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Business News/ Money / Personal Finance/  What is CAGR in mutual funds and why does it matter? MintGenie explains

What is CAGR in mutual funds and why does it matter? MintGenie explains

A fund’s CAGR reveals the extent to which your investment has expanded during a specific time frame.

The CAGR is a useful tool for evaluating mutual funds and making informed investment decisions.Premium
The CAGR is a useful tool for evaluating mutual funds and making informed investment decisions.

The main goal of investing in mutual funds is to generate substantial returns and construct a prosperous investment portfolio. Mutual funds provide several benefits that render them a favoured option for amassing long-term wealth, including:

Diversification: Mutual funds spread their investments across a range of securities, mitigating risk. If one security underperforms, others may still yield positive results.

Professional management: Skilled investment managers oversee mutual funds, leveraging their knowledge and expertise to make well-informed investment choices.

Affordability: Mutual funds offer cost-effective investment options, making them accessible to investors across various income brackets.

Liquidity: Mutual funds are highly liquid investments, thus, allowing for easy buying and selling.

Apart from the main goal of attaining returns and creating wealth, mutual funds can also serve as a means to fulfill other financial objectives, including saving for retirement, funding a child’s education, or purchasing a home.

Gauging fund performance through CAGR

Prior to selecting from the extensive range of mutual funds, it’s essential to examine their historical earnings. While future returns may not replicate past performance precisely, it remains valuable to assess how well the fund has maintained stability in the face of stock market fluctuations.

Mutual fund returns provide vital insights into the growth or decline of your investment over time, and they can be calculated through different methods. One common way of judging the quality of a fund is by looking at its Compounded Annual Growth Rate (CAGR).

The CAGR figure reveals the extent to which your investment has expanded during a specified time frame. When assessing a lump-sum investment with a duration exceeding one year, this proves to be a useful calculation method.

How to evaluate the CAGR of a fund?

Calculating a fund’s CAGR is a more precise method for determining long-term mutual fund returns. This approach considers the compounding effect, which means it computes the average annual return that an investment has generated over a specific timeframe, assuming reinvestment of returns annually.

The CAGR is calculated using the following formula:

CAGR = [(Current NAV / Initial NAV) ^ (12 / number of months)] - 1 × 100

Current NAV refers to the value at the time of redemption, while Initial NAV corresponds to the value at the moment of investment.

Why use CAGR to assess a mutual fund?

The CAGR provides insight into how compounding influences your investment returns. It aids in establishing achievable investment objectives and monitoring your advancement toward those objectives.

Here are some advantages of employing CAGR for mutual fund return calculations:

  • It offers a standardised performance measure, simplifying comparisons between various mutual funds.
  • It factors in the compounding effect, crucial for long-term investors.
  • It presents a consistent portrayal of the fund’s performance over multiple years, even in the presence of short-term fluctuations.

Certainly, this metric proves to be valuable for comparing the long-term performance of various mutual funds. Additionally, it serves as a useful tool for monitoring the growth of your own mutual fund investment as time progresses. Also, it proves particularly beneficial when comparing the performance of diverse mutual funds, as it factors in the compounding effect.

In contrast to absolute returns, CAGR offers a more precise assessment of a mutual fund scheme’s investment potential. Additionally, CAGR assists in gauging the level of return volatility within a specific time frame.

When should you use the CAGR method?

CAGR is frequently employed in the evaluation of mutual funds featuring consistent cash flows, like systematic investment plans (SIPs) and systematic transfer plans (STPs), as it presumes a consistent growth rate over a specific timeframe. This attribute makes it well-suited for comparing funds that maintain a steady investment pattern, including large-cap funds, balanced funds, and hybrid funds.

Moreover, it proves valuable for conducting in-depth long-term investment assessments, offering a straightforward gauge of the mean annual return across a defined duration. This can be advantageous for investors seeking to juxtapose diverse investment choices like mutual funds, stocks, and bonds, or for those aiming to monitor their investment performance throughout time.

Here are some instances of how CAGR can be employed in the evaluation of mutual funds:

  • An investor may assess the five-year CAGR of two large-cap funds to determine the superior long-term performer.
  • An investor might monitor the one-year CAGR of their balanced fund to assess its performance relative to the market benchmark.
  • An investor could utilise CAGR to juxtapose the returns of various asset classes, encompassing mutual funds, stocks, and bonds.

Nonetheless, it’s important for investors to recognise that CAGR represents historical data and doesn’t ensure future performance. Nevertheless, it remains a valuable instrument for assessing mutual funds and aiding in well-informed investment choices. The choice of calculating mutual fund returns depends on your specific needs and objectives. If your investment horizon is long-term, CAGR is typically the recommended method.

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Published: 26 Oct 2023, 09:05 AM IST
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