What is CAGR in Mutual Fund?

Compounding is popularly known as the “Eighth Wonder of the World.” In the longer run, compounding enables you to grow your wealth significantly. But while the concept of compounding is easier to understand for investments that generate fixed returns, how will you calculate average returns from an investment like equity mutual funds where annual returns are not guaranteed? Moreover, they go through fluctuations every day.This is where the concept of CAGR or Compound Annual Growth Rate comes into the picture. If you are about to begin your mutual fund investment journey, understanding CAGR is essential for you. Let’s take a look.

As mentioned above, market-linked investment options do not generate fixed returns every year. It is with the help of CAGR that you can calculate the average returns generated by a mutual fund scheme , stock, or any other market-linked product during a specific duration if you keep reinvesting the gains throughout the selected duration.For instance, let us assume that you've invested Rs. 1 lakh in an equity mutual fund. After five years, the investment grows to Rs. 1.50 lakhs. So, in these five years, your investment generated Rs. 50,000 profits. But how much did your investment generate in a year? CAGR can be used for calculating this.

The formula for calculating CAGR is as follows-

Here, VE = Value of the investment at the end of the investment termVI= Initial investment amountT= Investment tenure in yearsLet us replace the values in the example we’ve used above. So,VE = Rs. 1,50,000VI= Rs. 1,00,000T= 5 CAGR = (1,50,000-1,00,000) ^ (1/5) – 1 = 8.71% So, the average annual returns generated by this scheme in a year is 8.71%.

As the returns generated by mutual fund schemes depend on the market conditions, CAGR is one of the most effective ways to calculate the average returns a scheme generates over a particular time horizon. You can compare the CAGR of different schemes by adjusting the investment tenure to get excellent insights into how the scheme has performed over the years.Based on the CAGR analysis, you can then pick schemes that best suit your investment objective. But do note that CAGR does not take investment risk into account. So, if you are planning to invest in mutual funds like equity funds that have higher volatility, do keep your risk profile in mind while using CAGR.Another important thing to note is that the duration of data plays a very important role in calculating the right CAGR. Let’s understand this better with an example.Vijay is evaluating two funds on the basis of their CAGR. Fund X generates a CAGR of 45% in the last 1-year, whereas Fund Y has generated 60% CAGR in the same duration. While Fund Y may seem to be the obvious choice here in terms of return, let's look at the CAGR of the funds over 3-years and 5-years.

As you can clearly see, while Fund Y seemed to have generated better CAGR in 1 year, Fund X clearly wins when you compare data of 5-years.

Now that you know what is CAGR , check out the different ways in which you can use it to make better investment decisions.CAGR can be used in many different conditions, whether you are about to invest in mutual funds for the first time or are an existing investor. Take a look-

• If you are a long-term mutual fund investor who has invested in multiple schemes, you can use CAGR to know the average returns generated by every scheme over your investment tenure.
• If you have some specific return objectives from your mutual fund investment, CAGR can be used for comparing schemes and selecting ones that best meet your expectations.
• If you have long-term financial goals, CAGR can be used to predict the duration within which you might be able to achieve them.
• You can compare the CAGR of a mutual fund scheme with its benchmark to check whether the scheme is outperforming or underperforming the benchmark.
• If you are about to invest in a particular scheme generated, let's say 15% returns in 5 years, you can use CAGR to calculate the average returns generated by the scheme in 1 year.

While there are other methods, such as trailing returns, annualized returns, returns since launch, etc., that are commonly used for analyzing returns generated by mutual fund schemes, CAGR is probably the most popular for its simplicity and effectiveness. Apart from mutual funds, CAGR can also be used for analyzing stocks and every other market-linked investment.No matter if you are a beginner or a seasoned investor, add CAGR to your investment analysis strategy to be better able to choose investments with higher returns potential that is also in line with your long-term investment objectives.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.