For investors, returns are the key indicators of their investment performance. But how many of us really understand the returns and their underlying purpose? In mutual funds, NAV is the basic element used in calculating the returns because it keeps varying from one point of time to other. Thus, the purchase and sale value of investment is derived by multiplying the units purchased with NAV for respective period i.e. purchase date and sale date. For a layman, surplus earned over and above the principal is often termed as returns.
Returns are often termed in value and percentage change, for instance, investment of Rs 10,000 appreciates to Rs 15,000 during the term of 3 year of value. It means that principal has appreciated by Rs 5,000, while in terms of percentage change, its 50% appreciation. But, can we term this percentage change as the only method to gauge the performance of mutual fund investments. No. Read on…
Different ways of calculating investment performance.
The absolute returns are very easy to calculate as it measures the value of investment at one point of time with other. This is the most common method to interpret the investment performance. It is generally used to measure the performance of mutual funds with high equity exposure, who’s NAV (Net Asset Value) fluctuates from time to time.
For instance: If fund is purchased at Rs.10 per unit and after 3 years, if NAV appreciates to Rs. 18 per unit, here the absolute returns is 80% i.e. calculated as follows:
(Current Value - Purchase Value or Historical NAV) /(Purchase Value or Historical Value) *100
If calculating returns was as simple as taking the beginning balance and ending balance and then calculating the absolute return, tracking investment returns would be so much easier.
But there is time value in money and once you start depositing or withdrawing cash and receiving dividends, it makes calculating annualized returns that much more difficult.
Simple Annualized Returns:
The simple annualized return is just an extension to absolute returns. It is an average annual return on investments over the period of time. The simple annualized return is used for those funds, whose NAV is less volatile or fluctuates less frequently. In mutual fund industry, simple annualized returns are used for debt, liquid and short-term funds for a period less than year, as there NAV is less volatile.
For instance, a debt fund is purchased at Rs.10 per unit, after three month NAV appreciates to 10.20% after 3 months. The simple annualized return on the portfolio is 8.11%
((Current NAV- Purchase NAV)/ Purchase NAV)*100*365/ no. of days.
Compounded Annualized Growth Rate (CAGR):
The CAGR rate is used to calculate returns for the period beyond one year for all types of mutual funds.
The CAGR returns are annualized returns, which consider compounding effect. The CAGR is calculated as follows:
((Current NAV/ Purchase NAV) ^ (1/no. of years)-1
For instance: The fund is purchased at the NAV of Rs.10 per unit after three years NAV rises to Rs.20, then CAGR returns will be 25.99% i.e.
((20/10)^(1/3) -1) = 25.99%
The investor will be surprised to see 100% in term absolute returns during last three years or he may simply divide it by 3 to get 33 % per annum, which gives the incorrect picture!
The CAGR return actually calculates the growth rate of investment per annum by considering the compounding effect.
With reference to above example, the investment has appreciated by 25.99% every year to take the shape of Rs 20,000 at the end of three years.
XIRR Returns Calculation (XIRR):
With XIRR, you can calculate Annualised Returns even when cash flows are irregular.
Example: Purchase of Rs 7,000 through SIP over 1 year is illustrated below.
Once you start depositing, withdrawing cash, receiving dividends, switch in/ switch outs, this calculation becomes very useful in calculating the real return on the investment.
| XIRR Return
| Absolute Return
| Total Cost
| Total Value
(**Contributed by Dilshad Billimoria BBM, LUTCF CFPCM, Certified Financial Planner and Investment Advisor.)