Returns are a major reason why any investor would want to invest in a scheme.
But these returns depend on various factors. For example, when it comes to mutual funds, the returns generated by a fund are based on the performance of the underlying asset, the expense ratio, market conditions, etc.
Let’s say you are getting a mutual fund return of 13% over the past three years, what comes to your mind? That if you had invested three years ago, then you would have received a return of 13%. Or something else? Would you earn a higher return on a lump sum investment or a SIP investment?
Understanding the nature of your returns and learning how to calculate them is very crucial for deciding where you want to invest and for how long. However, people normally get confused between CAGR, XIRR, and absolute returns.
So let us discuss the types of mutual fund returns and how to calculate them.
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1. Compound Annual Growth Rate (CAGR)
CAGR is the most commonly used return type in Mutual Funds. It is used to measure a fund’s return over a period of years. It is calculated as the Final investment value divided by the initial investment value, raised to the power of 1 by n minus 1.
CAGR = (Final Investment Value/Initial Investment Value)^1/n – 1
So, for example, let’s say you invested a lump sum amount of Rs. 1,00,000 and after three years it has grown to 1,30,000. In this case, your CAGR would be 9.14%.
However, CAGR has a few limitations. First, it does not consider volatility, meaning it assumes a linear growth of your investment. Second, any redemptions from a mutual fund are not considered. Let’s look at another example. Here, instead of a lump sum investment, we start with a SIP of Rs. 5000 every month, and after three years we get Rs. 2,40,000 lakhs. In this case, multiple contributions are made at regular intervals.
So, the Extended Internal Rate of Return (XIRR) would be more suitable and a simple calculation in Excel would give you an XIRR of 11.57%
2. Extended Internal Rate of Return (XIRR)
XIRR calculates the CAGR for every SIP that you make. This is preferred over CAGR as it considers all contributions and withdrawals in a mutual fund over a period of years.
3. Absolute returns
Lastly, absolute return is used when the investment time horizon is less than one year. For example, you can use absolute return if you want to calculate the mutual fund returns for a scheme for three months, six months, one year, or a year to date. It is simply calculated as the final investment value minus the initial value divided by the initial value. So, if your investment horizon is less than one year, absolute return is more suited.
Also Read: Your Guide To Investing In Passive Mutual Funds
Conclusion
So, to conclude, if your investment horizon is more than one year and you have invested through the lump sum method, then CAGR is suitable. But if your investment horizon is more than one year and you have invested through a SIP, then XIRR is more suitable.
Disclaimer: The views expressed in the blog are purely based on our research and personal opinion. Although we do not condone misinformation, we do not intend to be regarded as a source of advice or guarantee. Kindly consult an expert before making any decision based on the insights we have provided.