What is CAGR in mutual funds?

Introduction

Compounding is a key principle in finance, where earnings generate earnings on investments and earning over time. This accelerates the growth of your investment, allowing it to expand more. To quantify this growth, we turn to the CAGR– full-form Compound Annual Growth Rate. In this blog, we will explore CAGR meaning and the concept of CAGR in mutual funds.

What is the Compound Annual Growth Rate?

The tool measures how much an asset or portfolio has appreciated on average each year, with compounding considered. Unlike simple averages, CAGR reflects a more consistent increase over time.

Hence this metric is crucial for evaluating the performance of various financial instruments over extended periods.

How to calculate CAGR?

To calculate CAGR, you need three key details:

1. Initial value: What you initially invested (IV)
2. Final value: What it’s worth now (FV)
3. Tenure: How long you held the investment (n)

CAGR formula

CAGR=(FV/IV)^^(1/n)- 1

To illustrate, let’s consider the example, ₹10,000 Initial amount invested and after 5 years, the value doubled to ₹20,000.

To find the CAGR:

= (20,000/10,000)^⅕ -1

=(2)^⅕ -1

≈ 1.1487−1

≈ 0.1487

≈14.87%

This CAGR return means that your money grew at an average rate of 14.87% per year.

CAGR is a straightforward way to gauge annual growth, ideal for scenarios with performance over time.

CAGR meaning in mutual funds

When evaluating mutual funds over periods longer than a year CAGR is often used. Asset Management Companies or AMCs usually disclose growth figures for different durations, such as 1 year, 3 years, 5 years or even since the fund’s inception. These figures are shared in monthly factsheets. This metric can be a valuable tool for gauging a fund’s overall growth trajectory.

Why is CAGR important?

• Long-term performance: CAGR can be a good option for looking at how a mutual fund has performed annually over several years. This helps understand whether the fund can deliver risk adjusted returns.
• Comparing funds: When you need to compare multiple mutual funds, CAGR gives you a standard way to see which fund has delivered better returns over time. This helps in making informed choices about where to invest.
• Simplicity: While there are many ways to measure returns, CAGR is easy to understand. It gives you one simple figure that summarises how well your investment has grown over a period of time.

This information can be useful in guiding your investment decisions. Yet it’s important to remember that past growth doesn’t guarantee future returns. If you’re uncertain about your options, seeking advice from a financial advisor can be a prudent approach.

Limitations of CAGR

1. Ignores market fluctuations

This metric provides an average rate of increase, but it doesn’t capture significant ups and downs. If there have been sharp changes in value, this method smooths them out, potentially giving a false sense of consistency.

2. Not ideal for short-term assessments

CAGR is most effective over longer durations. When analysing shorter spans, such as a year or two, it may not accurately represent the true performance, leading to a skewed understanding of the results.

3. Struggles with variable cash flows

This method assumes no additional funds are added or withdrawn during the time frame. If you modify your investment, the calculation might be off. It only considers the beginning and end, ignoring any adjustments made along the way.

4. Overlooks risk factors

While it shows the CAGR growth, it doesn’t account for volatility. Two funds might show similar results through this metric, but one could carry more risk. This omission can obscure important aspects of the overall financial picture.

CAGR in mutual fund investing simplifies the analysis of long-term returns, helping you assess past performance. However, it’s important to be aware of its drawbacks, like its inability to reflect market volatility or cash flow variations. For a more comprehensive evaluation, combine it with other financial indicators and it is advisable to not look at past performance alone while making investment decisions.

Past performance may or may not be sustained in the future.

Above article is authored by Quantum.

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