual fund’s returns.

If your holding period is less than a year, absolute return is a better metric to use when calculating the return from your investment. However, CAGR makes up for a better calculation metric for mutual fund investments with a holding period longer than one year.

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Frequently asked questions

What is the difference between CAGR and total return?

Although conceptually the same, CAGR and annualised returns differs as CAGR is showcased using the initial and ending investing values. On the other hand, annualised return is calculated by using the returns from multiple years.

How do you convert absolute return to CAGR?

If you have absolute returns, you just have to determine the holding period (N) along with the initial and final investment amount. Then, you can either use the formula or use the CAGR return calculator online to calculate CAGR.

What is the difference between XIRR and absolute return?

If your MF investments are through SIP, you need XIRR to calculate the returns as the mutual fund units and investment period vary significantly over time. Absolute return refers to the actual increase or decrease in the value of the investment over a specific period, expressed as a percentage.

Is 20% CAGR possible?

Yes, some mutual funds in the flexi cap, equity, midcap and multicap category have generated more than 20% CAGR. You can compare and analyse them based on their CAGR and other factors and invest for good returns.

What is the rule of 72 for CAGR?

The Rule of 72 is a simple mathematical formula used to estimate the number of years it will take for your investment to double at a fixed annual rate of return. You can apply this rule by dividing 72 by the annual rate of return.

When should I use Absolute Return vs. CAGR?

Absolute return is a suitable metric for short-term investments, as it provides a direct measure of the overall gain or loss. For long-term investments, CAGR offers a more accurate representation of annualized growth, facilitating comparisons between different investment options.

How do I calculate Absolute Return?

Absolute return is calculated by determining the percentage difference between the current value and the initial investment. The formula is:

Absolute Return = [(Current Value - Initial Value) / Initial Value] × 100

How is CAGR calculated?

CAGR is calculated using the compound annual growth rate formula, which accounts for the time period of the investment. The formula is:

CAGR = [(Ending Balance / Beginning Balance)^(1/n)] - 1

where n is the number of years.

Can Absolute Return be converted to CAGR?

Yes, absolute return can be converted to CAGR using a specific formula. By taking the nth root of the ratio of the current value to the initial value and subtracting 1, you can obtain the equivalent CAGR.

What are Absolute Return Strategies?

Absolute return strategies aim to generate positive returns regardless of market conditions. These strategies often employ techniques such as derivatives, arbitrage, and leverage to achieve consistent performance.

Why is CAGR important for long-term financial planning?

CAGR is a valuable tool for long-term financial planning as it provides a standardized measure of annualized growth. This allows for effective comparison and evaluation of investment performance over extended periods, aiding investors in making informed decisions.

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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.