What is CAGR in mutual fund?

What is CAGR in mutual fund?

The full form of CAGR in mutual fund is compounded annual growth rate. It is also known as annualized returns. In order to understand compounded annual growth rate we should know the concept of compounding.

What is compounding?

The term compounding is derived from the concept of compound interest. In compound interest, you get interest on not just the principal but also on accrued interest. For example, if your principal is Rs 100 and compound interest rate is 5%, then in the first year, you will get Rs 5 as interest. Next year, interest will be calculated on Rs 100 + 5 = Rs 105; so you will get Rs 5.25 as interest. Similarly in mutual funds, you can earn profits on profits re-invested in the scheme; this is known as compounding.

The longer your investment tenure, higher is the power of compounding and wealth creation. Over long investment tenures compounding has the power of multiplying your investments. For example, if you invested Rs 1 lakh in a mutual fund scheme which gave compounded returns of 10%, the value of your investment after 20 years will be Rs 6.7 lakhs. You can see that your investment multiplied nearly 7 times due to the compounding effect.

How is CAGR calculated?

The formula of Compounded Annual Growth Rate or CAGR is as follows:-

CAGR = {(Final Investment Value ÷ Initial Investment) ^{(1 ÷ Tenure)}} – 1

Let us understand with the help of an example. Let us assume that you invested Rs 1 lakh in a mutual fund scheme. The market value of your investment grew to Rs 1.4 lakhs after 3 years. In that case:-

CAGR = {(1.4 ÷ 1) ^{(1 ÷ 3)}} – 1 = 11.9%CAGR = {(Final Investment Value ÷ Initial Investment) ^{(1 ÷ Tenure)}} – 1

How to use CAGR for financial planning?

You can use CAGR to estimate the value of your investment at the end of your investment tenure with the help of the following formula:-

Future Value of Investment = Investment Amount X (1 + CAGR %) ^Tenure

Suppose you invested Rs 5 lakhs in a mutual fund scheme. Let us assume that the scheme will give 10% annualized returns. Corpus accumulated by you after 10 years will be = 5 X (1 + 10 %) 10 = 12.97 lakhs.

Difference between absolute returns and CAGR in mutual funds

Absolute return is the growth in your mutual fund investment expressed in percentage terms. For example, if your investment grew from Rs 1 to Rs 1.4 lakhs in three years, you made a profit of Rs 40,000 and your absolute return is be 40%. The problem with absolute return is that, it does not take into account investment tenure. A 40% absolute return in 3 years can be considered to be reasonably good, but 40% absolute return in 10 years cannot be considered to be good because it may be zero or negative on an inflation adjusted basis, assuming 4 – 5% inflation. CAGR in mutual fund is considered to be a much better measure of mutual fund performance because it takes into account investment tenure.

How is CAGR used in mutual funds?

All mutual fund performance for periods exceeding one year are expressed in CAGR. AMCs usually disclose 1 year, 3 year, 5 year and since inception CAGRs of their schemes in monthly fund factsheets. Please note CAGR mutual fund is used only for point to point returns; you cannot use CAGR for SIPs, STPs, SWPs, etc. However, CAGR is a good indicator of overall scheme performance. You can compare CAGRs of different mutual fund schemes and make informed investment decisions. You should consult with your financial advisor if required.

An Investor Education and Awareness Initiative by Mirae Asset Mutual Fund.
For information on one-time KYC (Know Your Customer) process, Registered Mutual Funds and procedure to lodge a complaint in case of any grievance Click Here.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.