How Are Returns Calculated in SIP
“If you can’t measure it, you can’t improve it”, goes a popular saying. The importance of measurement cannot be understated, especially in investing, where the returns will tell you how successful you have been in your endeavours.
Investing in mutual funds through a systematic investment plan (SIP) has recently gained popularity. An SIP allows an investor to invest a predetermined amount of money periodically.
However, due to the nature of an SIP and the varying net asset value (NAV) of mutual fund units, the calculation of returns can be tricky. In this article, we will go over how returns are calculated for an SIP and the various methods to do so.
There are three ways in which one can calculate returns on their investment. Let’s take a detailed look.
Absolute Return
Absolute Return helps an investor measure the returns of an investment by considering the initial value and the present value of the investment. The method to calculate absolute returns is straightforward and suitable to measure the short-term performance of an investment.
Absolute returns can be calculated using the following formula:
Absolute return = [(Final value – Initial value) / Initial value]*100
Here’s an example of how absolute returns are calculated.
Mr. A invested Rs 1,00,000 in a mutual fund. After a while, the investment had grown to Rs 2,00,000.
Using the formula we can measure the absolute returns of the investment.
Absolute Return = [(2,00,000 – 1,00,000)/1,00,000]*100
= [1,00,000/1,00,000]*100
= [1]*100
= 100%
Therefore, the absolute return on Mr. A’s investment is 100%.
Although calculating absolute returns is a straightforward method and requires less information, it has several disadvantages. Since the method does not take into account the tenure of the investment, it fails to measure the pace at which the investment grew or declined.
For example, Mr. A’s investment delivered 100% returns. However, the absolute returns will not help one ascertain whether the growth happened over a couple of months, a year, or multiple years.
Further, absolute returns are not a reliable metric to compare different mutual funds. Let’s say one investment delivered an absolute return of 500% over 10 years while another investment delivered an absolute return of 300% in 7 years. Since the holding period for both investments varies, it is difficult to gauge which of the investments performed better.
Compounded Annual Growth Rate (CAGR)
Compounded Annual Growth Rate is another method of calculating SIP returns by measuring the annual growth of the investment. CAGR takes the investment tenure into account which reduces the limitations of the absolute returns method of calculation.
CAGR also takes compounding into account. Compounding is a key term in understanding SIP returns. Compounding is a phenomenon in which profits are reinvested which results in an exponential growth in returns over a longer period.
CAGR is calculated using the following formula:
CAGR = [(Final investment value / Initial investment value)^(1/n)] – 1
Where n = the investment tenure in years.
Let’s take Mr. A’s investment again to understand how the CAGR is calculated.
|
Initial Investment |
1,00,000 |
|
Final Investment |
2,00,000 |
|
Investment Tenure |
5 |
|
CAGR |
[(2,00,000/1,00,000)^(1/5)] -1 = 0.1487 = 14.87% |
From the above example, we can conclude that Mr. A’s investment grew at a CAGR of 14.87%. The CAGR allows one to know the average growth of a fund on an annual basis. CAGR is suitable for lump sum investments. Put another way, the CAGR ignores any fluctuations that may have happened in the interim and gives a figure (14.87% in the above example) that can be assumed to be a linear rate of growth that will grow the initial amount (Rs 1 lakh) to the final amount (Rs 2 lakh).
While CAGR is useful for calculating returns of a single investment spread out over multiple years, it still has its limitations when calculating SIP returns. That is because an SIP consists of multiple investments and it will be difficult to calculate the CAGR for each investment, much less derive any clear picture out of it.
Extended Internal Rate of Return (XIRR)
One of the most suitable methods of calculating SIP returns is the extended internal rate of return (XIRR). XIRR calculates the returns on each investment in an SIP which provides an accurate representation of a portfolio’s performance over a period of time. XIRR is especially suitable for SIPs where multiple investments and withdrawals are made.
Since SIP investments consist of multiple instalments, the returns and investment tenure will differ for every instalment.
Let’s assume, Mr. A invested Rs 10,000 each month in a mutual fund scheme. The invested value after 3 years, or 36 months, has grown to Rs 3,60,000. The calculation of returns will be complex since the Rs 3,60,000 was not invested at one time but rather in a staggered manner.
XIRR solves this challenge.
This method aggregates the CAGR of each instalment made in an SIP to calculate its return rate. Since XIRR takes into account the time value of money and the timing of cash flows, it helps an investor accurately gauge the returns of the investment made over a period of time. Further, an investor can use XIRR as a reliable metric to compare the performance of different mutual fund portfolios.
XIRR is calculated using the following formula:
XIRR = (NPV (Cash Flows, r)/ Initial Investment)*100
XIRR can also be calculated easily with an Excel formula:
=XIRR (value, dates, guess)
Terms Related to SIP Returns
Here are some key terms related to SIP returns that one should know.
- Net Asset Value (NAV) is the price per unit of a mutual fund.
- CAGR measures the average annual growth of an investment.
- Absolute returns measure the gains or losses of the total investment value.
- XIRR takes into account the timing of transactions and the time value of money to calculate returns.
Conclusion
Calculating the returns on your mutual funds is a crucial step while making financial decisions. However, to accurately calculate the returns, it is vital to use the correct method. The XIRR method is suitable for calculating SIP returns while CAGR is suitable for lump-sum investments.