CAGR Vs Absolute Return: Which Is Better for Mutual Funds?

What is CAGR in Mutual Funds?

Compound Annual Growth Rate (CAGR) represents the annual average rate at which an investment grows for more than one year. It does not display the gain made from an investment over time but rather represents the overall growth in the form of a yearly percentage.

For example, we may assume that an investment of ₹1,00,000 becomes ₹1,33,100 in three years. Then the CAGR will be the annual growth rate at which this amount was reached, assuming the growth to remain constant every year.

Although the actual earnings on mutual fund investments might vary year on year, CAGR helps to make comparisons between the performance of lump sum investments in various mutual funds

What Is Absolute Return in Mutual Funds?

Absolute return measures the total percentage gain or loss on an investment between the purchase date and the redemption date. Unlike CAGR, it does not consider the time taken to generate the return.

For instance, if an investment increases from ₹1,00,000 to ₹1,15,000, the absolute return is 15%. This remains the same whether the investment was held for six months or two years.

Because it focuses only on the overall change in investment value, absolute return is generally used for investments held for shorter periods. For investments extending beyond one year, annualised measures such as CAGR are commonly used to compare performance over different time frames.

How Is CAGR Calculated?

CAGR measures the average annual growth of an investment over a specified period.

Formula:

CAGR = (Ending Value ÷ Beginning Value)1 ÷ Number of Years − 1

Example:

Suppose an investment grows from ₹1,00,000 to ₹1,52,000 over four years.

CAGR = (1,52,000 ÷ 1,00,000)1/4 − 1

= 11.1% approximately

This means the investment recorded an average annual growth rate of about 11.1% over four years.

How Is Absolute Return Calculated?

Absolute return measures the total percentage increase or decrease in the investment value over the holding period.

Formula:

Absolute Return (%) = [(Current Value − Initial Investment) ÷ Initial Investment] × 100

Example:

Suppose an investor invests ₹1,00,000 in a mutual fund. After eight months, the investment value becomes ₹1,15,000.

Absolute Return = [(₹1,15,000 − ₹1,00,000) ÷ ₹1,00,000] × 100

= 15%

The calculation shows only the total return earned during the investment period. It does not indicate the average annual growth if the investment is held for more than one year.

XIRR: The Missing Piece for SIP Investors

The following table highlights the key differences between the two return measures.

Key Points to Consider Before Comparing Returns

The following are some factors that may be reviewed while evaluating mutual fund returns:

• Check the investment duration before selecting a return measure.
• CAGR is commonly used for lump sum investments held for more than one year.
• Absolute return generally measures the total gain or loss over the investment period.
• XIRR is generally used for SIPs because it considers investments made on different dates.
• Compare mutual funds within the same category and over similar investment periods.
• Review returns along with factors such as investment objective, expenses, benchmark performance, and risk profile.

CAGR Vs Absolute Return: Which Is Better?

There is no single return measure that applies to every investment situation. The choice between absolute return vs CAGR metric generally depends on the investment period and the way the investment is made. The following points summarise the general use of each return measure:

• CAGR is commonly used to analyse lump sum investments held for more than one year.
• Absolute return is generally used to measure the overall gain or loss over the investment period.
• XIRR is commonly used for SIP investments because it considers multiple investment dates.
• The investment duration may influence which return measure provides a more meaningful comparison.
• Reviewing more than one return metric may provide a broader understanding of mutual fund performance.

Conclusion

CAGR and absolute return measure mutual fund performance in different ways. Absolute return shows the total percentage gain or loss during the investment period, while CAGR shows the average annual growth for investments held for more than one year. For SIP investments, XIRR is generally used because it considers investments made on different dates. Understanding how these return measures differ can help investors interpret mutual fund performance more accurately and compare investments using methods that match the investment period and investment approach.

XIRR: The Missing Piece for SIP Investors

Systematic Investment Plan (SIP) investments involve multiple instalments made on different dates. Since each instalment remains invested for a different duration, CAGR and absolute return may not fully reflect the overall investment performance.

In such instances, the Extended Internal Rate of Return (XIRR) approach is used by investors. XIRR considers both the amount invested and the timing of every investment and redemption while calculating the annualised return.

Example:

Consider that an investor invests ₹5,000 per month using a SIP for three years. In the end, the total value of the portfolio stands at ₹2,20,000.

Since each monthly investment remains invested for a different period, XIRR accounts for these varying investment durations and provides an annualised return based on all cash flows.