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Tata Capital > Blog > Wealth Services > What is CAGR in mutual funds? Full form, meaning, and formula

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What is CAGR in mutual funds? Full form, meaning, and formula

What is CAGR in mutual funds? Full form, meaning, and formula

Summary

CAGR’s full form is Compound Annual Growth Rate. It is the annualized rate of return used to measure the growth of a mutual fund from its initial to its final value over a definite period. The calculation assumes that profits, including dividends and gains, are reinvested. You can use CAGR to directly compare the performance of different mutual fund schemes across varying time periods. Its best use is to evaluate the performance of lump sum investments over a holding period of 1 year or more.

The CAGR formula reflects the snowball effect of reinvested profits in mutual fund schemes. It helps you project future growth and determine if your long-term goals are on track.

Compound Annual Growth Rate (CAGR) is the smoothed yearly growth rate of an investment over a specific period. So, if you have ever wanted to calculate your mutual fund investment’s growth each year on average, CAGR is what you need to use. It does not show the ups and downs from year to year, but presents growth as a steady annual rate. As a result, it makes it easier for you to compare different investments. CAGR helps you understand at what pace your money is growing over time, enabling you to efficiently plan financial goals like buying a home, a child’s education, or building a retirement corpus. In this article, you will learn CAGR’s full form, CAGR’s meaning, CAGR’s formula with an example, and how it is used in mutual funds.

What is CAGR? Full form and meaning

CAGR stands for Compound Annual Growth Rate. It is the constant yearly rate at which your investment would have grown, compounding steadily over time. It smooths out year-to-year ups and downs. In other words, it indicates the average yearly growth of your investment from the beginning value to the ending value. You can use the calculation method regardless of whether the investment is a mutual fund, fixed-income product, stock, real estate, or any other asset. Generally, investors use CAGR to compare performance and understand an investment’s long-term growth more clearly.

Also, read – Venture capital market in India

What is the CAGR formula, and how to calculate it?

The formula for calculating CAGR is:

((Ending value/Beginning value) ^ (1/n)) – 1

where,

Ending value refers to the final investment value

Beginning value refers to the initial investment value

n stands for the number of years

To get the CAGR percentage, you must multiply the result by 100.

Let us look at the following example to learn how to calculate CAGR in a mutual fund.

Suppose the starting value of a mutual fund investment was Rs. 1,00,000, while the ending value was Rs. 2,00,000. The time period was 5 years.

  • Ending value / starting value = 200000/100000 = 2
  • 2 ^ (1/5) – 1 = 0.1487
  • 0.1487 X 100 = 14.87%

So, the investment’s growth was at a CAGR of around 14.87% per year over 5 years.

Also, read – Where should NRIs invest their money in India?

What is CAGR in mutual funds?

After you’ve grasped CAGR’s generic meaning and formula, it is vital to understand the meaning of CAGR in a mutual fund specifically.

The numeric value indicates the annualized return of a fund over a period of 1, 3, 5, or 10 years. It shows how much a lump-sum investment would have grown each year on average if it had compounded at a steady rate.

You can find the CAGR value in mutual fund fact sheets. It helps you compare different funds on a like-for-like basis. However, it reflects the point-to-point growth of a lump-sum investment and does not account for regular Systematic Investment Plan (SIP) contributions.

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How to calculate CAGR for a mutual fund?

Learning how to calculate the CAGR for a mutual fund is vital to making the most of your investments. Here is an illustration to help with the same.

Suppose your initial investment amount in a mutual fund is Rs. 1,00,000, and its final value grows to Rs. 1,90,000 after 5 years.

CAGR = ((190000 / 100000) ^ (1/5)) – 1

The calculation estimates a CAGR of approximately 13.7% per year. This means your lump-sum mutual fund investment grew at an average compounded rate of 13.7% over 5 years. You can also calculate CAGR using the fund’s starting and ending Net Asset Values (NAVs) over a specific period.

What is the difference between CAGR and absolute return?

Absolute return estimates the total percentage gain or loss on an investment. It does not consider the holding period. On the other hand, CAGR converts the total return into an annualized growth rate. As a result, it becomes easier to compare investments held for different periods.

For example, if a mutual fund investment grows from Rs. 1,00,000 to Rs. 1,90,000 in 5 years, its absolute return is calculated as follows:

  • Absolute return = (Final value – Initial value) / (Initial value) X 100
  • Absolute return = (190000 – 100000) / (100000) X 100 = 90%

However, the CAGR is only approximately 13.7% per year. The CAGR shows the average annual compounded growth rate over the 5-year period.

Also, read – How many mutual funds should you hold?

CAGR vs XIRR: Which should you use for mutual funds?

The key differentiator between CAGR and Extended Internal Rate of Return (XIRR) is its suitability. CAGR is for a single lump-sum investment, and XIRR is for SIPs or multiple investments.

Here’s a table to help you differentiate between the two:

BasisCAGRXIRR
Full formCompound Annual Growth RateExtended Internal Rate of Return
Best used forSingle lump-sum investmentSIPs and multiple investments
Considers the timing of cash flowsNoYes
Suitable for regular SIPsNoYes
Calculation methodUses beginning value, ending value, and time periodUses all investment and redemption dates
Accuracy for SIP returnsCan be misleadingMore accurate
Common usePoint-to-point mutual fund returns are shown in the fact sheetsActual investor returns from SIPs and staggered investments

In a nutshell, if you invested once and held the fund, check the CAGR. If you invested through SIPs or made multiple transactions, use XIRR to understand your real returns.

What are the limitations of CAGR?

The limitations of CAGR are as follows:

1.    Assumes smooth growth:

CAGR assumes investments grow at a smooth, steady rate, which rarely happens in real markets.

2.    Hides volatility and drawdowns:

CAGR only looks at the starting and ending values. It hides volatility and does not show interim gains, losses, or market crashes.

3.    Depends on the start and end dates:

CAGR is highly sensitive to the chosen start and end dates, as it measures only point-to-point performance.

4.    Ignores immediate cash flows:

It does not account for intermediate cash flows, such as additional investments or withdrawals.

5.    Not suited for SIPs:

SIPs involve multiple investments over time. Thus, CAGR cannot accurately measure returns.

Why does CAGR matter to mutual fund investors?

If investors know what a CAGR is in mutual funds, they can compare the long-term performance of different funds. The method is simple and consistent. It helps set realistic expectations by showing the average annual growth rate of a lump-sum investment over time. However, you must not view CAGR in isolation. For a complete evaluation, you must also consider rolling returns, risk levels, and the fund’s volatility before making investment decisions.

Conclusion

Compound Annual Growth Rate, or CAGR, is a useful metric for understanding the average annual growth rate of a lump-sum mutual fund investment over a period of time. It smooths out year-to-year fluctuations and makes it easier to compare fund performance. The formula relies on a fund’s beginning value and ending value and assumes that the profits are reinvested.  However, if you are looking at SIPs or investments with multiple cash flows, XIRR is the more appropriate measure. To get a balanced view, you should also evaluate CAGR alongside risk, volatility, and rolling returns.

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