Mutual funds are a whole new world when it comes to the different forms of investment vehicles, and there is just so much we would have to learn about in this spectrum. Apart from knowing the kind of mutual funds you can invest in, how to get started, and much more – it is time to understand CAGR. What exactly is CAGR? How does it work? How to calculate it? You can find the answers to all these questions in this post.
What is the Meaning of CAGR in Mutual Funds?
CAGR stands for Compound Annual Growth Rate. In the context of mutual funds, CAGR represents the annualized rate of return of an investment over a specified period, assuming that the investment has grown at a steady rate and compounded annually.
Now, before taking a quick browse to find a CAGR calculator, let’s understand how to do this manually.
How to Calculate CAGR?
Here is how you calculate CAGR:
Formula
CAGR=( Initial Value/Final Value) Number of Years 1−1
Formula Expanded
- Initial Value: This is the initial value of the investment, and it typically is the net asset value of the fund at the beginning of the period.
- Final Value: Determine the final value of the investment at the end of the period, which will again be the net asset value of the fund at the end of the period.
- Time Period: This is the number of years in the investment tenure.
What is the Importance of CAGR in Mutual Funds?
CAGR is much more important than you think. Do you want to know how? Keep reading!
- It is a form of a standard comparison: CAGR provides a standardized method to compare the historical performance of various mutual funds over different time frames. By calculating CAGR, investors can evaluate how well a mutual fund has performed when compared to others, helping them make an informed investment decision.
- It sets realistic return expectations: CAGR helps an investor to set for himself realistic return expectations while investing in mutual funds. By examining the previous years CAGR of a fund, investors can gauge the fund’s potential for getting returns in the near future. While the past performance is not a sure factor of future results, CAGR offers enough insights into a fund’s track record to meet the primary need.
- It offers long term performance assessment: Mutual funds are typically long-term investment options, and you would know that if you are a frequent investor. CAGR is specifically utilized for assessing their performance over extended periods in the past. It captures the effect of compounding over a span of time, providing investors with a clear understanding of how their investments have grown so far every year on average.
- It is a way of risk analysis: CAGR primarily concentrates on returns; it indirectly mirrors the risk related to mutual funds. Funds with higher CAGR values could have typically experienced greater volatility or may have taken on more risk to attain those returns. Investors need to consider risk-adjusted metrics alongside CAGR to analyze the risk-return trade-off of mutual funds.
- It Helps to Set Goals: CAGR is essential for setting goals and better financial planning. Whether an investor is saving for retirement, education, or other long-term goals, knowing the historical CAGR of mutual funds can help them estimate how much their investments will grow over time and whether they are on the right track to meet these goals.
- It helps to monitor performance: Investors could use CAGR to monitor the ongoing performance of their mutual fund investments. With the comparison of the current CAGR with the historical CAGR, an investor gets to assess whether the fund’s performance is consistent or if there have been major fluctuations that warrant further investigation.
Why You Can’t Rely on CAGR Alone?
You can’t simply rely on CAGR alone, and there are reasons for that:
It Does Not Capture the Volatility of the Fund: CAGR represents the average yearly growth percentage over a particular period but does not account for changes in the fund’s value in that time. Mutual funds with high volatility could have experienced major ups and downs, which are not shown to you in the CAGR alone.
It has limited context: CAGR alone does not give you the complete picture of a mutual fund’s overall performance. It does not consider attributes like risk, expenses, investment strategy, or the fund manager’s skills, which are important elements for evaluating the overall quality of the investment.
CAGR Ignores Interim Cash Flows: CAGR assumes all dividends, interest, and capital gains are reinvested back into the fund, which is a big drawback. However, in reality, an investor could choose to withdraw these distributions or make additional investments elsewhere, which can affect the actual returns that are realized by the investor.
CAGR Could Overstate Returns: CAGR assumes that returns are compounded every year, which may not precisely mirror the mutual fund’s actual compounding frequency. For funds that compound more often, such as those with 3-month or monthly distributions, CAGR may overstate the actual returns that come in.
CAGR Can’t be Used Across Asset Classes: The CAGR may not be directly comparable across different types of funds or asset classes. Thus, you can compare only the same form of investment.
Conclusion
Now that you know what CAGR is, how to calculate it, its advantages and limitations, and its importance in mutual fund investments, one last point is that CAGR is one of the many other points you need to keep in mind while analyzing a mutual fund.
