Understanding the Basics of Compound Annual Growth Rate (CAGR) in Mutual Funds

 

CAGR full form is Compound Annual Growth Rate. CAGR in mutual funds is also termed as annualized returns and is commonly used as a performance parameter for a mutual fund scheme.

What is Compound Annual Growth Rate?

The Compound Annual Growth Rate (CAGR) commonly reflects the yearly returns generated by the mutual fund scheme, in contrast to absolute return, which only considers the return between two specific points in time without accounting for the duration required to achieve it. CAGR takes into account the effect of compounding.

CAGR is a commonly used parameter because it allows comparison of returns generated by diverse asset classes, as it presents the average annual return generated by an investment considering the initial invested amount, the final investment value, and the elapsed time period.

How is CAGR calculated?

There are a total of three inputs in the CAGR formula, these are:

1. Initial Investment Value → The value at the beginning of the period.
2. Final Investment Value → The value at the end of the period.
3. Number of years (n) → The total number of years invested.

 

The CAGR calculation process:

CAGR calculation formula: (Final Investment Value / Initial Investment Value ) ^(1/n) - 1Where: ‘n’ is the number of years invested.

CAGR calculates an investment’s average annual growth rate over a specific period, considering compounding. Let’s consider an investment with a starting value of Rs 100,000, and it grew to Rs 155,000 at the end of eleven years.

Using the formula, we calculated the CAGR for this investment = 4.48%

This means that, on average, the investment grew by approximately 4.48% per year over the eleven-year period. 

 

What is CAGR in Mutual Fund?

Mutual fund performance beyond one year is presented in Compound Annual Growth Rate form. Asset Management Companies (AMCs) commonly disclose CAGR figures for their schemes, including 1 year, 3 years, 5 years and since inception, in monthly fund factsheets or in performance disclosure advertisements. It's important to note that CAGR is applicable only for measuring point-to-point returns and cannot be used for SIPs, STPs, SWPs, etc. Nonetheless, CAGR serves as a reliable indicator of overall scheme performance. By comparing the CAGRs of different mutual fund schemes, you can make well-informed investment decisions. However, past performance may or may not be sustained and hence, if necessary, it's advisable to seek guidance from a financial advisor.

 

Selecting the best Mutual Fund using CAGR

Considering a scheme’s past performance is crucial when making investment decisions. It is essential to give adequate attention to this aspect to know the approximate period for which an investor will have to stay invested , allowing the investments to go through various market cycles. This approach can help investors evaluate the performance of the scheme in the past along with the timeframe for their investment which can be three, five, seven, or ten years and so on which in turn can help make informed decisions.

 

Understanding the limitations of CAGR

Although CAGR is commonly employed to assess the performance of schemes it possesses certain limitations, which are outlined below.

One limitation of CAGR is its failure to account for market fluctuations or volatility when evaluating the performance of stocks. This prevents a comprehensive understanding of the stock's true performance and can potentially misguide investors when making investment decisions.

Relying solely on CAGR is insufficient for making investment decisions in the stock market. Investors must consider other factors that incorporate the risks associated with market volatility and base their investment decisions accordingly.

CAGR does not capture short-term fluctuations in the market, making it an inadequate measure to compare two funds or portfolios for investment purposes. Therefore, it should not be used as the sole criterion when deciding between different investment options.

Conclusion:

All in all, CAGR can be a useful tool to help measure growth or decline in investment over a period of time. It can be used to evaluate past returns or estimate the future returns of investments. To invest in mutual fund schemes and get updates on mutual funds, investors can visit the websites of the mutual fund or Association of Mutual Funds of India (AMFI).

FAQ

What is the difference between CAGR and average annual return?

Average annual return provides the numerical average of annual growth rates. On the other hand, CAGR is the average compounded growth rate for the set duration of time.

Can CAGR be negative? If so, what does it mean?

The possibility of a negative compound annual growth rate exists, indicating a decline in investment rather than increase during a specific time frame.

What is risk-adjusted CAGR?

This refers to CAGR calculations that include the degree of risk that you must accept for the CAGR to be achieved.

 

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KMAMC is not guaranteeing/assuring any future returns/rewards.

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