What is CAGR in mutual funds

When Diya decided to start investing a part of her salary in mutual funds, including equity fund, debt funds and hybrid funds, her father asked her a simple question. What would the compound annual growth rate be, if you invest via lumpsum? Or are you planning to go the SIP route? Upon this question, Diya was confused because she did not know CAGR meaning or what CAGR in mutual fund actually meant. Her father advised Diya to read up on the topic and then, based on CAGR, take the right decision about investing.

What is CAGR in Mutual Fund?

First of all, CAGR full form can be defined as compounded annual growth rate. But what is CAGR? Well, in simple terms, CAGR is the annualised returns offered by any investment or asset, including mutual funds, and here, we will consider the different aspects of CAGR in mutual funds, along with the very important compounded annual growth rate formula. Before you move into CAGR, you need to understand the concept of compounding.

What is Compounding?

The concept of compounding is based on the theory of compound interest. With compound interest, you not only earn interest on your initial amount but also on the interest that has already accumulated on your investment. For example, you have INR 500 as your starting amount, and the compound interest rate is 5%. In the first year, the interest earned on INR 500 at a compound interest rate of 5% is: Interest = Principal × Rate = INR 500 × 0.05 = Rs 25. In the second year, the interest is calculated on the new total, which is INR 500 + INR 25 = INR 525. Therefore, you not only earn interest on your principal, but also on the interest generated by your principal. This scenario is also applicable to mutual funds, wherein you earn profits on the previously earned profits which are re-invested in the scheme. The concept of compounding works wonders over the longer term and has the potential to significantly multiply your investments. For instance, let's say you invested INR 5 lakhs in a mutual fund that provided compounded returns of 10%. After 20 years, your investment could grow to INR 33.6 lakhs. This example demonstrates how the compounding effect can multiply your investment by almost 7 times.

How is CAGR calculated?

Now let us come to the important CAGR formula. Having the CAGR calculation formula at your fingertips will enable you to easily calculate the annualised returns on your investments, thereby making you better prepared to take imperative financial decisions.

CAGR formula –

CAGR = {(Final Investment Value ÷ Initial Investment) (1 ÷ Tenure)} – 1

How to use CAGR for financial planning?

So, why did Diya’s father ask her to consider the CAGR on mutual funds? He did so to ensure that Diya would know how much return she can expect which would, in turn, allow her to align her portfolio with her underlying financial objectives. Similarly, you can also apply the formula to estimate how much your investment would actually be worth, at the end of your tenure. Here, you should use the following CAGR formula –

Future Value of Investment = Investment Amount X (1 + CAGR %) Tenure

Let's say, if Diya invests INR 5 lakhs in a hybrid mutual fund scheme today, with the expectation of earning 10% CAGR, and with a tenure of 10 years, then the amount of money she will accumulate will be –

5 X (1 + 10 %) 10 = INR 12.97 lakhs.

Difference between absolute returns and CAGR in Mutual Funds

The term absolute return, in mutual funds, refers to the percentage growth of your mutual fund investment. For instance, let’s say Diya’s investment increased from INR 5 lakhs to INR 7 lakhs in three years, her absolute return would be 40%, indicating a profit of INR 2 lakhs. However, the drawback of absolute return is its failure to consider the investment period. A 40% absolute return over 3 years might seem favourable, but the same return over 10 years might not be as impressive, especially when adjusted for inflation, which currently stands around 6%.  This is why CAGR is a more reliable measure of mutual fund performance, as it accounts for the investment's duration.

How is CAGR used in Mutual Funds?

Through her research, Diya realised that mutual fund performance beyond one year is typically presented as CAGR, with asset management companies typically revealing CAGRs for various periods – 1 year, 3 years, 5 years, and since inception – in their monthly fund fact sheets. It is important to note that CAGR is suitable for analysing point-to-point returns, but not applicable for SIPs, STPs, SWPs, etc. Nevertheless, CAGR serves as a valuable gauge of overall scheme performance because, by comparing CAGRs of different mutual fund schemes, you can make well-informed investment choices.

Now that Diya had a good idea about how much CAGR she could expect from different mutual fund schemes, she found it easier to select schemes which aligned well with her unique requirements. You can also apply this formula and add the most suitable mutual funds to your portfolio, thus making your investment journey all the more comprehensive.

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