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For any investor, learning how to calculate mutual fund returns is very important to compare and select the right fund. Just like any other asset class, mutual fund returns are determined by calculating the appreciation value of the amount you've invested over a period of time. For those who don't know, mutual funds have a Net Asset Value or NAV which indicates the current price of your fund. Hence, it is used to calculate the returns generated on your investment. But how mutual fund calculation goes on? Let's find out!
What is Mutual Fund Return?
Mutual fund total return = Net Asset Value (NAV) appreciation + dividend income
The NAV is calculated using the following formula: NAV = market value of assets - liabilities/number of units outstanding
The market value of assets is calculated by multiplying the unit price by times the number of units held
The dividend income is arrived at by dividing the net amount distributed among all the investors by the unit price.
This formula gives rise to the famous saying that "money does not grow on trees." It means that money has to work hard to earn profits for its owner.
Different Ways of Calculating Mutual Fund Returns
Before learning how to calculate mutual fund returns, let's discuss the types of returns for better understanding.
Basically, mutual fund returns are divided into two categories which are as follows:
1. Absolute Returns
Absolute returns indicate the amount by which your mutual fund investment has changed at the time of withdrawal or redemption. For example, suppose you have invested 1 lakh in a mutual fund scheme at the beginning of 2022. In January 2022, the value of your mutual fund scheme becomes 1 lakh 25 thousand. Now, if you choose to continue with your plan for another three years, then the absolute returns you will earn on your investment over 3 years will be calculated as:
Absolute Return = ( Final Investment Value - Initial Investment) * 100 / Initial Investment
= (1,25,000 - 1,00,000) * 100 / 1,00,000
2. Annualised Return
Annualised returns are the returns that you earn from a mutual fund on an annual basis. These returns are computed with the logic that your mutual fund plan has grown at a constant rate, but this is not always the case. However, these returns give an approximate estimate of what you can expect from your investment made over a year. Below is the formula for calculating the annualised returns:
Annualized Return = (Final Investment Amount / Initial Investment Amount)^ (1/number of years) - 1
Taking the above example, when you put all the values in this formula, you will get 8.5% as an annual return on your 1 lakh of investment.
3. Compounded Annual Growth Rate (CAGR)
The third way of calculating mutual fund returns is CAGR, which stands for Compounded Annual Growth Rate. It gives you the amount by which your investment has grown over a particular time period. Moreover, it also takes into account the interest that has grown on your principal amount as well as the interest earned on the interest itself.
CAGR is an important way to compute returns on your investments because it is able to use the time value of money. When compared with absolute returns, it provides you with a more accurate view of how profitable a mutual fund scheme can be for investment. Further, CAGR allows you to determine how volatile your returns can be, over a certain time period.
However, when you continue to invest for a longer duration by making multiple installments over irregular intervals, then CAGR becomes useless. So, in cases like SIPs (Systematic Investment Plan), the returns are calculated using another tool, which is XIRR or Extended Internal Rate of Return.
4. Extended Internal Rate of Return ( XIRR)
Extended Internal Rate of Return or XIRR is an effective way of calculating mutual funds for SIPs. As we have already discussed, SIPs involve investing a fixed amount of money in the form of instalments in a mutual fund scheme over fixed intervals of time. If you chose to pay monthly and redeem your amount on a particular day, your returns for that SIP will vary depending upon your holding period. Moreover, when you chose the SIP mode of investment, you purchase the MF scheme on the basis of its Net Asset Value(NAV) on that day.
Once you redeem the invested amount, you receive a value that is equal to the total number of units you held multiplied by the net asset value of your fund on that day of redemption. In simple words, XIRR acts as an aggregate of multiple CAGRs on every SIP instalments you make.
Calculating XIRR manually can be very complicated because you have to check the CAGR of every SIP instalments you have made. Hence, it is recommended to use either a SIP calculator or calculate XIRR in Excel.
The difference in Mutual Fund Returns Calculation
Closed-end mutual funds have an upper ceiling or a maximum limit of shares that can be issued. Open-ended funds have no limitations and keep issuing new shares every time their NAV appreciates by a minimum amount known as the split rate.
Unlike closed-end funds, open-ended mutual funds don't have a fixed number of shares issued, and outstanding shares can be traded in the secondary market. When you invest in a closed-end scheme, your return is always determined by reference to its NAV at the time of purchase.
But when you invest in an open-ended scheme, you can sell your units to realize profits if they appreciate. If there is a decline in NAV, you will only get back your original investment without any gain or loss.
Most schemes provide their returns in three different scenarios: one-year return, three-year return and five-year return. We invested Rs 10 lakh in a plan and want to check how many returns we made after three years.
Things to Consider about Mutual Funds returns
Mutual funds are generally targeted at long-term investors because they offer consistent growth and also save you from market volatility. In general, mutual funds have a tendency to underperform during the bull market, in comparison to the market average. However, they can also outperform during a bear market. Typically, long-term investors have a lower risk appetite because they focus more on lowering their risk and less on maximizing their returns from a mutual fund scheme.
When talking about mutual fund returns, the "good" returns are considered to be the ones according to an investor's desired level of returns, financial goals as well as expectations. So, there is no one-size-fits-all when it comes to the right mutual fund scheme. It is natural that most investors will be happy with returns that mirror the average returns of the market.
Simply put, any amount that can meet your goal as an investor will make a satisfactory annual return from your investment. On the other hand, if you expect much higher returns then you may get disappointed, especially when you have no plans to stay invested for long-term.
At the time of determining mutual fund returns, you must take into account the economic conditions and the current market performance. For example, Suppose it is an extreme bear market. At this time, it is quite normal for stocks to drop by 10-15%, but an MF investor who realizes a 4% profit can consider these to be very lucrative.
How to Invest in Mutual Funds?
To gain better returns in mutual funds, first, you need to stay invested for a long period of time. And secondly, you should know the right way to invest.
Having said that, below are different ways to invest in mutual funds:
1. Direct Plans
You can reach out directly to the asset management company and select any direct plan that matches your interest. Generally, these plans come with a lower expense ratio as they do not involve any commission. Therefore, you can earn better returns over the long term.
2. Mutual Fund Distributor
If not AMC, you can reach out to a registered and trusted mutual fund distributor who can help you with the purchase and selection of the right MF. You can select any regular mutual fund scheme. But note that, it will come with a commission as charged by your distributor.
This is one of the most convenient ways of investing in mutual funds. There are many third-party online platforms that allow you to invest in the best mutual funds in exchange for a small fee.
Modes of Investment for Better Returns in Mutual Funds
We have discussed the ways of investing in mutual funds, let's now understand the best modes of investment.
So, there are two modes of investment in mutual funds: Lump sum and SIP
1. Lumpsum Investment
You can invest a considerable amount of your savings in any mutual fund of your choice. With this mode of investment, you need to make only one-time investment. Although it is a convenient method of investment, it comes with slightly higher risks. This is the reason why it is advised to choose SIP over lump sum investment.
2. Systematic Investment Plan (SIP)
With a Systematic Investment Plan or SIP, you allow your bank to deduct a fixed amount from your savings account every month and invest in any mutual fund policy selected by you. In this way, you can keep buying MF units without worrying about the right time to enter the market. In fact, SIP allows to you enjoy compounded returns.
There are many types of mutual fund returns to consider before making any investment. Note that each type of return is affected by the general economic conditions and performance of the market. To calculate the mutual fund returns, you can use a variety of mutual fund return calculators available online. They offer the most accurate results as compared to calculating the returns manually. To learn more about mutual fund returns and investment, visit 5Paisa!