Mutual Funds

Understand how returns are calculated in different formats and how to interpret them

Return holds a lot of significance for retail investors while comparing mutual funds (MFs). You might have come across your MF agent saying an investment in XYZ Mutual Fund has become four times in the last 10 years. You may have also read that ABC Mutual Fund has generated 15 per cent on a CAGR basis. Do you know that four times in 10 years and 15 per cent CAGR in 10 years mean the same? As a prudent investor, one must understand how returns are calculated in different formats and how to interpret them correctly when you analyse a particular scheme.

Absolute return

Absolute return is what an MF earns over a particular period of time. This is the easiest way to calculate and interpret returns. If one had invested ₹1 lakh in SBI Bluechip Fund five years ago in June 2017, his/her investment would have grown to ₹1.61 lakh. This means an absolute return of 61 per cent. Hence, absolute return only considers the initial value and current value of the investment horizon. It doesn’t give importance to the tenure of the investment. Absolute returns should only be considered when the investment horizon is less than one year.

Trailing CAGR

You may have heard the term CAGR (Compounding Annual Growth Rate) in MF fact-sheets. This is one of the most commonly-used return metrics for analysing a particular fund’s return. If SBI Bluechip Fund has earned absolute return of 61 per cent over the last five years, its CAGR will be 9.99 per cent. CAGR representation can help you compare returns with other investment options such as a five-year fixed deposit which gives a return of, say, 7 per cent CAGR. In this case, the fund has done better. CAGR is nothing but year-on-year compounding return generated by an instrument. Unlike absolute return, CAGR takes into account the tenure of investment. One should not assume that this fund has earned 9.99 per cent each year. SBI Bluechip lost 13 per cent during 2019-20, while it gained about 58 per cent during 2020-21. Hence, CAGR doesn’t consider volatility of returns.

What’s in a return?

CAGR – year-on-year compounding return

Rolling return – a series of CAGR returns

XIRR – CAGR of investments with annualised return

Rolling return

Since volatility is inherent to market-linked investments, merely comparing MFs solely based on CAGR will not give the full picture. To take into account volatility of returns, one can use the rolling return metric. In this method, you will get a series of CAGR returns. For instance, if we take five-year rolling return over a 10-year period, we can check that SBI Bluechip Fund has generated a five-year CAGR return of around 18 per cent during 2013-18, 13 per cent during 2014-19, 5 per cent during 2015-20 and so on.

Hence, along with showing you how high your MF returns are, rolling returns can show you how consistent your returns could be. Despite being the most popular return calculation method, trailing or rolling CAGR doesn’t take into account periodic investments/withdrawals. CAGR can be used when an investment is made and held over time. So, it can be used in the case of lumpsum investments, but not periodic investments such as SIP.

The XIRR metric

An investor can make multiple investments on different dates over the investment horizon. In this situation, CAGR can’t give you one accurate single number telling you about the return. This is where the XIRR (Extended Internal Rate of Return) is the solution. This metric gives you an annualised return considering all the investments and withdrawals during different time periods. The XIRR can be helpful when one wants to check the return on SIPs. While investing in SIP, one would invest a certain amount at regular intervals and each such amount would remain invested for a different time period. The XIRR takes into account the CAGR of all investments and comes up with a single annualised return.

Relative return, total return

When investing in an active MF, one pays higher expense ratio compared to passive schemes. So, it becomes important to know how much extra the fund has delivered compared to its benchmark index. This is how you calculate relative return of the fund. When you compare the return of your fund with the fund’s stated benchmark, you must check whether the latter is PRI (Price Return Index) variant or TRI (Total Return Index) variant. While PRI captures only capital appreciation, TRI considers returns from dividend too. Hence, one should always look at TRI for a fair comparison. A good actively-managed fund will usually outperform its benchmark in rising, falling and flattish market scenarios.  

Published on June 11, 2022