Understanding Rate of Return in Equity Mutual Funds

The rate of return in equity mutual funds can vary widely, influenced by market conditions, the fund's investment strategy, the performance of underlying stocks, and the skill of fund managers. These funds aim for long-term capital appreciation by investing in a diversified portfolio of stocks, making their performance subject to the fluctuations of the stock market.

Choosing the Right Mutual Fund

When selecting an equity mutual fund, you should consider your time horizon and risk tolerance. Here are some popular fund categories:

Large Cap. Time horizon: 5 years. Risk level: lower Flexi Cap. Time horizon: 7 years. Risk level: medium Mid Cap. Time horizon: 10 years. Risk level: higher Small Cap. Time horizon: 15 years. Risk level: very high

It's important to note that there is no 'best' mutual fund, as the best ones change annually. Look for a fund that has generated returns exceeding the category average and benchmark index.

Understanding Returns and Risk

Mutual funds do not guarantee any returns; their aim is to generate profits through the appreciation of the underlying instruments. Past performance can provide insights, but it does not guarantee future returns.

Historically, one can expect an approximate return of 12% over a longer period, though this is not guaranteed, as equity investments come with inherent risks. For long-term investments, equity can provide returns higher than fixed deposits.

Types of Mutual Fund Returns

Mutual funds offer various methods to measure returns, including absolute returns, annualized returns, total returns, trailing returns, point-to-point returns, annual returns, and rolling returns. Here, we explain each in detail:

1. Absolute Returns

Expressed as a percentage, absolute returns indicate the increase or decrease in investment over a predefined period. For mutual funds with a tenure of less than a year, absolute returns are used. For longer periods, annualized returns are more appropriate due to the compounding effect.

2. Annualized Returns

Annualized returns measure the growth of investment value annually. For instance, if you invested Rs. 1 lakh in a scheme and it grew to Rs. 1.4 lakh over three years, the absolute return would be 40%. However, the annualized return would be 11.9%, reflecting the compounding effect.

3. Total Returns

Total returns encompass both capital gains and dividends. For example, if you invested Rs. 1 lakh at a NAV of Rs. 20, purchasing 5000 units, and the NAV increased to Rs. 22, your capital gains would be Rs. 10,000. If the scheme declared dividends of Rs. 2 per unit, your total dividend would be Rs. 10,000, making your total return Rs. 20,000.

4. Trailing Returns

Trailing returns are annualized returns over a specific trailing period ending today. For instance, if the NAV today is Rs. 100 and was Rs. 60 three years ago, the trailing return would be 18.6%. If the NAV five years ago was Rs. 50, the five-year trailing return would be 14.9%.

5. Point-to-Point Returns

Point-to-point returns are calculated between two specific points in time, requiring only the start and closing dates. For example, if the NAV on January 1st was Rs. 100 and on December 31st was Rs. 110, the annual return would be 10%.

6. Annual Returns

Annual returns refer to returns earned between January 1st and December 31st of a specific year, measuring the performance over a single year.

7. Rolling Returns

Rolling returns are annualized returns over specific periods such as daily, weekly, or monthly, compared to the benchmark or fund category. This method helps in assessing the performance consistently over time.

Calculating Compound Annual Growth Rate (CAGR)

CAGR is used to calculate returns from mutual funds with a holding period exceeding a year, reducing short-term volatility. The formula for CAGR is:

CAGR  ((Current Net Asset Value / Beginning Net Asset Value) ^ (1/Number of Years)) - 1

This method assumes steady growth, making it useful for evaluating long-term returns accurately.

Conclusion

Understanding the rate of return in equity mutual funds is crucial for informed investment decisions. By considering various types of returns and the factors influencing them, investors can make more strategic choices that align with their financial goals and risk tolerance.