In the previous article, we discussed NFO in mutual funds. In this article, we will discuss CAGR in mutual funds
CAGR or Compound Annual Growth Rate refers to the mean annual growth of any investment over a period usually longer than a year.
It is an accurate way to calculate and determine the return for investment portfolios, and individual assets that may rise or fall in value with time.
Investment consultants who boast about their market knowledge and funds advertising their returns use the phrase CAGR.
What is CAGR?
The compound annual growth rate, or CAGR, measures your investments’ yearly compounding rate. Let’s spend some time considering the word compounding.
Imagine you put Rs 1,000 into stock and received a 10% return. In the first year, the stock price will have increased by Rs. 100. Now that we are in the second year, the price has risen by 10% once again.
Will the cost increase by Rs 1,200 after two years? The answer is no. After a year, your initial investment of Rs. 1,000 has increased to Rs. 1,100.
At this point, a 10% growth of Rs. 1,100 increases the investment’s worth to Rs. 1,210 after two years. The fundamental idea behind CAGR, or compound annual growth rate, is compounding.
How does the compound annual growth rate work?
Several restrictions are associated with calculating the mean or arithmetic average of results. Because it offers a rate of return that is smoothed, CAGR aids in overcoming them.
It may be used to compare the success of various assets over time and provides a reasonable prediction of the yields from an investment when compounded yearly.
Most of the time, when we evaluate the success of our assets, we are just interested in the total return. However, we frequently fail to consider the temporal worth of money. CAGR differs in this manner.
In actuality, CAGR prefers taking the time value of money.
CAGR calculator and mutual funds
Mutual fund investors can benefit significantly from the CAGR calculator. This can help you find out how good-performing your fund is for helping you take the required investment decisions.
Uses of a CAGR in Mutual fund
Compare returns between different funds and benchmarks
The CAGR calculator may also be used to contrast the returns you receive from one fund with those of other funds of a similar type. This might help you understand the mutual fund’s performance compared to its competitors.
For further clarity, you may also evaluate against the benchmark indexes.
How should investors interpret the compound annual growth rate over a period of time?
As we previously mentioned, CAGR displays the average annual rate of return on your assets. CAGR accurately gauges an investment’s growth (or decline) over time.
A typical rule of thumb is that stocks generally favor firms with CAGR growth over 4-5-year intervals.
Profits are expected to be reinvested after each year of the time horizon for calculating CAGR. The CAGR is illustrative and inaccurate.
This is so that people understand that when you state something like “CAGR has risen 15% over five years,” it does not always indicate that it did so continuously over the five years.
It may have fluctuated between positive, flat, and even negative growth during this time.
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Advantages of CAGR
- It enables investors to evaluate the returns in various situations. For instance, you may model different CAGR scenarios to see how much your original investment would increase over time. It helps with financial planning.
- It is simple to use and comprehend. Only the beginning value, the end transaction, and the preferred investment time must be entered. You may simplify the calculation using Internet calculators, excel spreadsheets, or scientific calculators.
- Absolute returns over a longer time horizon may be deceptive. In these situations, the CAGR can assist you in comparing with other comparable instruments to see whether you outperform the market. For instance, if you previously bought units of an equity fund and their value has since grown, you can efficiently utilize the CAGR to evaluate the average yearly gains you have achieved.
- When comparing CAGR to the cost of funds, it is essential to remember that CAGR is a return on the capital metric. For instance, to make a spread, you would need to look at an investment with a CAGR return of above 12% of your cost of funds was 9%.
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CAGR and mutual fund returns
While investing in mutual funds, you need to know if it’s worthy of an investment. You need to measure the performance of a mutual fund over a period of time.
Mutual fund fact sheets usually give you growth rates across various time horizons of a fund, which makes it difficult to understand the performance of a fund based on multiple rates.
If you knew how it grew gradually over a specific period of time, it would get easier. CAGR does that, and it gives the investor the single annual growth of a fund. CAGR is one of the effective ways to calculate fund performance.
Limitations of CAGR
CAGR doesn’t take into account the volatility of investment since it gives you a smoothed rate of return over a period of time.
CAGR calculations will be accurate only if you don’t withdraw your initial investment and reinvest the returns you gained out of an investment.
