CAGR, XIRR, and Absolute Return: How to assess mutual fund returns?

When you hear of a mutual fund with a 10-year return of 13%, what crops up in your mind? Does it make you think if you invested in this mutual fund scheme for 10 years, you would generate an overall 13% return? Would it be possible to achieve the same returns regardless of whether you invest through the lumpsum or Systematic Investment Plan (SIP) mode?

It is tricky, to say the least, to understand the return generated on mutual funds. With complex terms such as Compounded Annual Growth Rate (CAGR), Extended Internal Rate of Return (XIRR), and Absolute Return, there’s a high possibility of getting confused.

To mitigate this confusion, here, we explain a few popular metrics that are used to evaluate mutual fund returns and how each metric differs from the other. Remember, all metrics for determining mutual fund returns, such as CAGR, XIRR, and Absolute Return, use previous returns data of the scheme in question to determine its scope for capital appreciation. Although you may use these metrics to understand the growth potential of the fund, you must not base your investment decision solely on them.

Why should you avoid considering past performance alone?

While previous returns of mutual fund schemes can provide insights into a scheme’s historical performance and risk-return profile, you must remember that mutual funds are prone to market risks and are affected by distinct factors. Thus, depending solely on previous performance to estimate a scheme’s future performance is an incorrect approach. Capital markets are dynamic by nature and may be influenced by parameters such as industry trends, economic conditions, and geopolitical events. Such variables often make it difficult to estimate with certainty how a fund would perform over the long term.

Thus, instead of depending solely on the past performance of a scheme, it is crucial to assess other factors such as the scheme’s investment objective, fund manager’s experience, investment strategy, expense ratio, and asset allocation. To get these details, review the scheme’s prospectus. To make a prudent investment in the market, ensure that you align your investment in a specific mutual fund scheme with your financial goals, investment horizon, and risk appetite. In case you are still confused after reviewing a few schemes, you can consider approaching a qualified investment advisor who can evaluate your financial situation, investment goals, and risk appetite to provide personalized guidance.

Note that periodic monitoring, diversification, and investment discipline are vital for building a robust investment portfolio. Mutual fund investments must be considered a long-term commitment, rather than a short-term endeavor, especially if you are investing in an equity mutual fund or a hybrid mutual fund. Staying invested over the long term in such categories might allow you to generate higher, potentially inflation-beating returns owing to the power of compounding.

That being said, past performance metrics such as CAGR, XXIR, and Absolute Return play a key role in helping you make an informed decision when investing in mutual funds. Wondering what are the takeaways upon reviewing the past performance of a mutual fund scheme? In what follows, we discuss the benefits of reviewing a scheme’s past performance.

What are the benefits of reviewing a scheme’s past performance?

Track record
Assessing the past performance of a target mutual fund allows you to know how it has performed over distinct economic conditions and market cycles. It offers a record of the scheme’s potential to offer returns and mitigate risk across distinct market scenarios.

Consistency
Consistent performance is a vital parameter to consider. By reviewing a mutual fund’s previous performance, you can assess whether it has consistently outperformed its benchmark indices and peer funds over time. Consistency can even indicate the mutual fund’s potential to navigate market fluctuations and yield stable returns.

Risk-return analysis
Knowing a fund’s previous performance allows you to evaluate its risk-reward profile. By reviewing historical returns, you can assess how much risk a fund has assumed to generate returns. You can measure this by analyzing the fund’s downside protection, standard deviation, and volatility during market downturns.

Comparison
Past performance allows you to compare the performances of different schemes. By assessing the risk and return metrics of various mutual funds, you can make a better decision about which schemes have a good track record and are in line with your investment goals and objectives.

Investment strategy
A mutual fund’s previous performance provides insights into its portfolio management and investment strategies. By assessing the historical performance and data of a fund, you can understand its asset allocation, investment style, and sector preferences. These data can assist you to evaluate whether the mutual fund’s strategy is aligned with your risk appetite and investment goals.

Fund manager’s skill and expertise
By reviewing past performance, you can assess the skill and expertise of the fund manager. Constant outperformance of the fund over time suggests that the fund manager can make prudent decisions to generate positive returns. You may also consider the fund manager’s track record as a parameter for evaluating the fund’s potential to generate returns in the future.

Now that you now know the importance of reviewing the past performance of mutual fund schemes, let’s dive into three important metrics that you can use to evaluate the growth potential of mutual funds.

CAGR—Compounded annual growth rate
CAGR is a vital metric that helps you evaluate a mutual fund’s growth potential over a particular investment timeframe by factoring in the compounding effect. CAGR is a standardized metric for comparing different investment returns over the same time horizon.

Formula of CAGR
CAGR = (Final value/Initial value) ^ (1/Number of years) – 1

What are the benefits of using CAGR as a metric?

• Standardized comparison
CAGR permits you to compare the past performances of different mutual funds. By factoring in the CAGR over the same time horizon, you can identify which mutual funds have provided high returns.

• Assessment of long-term growth
CAGR is useful for evaluating a mutual fund’s long-term growth potential. It smooths out short-term downturns and provides a clear picture of the overall performance of the fund.

