Mutual Funds and Compound Annual Growth Rate (CAGR): Understanding the True Return on Investment

When mutual fund managers advertise or discuss a potential return of '10-12% in 10 years', it is often in the context of Compound Annual Growth Rate (CAGR). This article explains why CAGR is a crucial metric for understanding investment performance over time.

Understanding CAGR in Mutual Funds

The short answer is yes, CAGR is typically used to describe the potential growth of an investment over a specific time frame. Let’s understand why CAGR is preferred over absolute returns through examples.

Example of Absolute Return vs. CAGR

Imagine you invested Rs. 1 lakh in a mutual fund scheme. Over 10 years, the investment earned Rs. 50,000 in profit. At first glance, a 50% return on investment seems quite impressive!

However, the actual value of this return is heavily influenced by time. If this profit was earned in one year, you would indeed be happy. But if it took 10 years, the growth rate per annum would be much lower. This is where the concept of compound growth becomes essential.

The Role of CAGR in Mutual Funds

CAGR (Compound Annual Growth Rate) measures the average annual growth rate of an investment over a given period. It accounts for the time value of money and the effects of compounding. This metric is crucial for mutual funds as it shows the consistent growth rate that your investment has achieved each year.

In mutual funds, the return on your investments, including any profit, is reinvested. As a result, CAGR provides a more accurate view of the long-term performance of your investment, as it considers both the principal and the reinvested returns. Depending on the time period, an investment with a 10-12% CAGR over 10 years will yield significant growth.

Comparing Mutual Fund Schemes Using CAGR

Consider two examples:

Example 1

Investment Scheme A delivered an absolute return of 45% over 3 years. So an initial investment of Rs. 1 lakh grew to Rs. 1.45 lakh.

Example 2

Investment Scheme B delivered an absolute return of 38% over 2 years. So an initial investment of Rs. 1 lakh grew to Rs. 1.38 lakh.

If you only look at the absolute returns, Scheme A appears to be a better investment. However, when you use the CAGR formula, the story changes:

Scheme A would have delivered a CAGR of approximately 13.2%. Scheme B would have delivered a CAGR of approximately 17.5%.

Therefore, Scheme B is growing at a faster rate, indicating better long-term performance using the CAGR metric.

Conclusion and Further Reading

It is essential to use CAGR to evaluate mutual funds and understand the true return on your investment. By considering both the principal and reinvested returns, CAGR provides a clearer picture of the investment's performance over time. This makes it easier to compare different mutual fund schemes and make informed decisions.

To deepen your understanding of personal finance, follow us at ET Money.