In case you withdraw or add funds to the investment, the calculation may not be accurate. CAGR can also be used to compare funds that have similar investment periods.
CAGR is usually used to calculate returns for extended periods, and it may not help in calculating the rate of returns over small investment tenure.
Points to remember about CAGR
The compound Annual Growth Rate assumes compounded growth, which basically means any returns you gain on the investment are reinvested.
If you had invested Rs. 200 and earned a return of Rs. 30 after one year of investment, your gain of Rs. 30 gets reinvested.
If you plan to use CAGR for two different investments, you need to make sure to keep the same time period for both investments because CAGR offers a rate of return over a specific time period.
You may not be able to know the risks involved in the investment and the volatility of an investment with the help of CAGR.
FAQs
What is a good CAGR for mutual funds?
An ideal compound annual growth rate can be between 8% and 12% for a long-term investment.
What does a 10% CAGR mean?
CAGR is the average rate at which a fund moves from one value to another within a specific period. Imagine you put Rs 1,000 into stock and received a 10% return.
In the first year, the stock price will have increased by Rs. 100. Now that we are in the second year, the price has risen by 10% once again.
Will the cost increase by Rs 1,200 after two years? The answer is no. After a year, your initial investment of Rs. 1,000 has increased to Rs. 1,100.
At this point, a 10% growth of Rs. 1,100 increases the investment’s worth to Rs. 1,210 after two years. The fundamental idea behind CAGR, or compound annual growth rate, is compounding.
Is a CAGR of 5% good?
For large-cap companies, the compound annual growth rate of 5 – 12% is considered good.
What does 5-year CAGR mean?
CAGR, or Compound Annual Growth Rate, refers to the mean annual growth of any investment over a period usually longer than a year.
It is an accurate way to calculate and determine the return for investment portfolios and individual assets that may rise or fall in value with time.
CAGR is a beneficial formula for estimating an investment’s growth rate. It can help enhance the returns on the assets or evaluate historical profits as well.
How much CAGR is considered good?
A good CAGR for mutual funds depends on the investor’s financial goals and risk tolerance. Generally, a CAGR of 12-15% is considered good for equity mutual funds, while a CAGR of 8-10% is considered good for debt mutual funds.
It is important to note that these figures are not guaranteed and can vary depending on market conditions and the specific mutual fund in question.
Investors should consider their investment objectives, time horizon, and risk appetite when evaluating the potential returns of mutual funds.
How is CAGR calculated in mutual funds?
CAGR, or Compound Annual Growth Rate, is a measure of the annualized rate of return of an investment over a specific period of time.
In mutual funds, CAGR is calculated using the formula: [(Ending value/Beginning value)^(1/number of years)] – 1. The beginning value is the value of the investment at the start of the period being measured, while the ending value is the value of the investment at the end of the period.
The number of years is the length of the investment period. By using this formula, investors can assess the average annual growth rate of their mutual fund investment.
How can I use CAGR to compare mutual funds?
CAGR can be a useful tool for comparing the returns of different mutual funds over the same investment period.
By calculating the CAGR for each fund, investors can get a sense of the average annual growth rate and compare the performance of different funds. However, it is important to compare funds with similar investment objectives and risk profiles.
For example, comparing the CAGR of an equity mutual fund with a bond mutual fund may not provide meaningful insights due to the different risk-return characteristics of these asset classes.
Additionally, CAGR should not be the only factor considered when selecting a mutual fund, as past performance does not guarantee future results. Investors should also consider other factors such as fund expenses, investment strategy, and the expertise of the fund manager.
What are the limitations of using CAGR to evaluate mutual funds?
While CAGR is a useful metric for evaluating the performance of mutual funds, it does have certain limitations.
One limitation is that CAGR assumes a steady rate of growth over the investment period and ignores volatility. In reality, mutual fund returns can fluctuate significantly from year to year.
Additionally, CAGR does not account for when an investor adds or withdraws funds from the portfolio over the period being measured. This can impact the overall return and may not be accurately reflected by the CAGR.
Lastly, CAGR may not be representative of the fund’s performance if the investment period is short. It is important for investors to consider other factors such as risk-adjusted returns, expense ratios, and fund manager track record when evaluating mutual funds.
