How to calculate Returns of Mutual Funds ?

 

How to measure the return on investment of a mutual fund? 

We have all heard about "compounding effect" and how "staying invested" helps in the long run. What we are all talking about is the return on investment. There are a few metrics that one can use to evaluate the returns on a mutual fund investment. We often use these metrics while comparing, selecting and evaluating investments. These are Absolute return, CAGR and XIRR. Ever wondered, which is the more appropriate metric for you? Let’s find out.

Absolute Return

The most common is the absolute return which simply shows how much the investment has grown in the period. If an investment of Rs. 10000/- is now worth Rs. 15480/-, the absolute return is Rs. 5480/- and the investment has grown by 54.8%. Wow, that's great. But is it really? Absolute returns  simply considers the return from the initial investment till the present day without factoring in the period of the investment. In the above case, whether the initial investment of Rs. 10000/- was done  7 years or 2 years or 3 years ago is irrelevant; in all 3 cases, the absolute return would be the same - a cool 54.8%. This gives a misleading picture of return on investment. 

Compounded Annual Growth Rate (CAGR)

CAGR shows the periodic (annual) return of the investment. 

The formula for CAGR is 

CAGR = (Current Value of the Investment/ Initial invested Amount)^(1 / Number of Years) – 1

For the above case considering investment period of 2 years, the CAGR is 24.42% - meaning the growth has been 24.42% in each of the two years. CAGR is an appropriate analysis for one time investments. To predict the future value of a lumpsum investment, it is CAGR that will be useful and not the absolute return.  

However, what if the investment is through an SIP where the investment period and value are both irregular. For SIPs, the metric that gives a more accurate return is XIRR. 

Extended Internal Rate of Return (XIRR)

In case of an SIP of Rs. 1000/- per month, the annual investment is Rs. 12000/- but only Rs. 1000/- is invested for the first month. The period the Rs. 12000/- is invested is not really a complete 12 months of the year. If one does a top up every year, the amounts again change every 12 months. For SIPs, the amounts and the time periods are irregular. Hence the way to calculate the returns by factoring in the irregular values and time periods of investments is by finding the XIRR. XIRR has to be calculated in excel. 

So to analyze performance or to predict the future value of ongoing SIPs, XIRR is more accurate than CAGR.

So next time you want to evaluate your mutual fund scheme performance, know which metric to select.