Understanding Mutual Fund Returns: CAGR, XIRR, Rolling Return

Significance of Mutual Funds returns – CAGR, XIRR, Rolling Return:

Understanding MF Returns: CAGR, XIRR, Rolling ReturnReturns have always been the basic benchmarks while going for any investments. These indicate how much the fund has lost or gained during particular investment tenure. You may come across returns expressed in a variety of nomenclatures.

Sometimes, these may be quoted as absolute returns, and at other times you may find them as CAGR. When you go for SIPs, you may be guided to ascertain the IRR or XIRR of the fund whereas in the case of lump sum investment the factsheet may highlight the rolling returns of the fund.

Have you ever wondered “what does each kind of return signify?” Or “Why not use a single kind of return in all types of investments?” “What is the need to quote CAGR in lump sum investment while XIRR in SIPs?” It is the awareness of these subtle yet significant differences that is going to take your investments to new heights. The more you get to know the significance and application of each one these returns, the more comfortable you are going to feel with your investment reports.

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As a prudent investor, now it’s time to know the relevance of each one of these returns to make comparisons and interpretations in a better and accurate manner.

Also read: How to Select a Good Mutual Fund that suits you best

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Absolute/Total Return

The absolute return or total return refers to the amount of funds that your investment has generated over the investment horizon. It measures how much your investment has gained or lost in percentage terms. It means if NAV of your investment was Rs. 150 at the beginning of the year and it reached to Rs 200 at the end then what percent of value was added to the fund. It is calculated as follows:

Absolute returns = 100* (Selling Price – Cost Price)/ (Cost Price)

Suppose you bought units of an MF scheme in January 2005 by investing a lump sum amount of Rs 20,000. After completion of one year, you redeemed your investment in January 2006 at the cost of Rs 30,000. Hence, how much money you made out of this or the Absolute returns in this case will be:

Absolute Returns = 100* {(30000-20000)/(20000)} = 50%

But there lies a demerit in this measure. You may be aware of the time value of money i.e. a rupee received today is more valuable than rupee received tomorrow. But the absolute returns does not account for the investment horizon. If you had redeemed your investment after three years instead of the said tenure, even then also the absolute returns would have used the same method to calculate returns. So, this can be called as a crude measure which needs to be considered with other sophisticated measures.

Relative Return

Now imagine a situation when your portfolio generated a return of 20% when the Nifty earned 25% but fell only 10% when the benchmark falls to 15%. How will you decide whether you have invested in the right mutual fund or not?

In such cases, you need to make use of the Relative Return. It is the excess return generated by the portfolio over benchmark returns. If the absolute returns of your mutual fund portfolio are 15% and the benchmark index say Nifty earned 12%, then the relative return would be +3% (15%-12%) which means that your portfolio outperformed the benchmark index by 3%. It, in turn, means your money is in the right hands.

However, while using relative return to assess the performance of your mutual fund investment, it would be prudent to compare it against an appropriate benchmark. Selecting an appropriate benchmark is necessary to avoid misinterpretation of results. Moreover, the benchmark should also reflect the investment style of the portfolio, the amount of risk you are willing to assume, the amount of investment and the cost you undertake for such investment.

In other words, relative return helps to determine the value added by the fund manager. An ideal portfolio is one which outperforms the benchmark during bull runs and makes fewer losses when the benchmark tends southwards.

Compound Annual Growth Rate (CAGR)

Consider a scenario wherein a fixed deposit gives you Rs 55,000 for an investment of Rs 50,000 for one year while the same amount when invested in the mutual fund for 2 years gives you Rs. 65000. How would you decide which is a better investment?

In such cases, you may use CAGR as a deciding criterion. It is the year-over-year growth rate of an investment over a specified period. To calculate CAGR, divide the price at the end by the price at the beginning, then take the nth root of the result wherein ‘n’ stands for the number of periods and finally subtract one from the following result. The formula is represented as follows:

CAGR= {(Ending value/Beginning Value)^(1/n)}-1

Let’s understand with the help of an example:

Suppose you started mutual fund investment on Jan 1, 2015, with a lump sum of Rs10,000. Let us assume that by Jan 1, 2016, your portfolio had grown to Rs13000, then to Rs14000 in 2017 and reached a high of Rs. 19,500 by Jan 1, 2018. The CAGR is computed as follows:

CAGR = {(19500/10000)^(1/3)}-1 = 24.93%

It means that on average your investment would have grown at the rate of 24.93% year on year.

However, the CAGR isn’t the actual rate of return in the sense that it shows the rate at which your mutual fund investment may have blossomed if it had grown at a steady rate. But in reality, this never happens. CAGR just acts as a tool to smooth out the fluctuations present in an investment’s returns to make the figures comprehensible.

