Mutual fund investment is made into for reaping gains over the period of investment and there are various available methods to determine as well as compare the performance of one mutual fund to the other. Now here we will delve on the CAGR method to evaluate and calculate Mutual fund returns:
CAGR as a metric to assess mutual fund performance
What is CAGR?
CAGR or Compounded Annual Growth Rate is representative of compounded growth of your investment into a mutual fund scheme. Typically this method of performance evaluation is based on the performance that the investment is registering a steady growth rate.
For better understanding we can learn the same method via an example:
Say an executive Mr. X invested a lump sum amount of Rs. 1 lakh into an equity bluechip fund and then redeemed the same after 5 years and got Rs. 1.51 lakh
CAGR calculation: (Final investment/Initial investment)^1/n - 1
So in the above example it shall be (Rs. 51000) )^1/5 - 1: Here the annual return has been at 8.5%. Primarily CAGR is the annual returns generated on an average from the mutual fund over a period of time. In case a 5-year CAGR stands at 8.5% this typically implies that the mutual fund in the past 5 years has growth at an average rate of 8.5%.
Thus the parameter CAG will tell how the investment performed on an average during the investment horizon.
In the short term, the CAGR measure incorporates or factors in all such factors that impact the investment, including market parameters. Nonetheless, in the longer period the CAGR does not factors in the various short term fluctuations.
When is CAGR the good tool for measuring mutual fund performance?
CAGR is good to assess mutual fund performance when investments are made as lump sum payments but in a case when there are various inflows towards the investment as in the case of SIP it is not the suitable method. This is as each of the fresh inflow into mutual fund scheme via SIP is a new investment and is for various time horizon.
Drawbacks of CAGR
Investors are misguided through the measure as via the annual average return derived by it via the calculation of CAGR, investor is so not provided with inputs on the variation in returns over the course of investment and he or she may misinterpret it to be giving linear growth.