CAGR vs Absolute Returns: Which is Better for Mutual Funds?
Investors often focus on mutual fund performance, but assessing it can be challenging. There are multiple ways to evaluate a fund's returns, with Compound Annual Growth Rate (CAGR) and absolute returns being two of the most commonly used methods. Understanding the distinction between CAGR vs absolute return enables investors to better gauge their mutual fund's performance and track their progress toward achieving financial goals.
What is CAGR in Mutual Funds?
Compounded Annual Growth Rate (CAGR) is a metric used to show the returns a mutual fund generates over a given time, with the assumption that all profits are reinvested. CAGR indicates the annual growth rate of an investment, reflecting how it reaches its final value over time. It simplifies fund performance, making it easier to comprehend and compare with other investments. By using CAGR, you can assess and compare the performance of two different investments over a specific period.
The formula to calculate Compounded Annual Growth Rate in mutual funds is as follows:
CAGR = [{(Ending value/ Beginning value) ^ (1/n)} – 1] X 100
Here
- The ending balance represents the investment's value at the conclusion of the investment period.
- The beginning balance is the investment's value at the start of the investment period.
- n represents the investment tenure
Suppose you made an initial investment of Rs 80,000, which increased to Rs 1,20,000 over seven years. Using the formula:
CAGR = [{(1,20,000/ 80,000) ^ (1/7)} – 1] X 100= [{(1.5) ^ (0.14)} - 1] X 100 = [1.0596 - 1] X 100 = 0.0596 X 100 = 5.96%
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What is Absolute Returns in Mutual Funds?
Absolute returns in mutual funds indicate the total return generated over a specific period. This figure represents the overall growth or decline in the value of the investment since the initial date of investment and is expressed as a percentage. Absolute returns focus solely on the investment's pure performance, which can either be positive or negative. Fund managers strive to achieve positive absolute returns through various strategies, including short selling and the use of derivatives.
The formula to calculate absolute returns in mutual funds is as follows:
Absolute Returns = [(Current Value / Initial Investment Value) – 1] X 100
For example, suppose you invest Rs 50,000, and over time, it increases to Rs 85,000.
To calculate the absolute return:
Absolute Return = [(85,000 / 50,000) -1] X 100
Absolute Return = 70%
Comparison of CAGR vs Absolute Returns
The following table shows the difference between CAGR and absolute returns:
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CAGR vs Absolute Returns |
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Parameters |
CAGR |
Absolute Returns |
|
Objective |
Indicates the yearly return on an investment over a specified period, assuming profits are reinvested |
Reflects the total increase or decrease in investment value, regardless of the investment period |
|
Calculation Formula |
[{(Ending value/ Beginning value) ^ (1/n)} – 1] X 100 |
[(Current Value / Initial Investment Value) – 1] X 100 |
|
Consideration |
Takes the investment duration or tenure into account |
Does not consider the investment duration or tenure |
|
Accuracy |
Provides a more accurate and comparable earnings percentage |
Less accurate for comparing investments of different durations |
|
Suitability |
Applicable for calculating return on investment (RoI) held for over a year |
Applicable for calculating return on investment (RoI) held for less than a year |
CAGR vs Absolute Return: Which is Better?
Both CAGR and absolute returns are considered valuable metrics when it comes to evaluating investment performance, but the key difference lies in their approach to time.
Generally, CAGR is a preferred metric for longer-term investments. This is because CAGR calculates the annual growth rate of an investment over time, reflecting how the investment's value changes each year and providing a clearer picture of its growth pattern. Alternatively, absolute returns simply measure the difference between the initial investment and the final value at the time of sale, without accounting for the time factor in determining profit or loss.
If you hold investments for less than a year, the straightforward nature of absolute returns might make them a more suitable choice. However, when dealing with investments over several years, CAGR provides valuable insights into the growth pattern and overall performance.
The Bottomline
After this close look at CAGR vs absolute return, it is clear that both methods have their own unique advantages depending on your investment timeline. The absolute return shows the actual financial result of an investment, while CAGR offers a consistent way to compare different investments, especially for the long term. You should consider both metrics to fully understand how an investment is performing, keeping in mind their risk tolerance and investment goals before making any decisions.
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