It is better than absolute returns as it considers the time value of money and gives a broader picture of portfolio performance in the face of inconsistent annual returns. It can be used as a criterion to shortlist an investment avenue from amongst several alternative avenues like FDs, MFs, real estate, gold, etc.

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Nevertheless, you cannot count on CAGR only as a holy cow because it has certain limitations. Firstly, it ignores volatility by assuming steady growth rate over the entire investment tenure. Your returns may have fallen several times below 24%, but that’s not shown by CAGR. Secondly, it shows historical performance as in you should not expect your investments to grow as per CAGR in future. Thirdly, it does not consider the in-between values and relies only on  the Ending value & the Beginning Value which may again give a wrong picture if you ignore yearly returns.

Rolling Return

You must have been very satisfied with using CAGR as an appropriate tool. But consider a scenario where there are two funds A and B. NAV of both the funds were Rs 100 on 1 January 2014 and increased to Rs 200 on 31 December 2014. The CAGR comes out to be 100% for both the funds.

Now, how will you decide which is a better investment option?

As a prudent investor you need to understand that apart from higher returns, a mutual fund should also give consistent returns. But as CAGR depends only on  beginning and end values, it does not indicate what happened in between the investment period.

This kind of problem can be solved by using rolling returns which divide the larger tenure into smaller investment periods to give an in-depth picture of the stream of returns generated by the fund. Hence, the rolling return is the annualised average of the smaller period returns. It enables examining the behaviour of returns for investment horizons similar to those experienced by investors.

Rolling returns are calculated by adding the following period and dropping the oldest period until you get single point results for the all the periods in the particular investment tenure. Unlike point-to-point return, it helps to assess the consistency of the fund.

Let’s understand this with an example.

The table below shows the monthly rolling returns for 1-month, 3-months and 5-months for Mutual Fund (Growth) for a 13-month period starting from 1 Jan 2015 to 1 Jan 2016. CAGR of 2.907% shows that the fund grew at the rate of 2.907% over the one year. But, the rolling returns present a different picture altogether by highlighting that the fund fared poorly regarding consistency. It generated more negative returns as compared to the positive returns and hence carries a greater risk of loss.

Rolling returns for the Mutual Funds

Although rolling returns are better analytical tool than other single point returns, it possesses some demerits which limit its scope of use. The usage of the data in the middle is more as compared to the beginning and ending values.

Internal Rate of Return (IRR) & Extended Internal Rate of Return (XIRR)

Suppose you invest SIPs of 4000, 9000, 5000, 4000 and 6500 in 5 yrs and receive Rs. 53,000 at the end of 5 yrs then what is your Return on investment? It is 22%. The resultant value is known as IRR. This concept is used to find out how much have you earned out of your investments in case of cash flows that are equally spaced in time. It means that you invested the amounts mentioned above every year on 1st of January.

Also read: SIP vs Lump sum Investment

But usually, investments are not as evenly spaced as you saw above. Especially, in the case of mutual fund investments, you tend to invest and redeem investments at irregular intervals. It will cause cash inflows and cash outflows at different points in time. In such a scenario, in addition to the amount of investment, the time of such investment also assumes significance to yield certain outcome. You may use the concept of Extended Internal Rate of Return (XIRR).

The table below shows that you earn XIRR at 48.98% when the return is computed on the same series of investments along with the time of investment as additional consideration.

Calculation of XIRR for a Mutual Fund investment

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Final Words

You may have been able to relate the importance of returns in your mutual fund investments. In the case of lump sum investments make use of CAGR and absolute returns. When going for SIPs which happen to spread over the entire investment period, employ XIRR to get a correct picture of your returns. Ultimately, being a smart investor is all about knowing what you want and then ensuring that you get it as envisaged.

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About the author

KishorKumar Balpalli, believes that financial literacy and discipline is the key to one’s financial freedom. KishorKumar is a Certified Financial Planner, Personal Finance Blogger & the Founder of myMoneySage.in an award-winning Wealth Management platform. myMoneySage simplifies investing for individuals and amplifies business growth for Registered Investment Advisers by leveraging Artificial intelligence and machine learning. The AI of the machine plus the intellect of the human advisor enables comprehensive & client-centric advice at a fraction of the cost of a conventional adviser.

myMoneySage.in is an award winning personal finance platform. It helps you aggregate all your personal finance accounts like FD, Equity, Mutual Funds, PPF EPF, NPS including, Credit Cards & Loans etc. It's one place where you can track, plan and invest seamlessly. myMoneySage.in empowers you to invest in zero commission direct plans of mutual funds thereby helping you generate higher on investments. The best part is it comes with a lifetime Free plan.

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  • Varun Mundra says:

    Compare Rolling Returns of upto 5 funds here

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