In recent years, mutual funds have gained popularity among retail investors' portfolio construction. Mutual funds can act as wealth builders and aid investors in realising their financial goals, provided the fund is chosen judiciously and the investor keeps his horizons long-term. The Compound Annual Growth Rate, otherwise known as CAGR, is one of those integral metrics that investors employ whenever they look into the performance of mutual funds. In this article, we will learn CAGR meaning in mutual funds, how it is calculated, its benefits as a performance measure, and some of its drawbacks that an investor must be mindful of.
What does CAGR stand for?
Compound Annual Growth Rate, or CAGR, is a mathematical measure utilised to determine the annual growth return of an investment over time. It supplies the yearly growth rate needed to bring you from the beginning value of an asset to its current value over the evaluation period, assuming the investment compounds during the same period. In simple language, CAGR is a measure to show what geometric annual return an investment has had over a certain number of years It totals the hypothetical constant rate at which an investment would have grown alternately each year if it grew steadily.
In the case of mutual funds, CAGR helps measure the annual return accumulated by the fund over 3,5,10 years or a more extended period.
How to Calculate CAGR
CAGR is calculated using the starting value of the investment, the ending value, and the number of years the investment was held. The formula below helps to calculate CAGR once one has established this information:
CAGR = [(End Value/Beginning Value)^(1/No. of years) - 1] x 100
To understand it better, let's say you invested an amount of ₹ 50,000 in a mutual fund, and the value of your investment increased to ₹ 1,00,000 in 5 years. The CAGR of that mutual fund will be:
=[ (1,00,000/50,000)^(1/5) - 1 ] x 100
=( 1.1487-1) x 100
= 0.1487 x 100
= 14.87%
Consequently, during the 5 years, the mutual fund registers a CAGR or annual compound return of 14.87%.
Benefits of CAGR Funds
The following are the poignant benefits of the CAGR Fund that emanate from its use to measure mutual fund performance:
1. Simplicity: CAGR expresses the fund returns in the simplistic manner of a plain single number that averages out quickly and is easily understood by an average investor.
2. Adjusts for Volatility: CAGR smoothens the fluctuations in periodic returns from a mutual fund instead of simple returns, thus proving handy to compare funds by adjusting for volatility and helping to know which fund is safer than others due to less fluctuation.
3. Consistency: Being a measure of returns over a time range adjusting for compounding, CAGR is the best to compare the long-term performance vis-à-vis the funds comparatively.
4. Investment Horizon: The CAGR reflects the impact of compounding and brings out the growth rate from an investor's angle per his investment horizon.
5. Performance Comparison: CAGR enables comparison of the returns obtained from various mutual funds across an equal period, making it a measure with which normalised performance evaluation metrics are realised.
Disadvantages of Using CAGR
While CAGR is a handy and helpful metric, there are some drawbacks to relying solely on CAGR for mutual fund analysis:
1. CAGR smoothens Volatility: Averaging out the returns over a period, CAGR does not reflect the volatility or fluctuations in periodic returns. It may hide periods of negative returns experienced by a fund.
2. Depends on Timeframe: CAGR calculations depend on the investment term the investor uses and should not derive differing results because of which periods he uses as - beginning and ending time points.
3. Assumes Reinvestment: The CAGR assumes reinvestment in gains and payouts earned by the mutual fund across the holding period. But, an investor may not choose to reinvest the payouts.
4. Uninformative of Risk: CAGR does not depict the risk level in mutual fund investment strategy. A higher CAGR, at times, may imply more risk was taken to earn such returns.
5. May Disregard Fees: Charges from brokerage and fees charged by the fund management or others may reduce actual investor returns cases but are unlikely to reflect in CAGR calculations.
Hence, CAGR as a single decision metric is not to be used by retail investors but put together with other performance ratios like the Sharpe ratio, Sortino ratio, drawdowns, etc., while making informed mutual fund selections. On a sign-off note, considering risk parameters and actual investor experience, CAGR should be seen.
Conclusion
Conclusively, Compound Annual Growth Rate or CAGR is an easy and helpful metric for analysing mutual funds' historical performance over defined time sets. This displays the average annual return rate that would make a fund's beginning and ending value equal after adjusting for compounding. However, CAGR shows little volatility or the quality of returns much information. Investors should consider CAGR along with other risk-adjusted return measures and authentic experience in investing before opting for mutual funds purely based on the highest CAGR value. CAGR should be part of an overall analysis rather than the only factor for mutual fund selection.