• Sets realistic expectations
By reviewing the CAGR of a fund scheme, you can obtain insights into its past performance, which can help you to set realistic future expectations and avoid any unreasonable assumptions.

• Decision-making
CAGR is a useful instrument that can help you to make sound investment decisions. By comparing the CAGRs of various funds, you can make an informed choice based on the historical performances of the funds.

• Monitors progress in investment
By regularly reviewing the CAGR of a fund, you can gauge its performance against your investment goals, time horizon, and risk appetite.

Is CAGR an appropriate metric to measure SIP investments?
While CAGR is a prudent metric for assessing your lumpsum investment returns, it might not be suitable for assessing the performance of your SIP investment. Read on to understand.

• Investment timing
In an SIP, you invest a predetermined amount at periodic intervals. Your investments are disseminated over time periods, and each contribution to an SIP mutual fund is subject to market movements. CAGR assumes a fixed investment figure at the start and end of the investment horizon, which is not consistent with the periodic nature of SIPs.

• Differing investment amounts
An SIP investment exploits the concept of rupee-cost averaging. In detail, when markets are in a downturn, your fixed investment amount purchases more units, and during bullish market phases, the same investment amount purchases fewer units. This concept reduces the effect of market volatility. However, CAGR does not factor in the differing investment contributions and the rupee-cost averaging concept.

Therefore, while CAGR is an apt choice for computing the growth rate of a lumpsum mutual fund investment, it is not the correct measure to evaluate your SIP investment in mutual funds. For this, you must consider the XIRR method.

XIRR—Extended internal rate of return

XIRR is a prudent metric for assessing the performance of SIP investments. Unlike CAGR, which assumes fixed investment figures at the start and end of investment time frames, XIRR factors in variable investment figures and the timing of such investments.

XIRR computes the annualized return rates of various cash flows at irregular intervals. Moreover, it factors in the actual dates, investments, and withdrawals performed during the investment horizon to provide an accurate measure of the SIP’s performance.

The XIRR formula estimates the return rate by equating the existing cash flow value (both investments and redemption) to zero. The XIRR computation is complex and is usually performed using MS Excel or online financial calculators.

What are the benefits of XIRR?

• Accurate assessment
XIRR factors in an SIP’s irregular investment pattern and provides an accurate measure of the investment’s market performance.

• Factors in cash flow s

XIRR considers the value and timing of every investment to provide a realistic return assessment.

• Goal tracking
XIRR allows you to monitor your investment’s progress and check whether it is aligned with your financial goals and objectives.

Absolute Return
Absolute return is a basic metric utilized to measure the actual appreciation or loss generated by a particular investment over a specific time period. This metric represents the overall percentage change in investment value from the start to the end of a specific period, without factoring in the effect of compounding.

Unlike CAGR and XIRR, which factor in the timing and value of the investment, Absolute Return concentrates solely on the change in the investment figure without factoring in the frequency of contributions, withdrawals, or duration of investment.

Absolute Return formula
Absolute Return = [(End value – initial value)/Initial value] * 100

What are the benefits of Absolute Return?

• Simplicity
Absolute Return is a straightforward measure of percentage change in the value of an investment, which makes it simple to understand and compare across distinct mutual funds.

• Quick comparison
Using Absolute Return, you can quickly compare distinct mutual fund schemes to decide which one has performed well in terms of profit or loss.

• Short-term analysis
This metric is specifically helpful for short-term investment analysis, where the effect of compounding might not be substantial.

• Performance assessment
Absolute Return helps you to evaluate a mutual fund’s actual performance without factoring in the frequency or timing of investment, thus offering a clear view of the investment’s profitability in investment.

However, because Absolute Return does not factor in the compounding effect and the time value of money, which are factored in by XIRR and CAGR, the metric is suitable only for providing a quick snapshot of an investment’s performance. Absolute Return cannot provide a comprehensive picture of the actual annualized return rate or long-term growth potential of a fund.

Conclusion
CAGR, XIRR, and Absolute Return are important metrics for evaluating mutual fund returns. While each metric has its own set of strengths, you must not depend on just one metric when making an investment decision. Instead, you must look at evaluating mutual funds comprehensively by factoring in various parameters such as investment objective, fund manager’s expertise, risk level, and asset allocation strategy. Ensure that you understand the limitations and potential biases of all metrics to make an informed decision.

By reviewing the historical performance of a mutual fund scheme on the basis of metrics such as CAGR, XIRR, and Absolute Return, you can obtain in-depth insights into the scheme’s track record, risk-return profile, consistency, fund manager’s skill, and investment strategy. This information, clubbed with a holistic examination of other parameters, can help you align your investment decision with your financial goals, risk appetite, and investment horizon, resulting in a more prudent and informed investment approach.

Source: Axismf Research
Note: Views and opinions contained herein are for information purposes only and should not be construed as investment advice/ recommendation to any party or solicitation to buy, sale or hold any security or to adopt any investment strategy. It does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The recipient should exercise due caution and/ or seek professional advice before making any decision or entering into any financial obligation based on information, statement or opinion which is expressed herein.

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