When it comes to investments, one would like to understand how their investments grew and at what pace over different time periods. There are many metrics that can be used to calculate the rate of return on investments, but the most common one amongst them is CAGR. CAGR is the annualized growth rate of investment over a specific period of time. In other words, it is a measure of how much your investments have grown during a given interval of time.
Many investors also calculate annualised returns to compare the investment performance of different funds. However, it does not consider the time value of money, and thus it will generally calculate higher returns, which may also lead to higher expectations amongst the potential investors.
One may use the concept of CAGR to calculate mutual fund returns and investment performance more effectively. It considers the time value of money, the overall investment period, and factors in the returns reinvested into the investment portfolio and provides with a single rate of return for the investments across periods.
Calculation of CAGR
1. Take the NAV of the fund at the end of the investment period.
2. Fetch the NAV of the fund at the beginning of the investment period.
3. Calculate the CAGR as per the formula:
CAGR= (NAV at the end/ NAV at the beginning) ^ (1/ No. of years) - 1
For example, the NAV of the fund at the time of investment is 100, which grows to 150 in 4 years. As per the formula using above, one may calculate CAGR to be 10.67%.
Limitations of CAGR
1. CAGR does not reflect the volatility of the returns: Since CAGR calculates a
smoothed rate of growth over a period, it ignores volatility and implies that the
growth during that time was steady. Hence, CAGR may leave a wrong
impression with investors of having steady returns across the investment
2. Another limitation when assessing investments with CAGR is that, investors
cannot assume the same rate of return will occur in the future.
3. CAGR is not effective for calculating returns from investments with a holding
period of less than one year.
Difference between CAGR and Absolute Return
Absolute return refers to the profits generated by the mutual fund during a period and may be calculated by merely dividing the fund appreciation with the actual investment cost. For example, if the fund has appreciated by 50% over the last four years, the absolute returns will be 50%, while the CAGR of the investments is calculated as 10.67%.
As such, CAGR is preferred over absolute returns when it comes to calculating the mutual fund returns
. This is because absolute returns fail to appreciate the investment period as well as the returns reinvested into the investment portfolio and calculate the returns only over the actual investment amount.
The absolute returns may be highly misleading for the investors, as the investment period gets longer.
Difference between CAGR and Annualised Return
Annualised return refers to the simple annual returns generated by mutual fund scheme during the investment period. It may be dividing the absolute returns with the investment period. For example, if the fund has appreciated by 50% over the last four years, the annualised returns will be 12.5%. However, such returns fail to appreciate the returns generated on the existing returns that are reinvested.
As such, it shows higher returns to the investors, which may be misleading. On the other hand, the CAGR of such investments is 10.67%, which is reflective of the actual investments, including the reinvested returns. Thus, CAGR is preferred over annualised returns as well.
Difference between IRR and CAGR
While CAGR is preferred to calculate returns between two time periods, IRR (Internal Rate of Return) is advisable when the investor has made multiple investments across different periods.
This is because CAGR considers only one investment amount, IRR carries the ability to calculate the returns through various investment amounts made at different periods. Thus, CAGR may be suitable for calculating returns for lump sum investments, while IRR may be suitable for calculating SIP returns.
CAGR is a well-accepted measure of mutual fund performance, widely used by the mutual fund houses as well for investment periods of more than one year. As such, one may make use of the CAGR formula and review the fund performance in a better manner.