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Evaluating returns: simple and complex

There is no one right way of assessing performance. Use a combination of tools to get the right picture

An accurate evaluation of your investment performance is a must. While, investment return is about exactly how much more money you make, assessing the performance of the product or portfolio isn’t quite so simple.

To do the latter, first you need to compare returns either against other products or at least a benchmark. Second, if you invest in regular instalments, then the return from each instalment will be different at any given point in time. So your performance evaluation formula has to consider both cash flows and comparison. When all these factors come into play, evaluating performance becomes more than just the amount of money earned on an investment. And this is where it becomes important to distinguish between a simple absolute return and annualised returns such as XIRR and compounded annual growth rate (CAGR).

Read on to see what these terms mean for portfolio performance and why you should look at more than just one parameter to get a fair understanding of returns.

Absolute: simple returns

Absolute returns show you exactly how much your money has grown (or de-grown). So, if you invested 10,000 two years ago and today the investment is worth 15,000, your absolute return is 5,000, or in percentage terms, 50%.

This simple representation is why absolute return is the most popular way in which people like to look at returns.

“Looking at absolute returns gives a sense of how much money there is in the pocket and hence, people like to see that value for their overall portfolio," Srikanth Meenakshi, co-founder and chief operating officer, Fundsindia.com.

Absolute returns are an accurate method of assessment for fixed return products that have a defined annual payout, which can be compared across periods. However, when it comes to dynamic-return products or a portfolio with more than one type of security, looking at the absolute returns doesn’t give the full picture, and is not accurate in defining your return. This is because products with dynamic returns need to be benchmarked and then the time period of your investment matters.

Let’s say you have invested 10,000 in 2010 in a fixed deposit that will give you 15,000 (pre-tax interest + principal) after five years, in 2015. At the same time, let us say you have a debt mutual fund investment, which you started off with 10,000 in 2011, and find that it has increased only to 14,000 in 2015. Simply comparing 15,000 and 14,000 may give you the impression that the mutual fund investment hasn’t done as well but it has completed only four years, versus the five of the fixed deposit. Therefore, if we use absolute returns, they are not strictly comparable for the two products.

Abhishake Mathur, head investment advisory, ICICI Securities Ltd, said, “If your portfolio hasn’t gone beyond a year then point to point absolute returns work. But absolute returns as such do not convey the full picture especially in long term."

Moreover, for a portfolio of securities where investments keep getting added at various times, an absolute return doesn’t mean much since each investment hasn’t been held for an equal period of time.

Compounded annualised returns

To compare investments across time periods, there has to be a standardised return that you can rely on regardless of how much time you have owned the investment. The practice is to compare annualised returns rather than absolute.

CAGR is a form of annualised returns that breaks down returns and spreads evenly across one-year periods. Since, for most fixed return securities interest coupons are also expressed as annual payouts, it makes sense to compare annualised returns on dynamic products such as mutual funds.

Even when we look at physical assets such as gold and real estate, people mostly talk in terms of absolute returns, whereas the better way would be to compare annualised returns as that means comparing returns across asset classes and time periods in a better way.

In the example above, the fixed deposit which grew to 15,000 in five years had a CAGR of 8.44% and the debt fund, which grew to 14,000 in four years, 8.77%.

Looking at CAGR is important if you are comparing returns between two products, against a benchmark or for a portfolio. But here the interpretation of the return is a hurdle. CAGR is represented as a percentage and this can be confusing.

On websites such as moneycontrol.com and Valueresearchonline.com, you can input details of your mutual fund portfolio and stocks (Moneycontrol) and create a portfolio tracker which gives an overview of the performance with statistics including annualised returns.

“While clients do understand the annualised returns on their own portfolio, when it comes to published returns of products, the multiple time periods can get confusing. We are frequently asked questions like, if a fund’s one-year performance is 25% and three-year performance is 17%, then why should I invest (since the three-year return is lower)," said Srikanth. In the example here, the fund has earned an average of 17% per year for three years.

Even though CAGR is one number, it is not representative of linear growth in money; it depicts the final return in terms of per year return so that it is comparable. Keep in mind that the annualised return here is for investments which are more than a year old. For those that are yet to complete a year, absolute returns are more accurate since the annualised return is an estimation (given that a year is not over yet) and which can vary from the actual annual return.

Decoding XIRR

Most of us invest at different times. There could also be instances of withdrawals from time to time. When performance is to be measured with regular cash inflows and outflows, simply annualising returns isn’t enough. While CAGR is a good way to track the investment returns of a product, your own return will be influenced by interim cash flows as well.

This is where XIRR comes into play. This basically measures the internal rate of return (IRR) while adjusting for the cash flows. So, XIRR works well in evaluating the return of a systematic investment plan (SIP) or a portfolio that has SIPs and systematic withdrawals.

Ashish Shanker, head investment advisory, Motilal Oswal Wealth Management Ltd, said, “Where multiple cash flows are involved, XIRR is the most common way to evaluate performance. People understand it and it reflects how a client has allocated return."

But this too is an imperfect formula. The shortcomings of XIRR originate from the fact that the formula considers both realised and unrealised gains, and it shows returns assuming that any money taken out earns a similar return. Say, you withdrew half of your investment at 50% gain a year ago and today the remaining investment is at a lower gain of only 25%, the XIRR will show a value between 25% and 50% even if the money still invested isn’t earning that much.

Ideally, your adviser will be able to give a detailed evaluation. Or, if you invest through a broking site, such an analysis is possible. However, not all mutual funds provide such detailed return comparisons if you invest directly with them online.

What should you do?

Performance evaluation needs to be scientific but at the same time, it has to appeal to your intuitive mind. Experts are unanimous in saying that it’s best to refer to more than one measure. While absolute return will show the growth in quantum of money, for the overall portfolio, look at annualised return, which can be compared against a benchmark or can be used to compare products in different asset classes.

If your portfolio has moved from 1 lakh to 1.5 lakh, but you haven’t booked any profits or redeemed money, your portfolio statement should show an absolute gain of 50,000. But since the portfolio has a mix of different securities, how do you assess whether this return is good or not? For that you have to compare returns against a benchmark (which can be incorporated according to your asset allocation), using annualised percentage returns. XIRR is annualised return with multiple cash flows.

Mathur said, “It also helps to define the objective of performance evaluation; do you want to evaluate your experience with an investment in the past or do you want to benchmark with the market, or is it to see if you have achieved a target return of the investment that you hold today."

To see how your much money you are making, absolute returns are good.

To see if you have achieved a target return, you will have to look at unrealised gains. To judge portfolio performance, comparing annualised returns against a benchmark will work. Together these will give the most accurate information on how much you are earning and how this performance stacks up against a benchmark. So, keep track of both.

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