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How Are Returns Calculated in SIP

27 December 2021

There are two ways to invest in a mutual fund.

In an SIP, a predetermined amount is invested in the mutual fund every month. In a lump sum deposit, the amount invested is a constant figure on which the return is calculated.

The mutual fund’s units are bought at a particular NAV with lump-sum investments while the NAV keeps fluctuating with SIP investments. This makes it difficult to assess the lump sum and SIP returns with a single method. 

There are three ways to calculate mutual fund returns. Let us discuss these in detail. 

Absolute Return

Absolute returns calculate how much you have gained (or lost) in a year. The method to calculate mutual fund returns is straightforward. It shows point-to-point growth in your investment, often under one year. It requires a basic formula, which is as follows:

Absolute return = [(Final NAV – Initial NAV) / Initial NAV]*100

Let us take an example. 

Assume that the initial NAV of your investment is Rs. 50. This grows to become Rs. 65. This would mean that the absolute return on your investment would be:

Initial NAV Rs. 50
Final NAV Rs. 65
Absolute Return
[(Final NAV- Initial NAV) / Initial NAV]*100
[(65-50)/50]*100
= 30%

Let us see how to do this if you wish to calculate the return in terms of the amount invested. Assume that you invested Rs. 1,00,000. This amount has grown over a year to become Rs. 1,30,000. In this case, absolute return is calculated as: 

Initial Value Rs. 1,00,000
Final Value Rs. 1,30,000
Absolute Return
[(Final value – Initial value) / Initial value]*100
[(130000-100000)/100000]*100 

= 30%

Things to know about absolute returns

  • This method of calculating SIP returns has immense benefits, the foremost one being the ease of calculation. All you need to know is the present value of your investment and the amount you initially invested. It is a great tool to measure the return on short-term investments. 
  • However, the disadvantages of this method are more significant. It does not consider the tenure of investment. This means that it will indicate the growth (or decline) of investment, but not the pace at which this happened. It also makes the comparison of two mutual funds difficult. In the above example, a 30% return seems enticing, but whether this gain was made in 6 months, 1 year, 3 years, or 5 years cannot be ascertained.

This is where the Compounded Annual Growth Rate comes in.

 

Compounded Annual Growth Rate (CAGR)

CAGR eliminates the limitation of the Absolute Method of calculating SIP returns by taking the investment tenure into account. The mutual fund returns calculated are an average of the annual growth of the investment. It also assumes that the value of the investment gets compounded over the period. 

The formula used in this method is as follows:

CAGR = [(Final investment value / Initial investment value)^(1/n)] – 1

In the formula above, ‘n’ refers to the investment tenure in terms of years.

Let us take an example for easy understanding.

Assume that you invested Rs. 1,50,000 in a mutual fund of your choice. This amount grew to Rs. 2,00,000 over 5 years. The CAGR will be calculated as follows:

Initial investment value Rs. 1,50,000
Final investment value  Rs. 2,00,000
Number of years (n) 5
CAGR

 [(Final investment value / Initial investment value)^(1/n)] – 1

[(200000/150000)^(⅕)] – 1

= 0.05

= 5%

Things to know about CAGR

  • Therefore, 5% is when the investment grows every year to reach the final amount. The CAGR method of calculating mutual fund returns shows a picture of the yearly average performance of mutual funds. 
  • You may calculate the returns for different durations using this method. However, this displays an averaged outgrowth and overlooks volatility. It does not indicate that the mutual fund has grown by 5% every year. There may have been periods of negative returns, followed by very high returns, which may cover the negative gains- CAGR indicates neither of these. 
  • Another thing is that CAGR is apt for lump sum investments. It is not a preferred method for measuring SIP returns. If you use this method, you will have to calculate the CAGR separately for every instalment. This is because the time duration in the formula keeps changing every month.  For example, you start a SIP where you invest Rs. 10,000 every month for 2 years. For the first instalment, returns will be calculated for 24 months. The next one will be 23, then 22, and so on. This makes the calculation very tricky.

The question that arises here is how to calculate SIP returns? For this, the most suitable method is XIRR.

 

Extended Internal Rate of Return (XIRR)

XIRR is an excel function that helps calculate the returns on mutual fund investments via SIP.

A feature that gives XIRR method an edge over the others is that it considers all the different numbers of investments made during the investment period. These are also known as SIP instalments. In this method, the return is calculated by aggregating the CAGRs of every installment via a mathematical function of excel. 

The CAGR is calculated for every installment with a different period. For example, through your SIP, you invest Rs. 7,000 per month. This is then aggregated to give the value of your SIP return rate. The XIRR method is apt in this scenario as it gives a clear picture. Using the absolute method is misleading, as it disregards the time duration of the instalments while the XIRR method takes all of it into account.

Another benefit of using this method is that it makes SIP calculation easy. The formula for this comes in-built in MS Excel. All you need to do is employ the correct formula. Simply type: 

=XIRR (value, dates, guess)

You can create columns of information and put the cell numbers in the formula. The calculation will be done for you with a click.

You can also use mutual fund SIP return calculator.

 

To conclude

To calculate your mutual fund returns, first consider your way of investment. The calculations differ for the lump sum method and SIPs. The timing of your instalments also affects your returns. While the CAGR method is excellent for calculating lump sum returns, the XIRR method is best suited for SIP returns. You may even use a SIP return calculator on Groww to find the best mutual fund for yourself by comparing the investment return on each mutual fund via SIP over a set investment tenure. 

 

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