Understanding the Basics of Compound Annual Growth Rate (CAGR) in Mutual Funds

Compound Annual Growth Rate

If you’ve ever researched the performance of a mutual fund, you might have had to contend with the figure called CAGR. This is a finance term that sounds very complicated, but after breaking it down, you’ll see that it is a simple one to understand. Through this blog, we will try to explain what Compound Annual Growth Rate is, how it is calculated, and why it is an extremely important factor when playing the mutual fund game. This guide will help you read any mutual fund performance report with confidence and make sense of fund returns, whether you are just starting out with your investments or looking through the many types of fund returns.

Starting from the fundamentals:

What Is CAGR?

It stands for Compound Annual Growth Rate. Simply put, the rate at which your investment grows yearly upon the profits being compounded annually. It provides you with a smooth, annualized growth rate for the investment and thereby explains the average growth of your investment over the timeline.

Put another way:

Let’s imagine that you had invested ₹1,00,000 in a mutual fund for 5 years, and after 5 years, it matured to ₹1,80,000. Compound Annual Growth Rate would say that the investment grew at a fixed rate of return every year, which was responsible for growing the ₹1,00,000 investment to ₹1,80,000 in 5 years.

This is helpful to know because investments do not grow at the same rate each year; some years might be a big plus, some might be a little minus. Compound Annual Growth Rate smooths out those ups and downs and gives you one figure to go by. In short, Compound Annual Growth Rate is an answer to the question, “If an investment had built up at the same pace every year, how much would that pace have been, what would the annual growth rate be?”

How Is CAGR Calculated?

The formula for CAGR is:

CAGR = [(Ending Value / Beginning Value) ^ (1 / Number of Years)] – 1

Let’s break it down:

• Beginning Value: The amount you initially invested
• Ending Value: The value of your investment at the end of the period
• Number of Years: The time duration for which the investment was held

Here’s a quick example:

You invested ₹50,000 in a mutual fund. After 3 years, it grows to ₹65,000. What’s the CAGR?

CAGR = [(65,000 / 50,000) ^ (1 / 3)] – 1

CAGR = [(1.3) ^ 0.3333] – 1

CAGR ≈ (1.0914) – 1

CAGR ≈ 0.0914 or 9.14%

Your investment, therefore, generated a 9.14% per annum average return over three years. 

Note: The Compound Annual Growth Rate presumes that gains were reinvested during the relevant time frame and assumes that no additional investments or withdrawals occurred in the period.

Why CAGR Matters in Mutual Fund Investing

Mutual funds, just like any other potential investment, could compromise the importance of appropriate comparisons, returns may seemingly look very different when the same set of funds are compared for different time periods. The fund might be returning 20% as against 5% in the other year. Using annual returns alone, it becomes hard to judge if the fund is doing well or not. This is where using the CAGR is beneficial. This provides one number, summarizing the performance of the fund over a period, and greatly helps in comparing two funds side by side.

Importance of CAGR in Mutual Funds

1. Consistent Benchmark for Comparison

Different mutual funds perform differently across years. Compound Annual Growth Rate gives you a uniform way to evaluate and compare them over the same period. Whether it’s an equity fund, a debt fund, or hybrid fund, you can use Compound Annual Growth Rate to understand which fund grew more efficiently over time.

2. Measures True Growth Over Time

Unlike simple average returns, Compound Annual Growth Rate accounts for the power of compounding. It shows how your money grew each year, as if it grew at a steady pace—even if actual yearly returns were inconsistent.

3. Eliminates Short-Term Noise

Markets can be volatile. Some years see huge spikes, others see drops. Compound Annual Growth Rate filters out this “noise” and helps investors focus on long-term performance, which is more meaningful for wealth building.

4. Helpful in Goal-Based Planning

For some goal planning, like the purchase of a new house, the education of the child, and retirement, Compound Annual Growth Rate helps you to estimate the likely predictable average growth of your mutual fund investment.

5. Serves Comparison Purposes

You can compare the mutual fund’s CAGR with that earned in fixed deposit, PPF, or even from real estate. While these products work differently, CAGR levels the playing field by converting everything to an annualised growth rate.

CAGR vs. Other Return Measures

Let’s quickly look at how CAGR compares with other common return calculations:

1. Absolute Return

This tells you the total return during the period, ignoring the time it took for the return.

Example: Suppose you invest ₹1,00,000, which later becomes ₹1,20,000; this is a 20% absolute return. But whether the return took 1 year or 3 years makes a huge difference, and this is why Compound Annual Growth Rate finds better usage with long-term investments.

2. XIRR (Extended Internal Rate of Return)

XIRR comes in handy when SIP investments are made into the mutual fund, or contributions at varying times are made. The best application of Compound Annual Growth Rate is for a lump sum investment made at the start. 

Limitations of Compound Annual Growth Rate

A powerful tool, but not perfect. Here are some caveats:

1. Does Not Reflect Volatility

Compound Annual Growth Rate smoothes out the returns, ignoring the ups and downs during the investment period. It does not indicate how volatile a particular mutual fund might have been during that period. Different mutual funds may have had the same Compound Annual Growth Rate, but the volatility/risks involved could have been different.

2. Doesn’t Account for SIPs

If you invest regularly through SIPs, Compound Annual Growth Rate isn’t the best tool to evaluate your returns. Use XIRR in that case, as it accounts for multiple investments made over time.

3. Doesn’t Predict Future Returns

Compound Annual Growth Rate shows past performance, not future guarantees. Just because a fund gave 12% CAGR over 5 years doesn’t mean it will continue at that pace.

4. Assumes No Interim Transactions

Compound Annual Growth Rate assumes no withdrawals or extra investments during the period. In real life, investors often add or withdraw money, making Compound Annual Growth Rate less accurate for them.

How to Use CAGR in Mutual Fund Selection

1. Look at 3-Year, 5-Year, and 10-Year CAGR

Rather than focusing only on recent returns, check how the fund has performed over different periods. A good fund should have a consistent CAGR over the long term.

2. Compare With Benchmark CAGR

If a mutual fund consistently beats its benchmark (like Nifty 50 or BSE 100) CAGR, it’s a sign of strong management and good strategy.

3. Check Peer Group Performance

Compare the Compound Annual Growth Rate of the fund with other funds in the same category (e.g., large-cap, mid-cap, ELSS). It helps you identify top performers in that group.

4. Don’t Chase Highest CAGR Blindly

A fund with the highest past CAGR may not always be the best. Always consider other factors like risk, fund manager experience, portfolio quality, and expense ratio.

Also, check – CAGR vs XIRR – Calculate Mutual Fund Returns

Conclusion

To put it simply an easy way to analyse mutual fund performances is by applying Compound Annual Growth Rate. One is supposed to strip off any complications or fancy calculations,  by giving concrete points for a common comparison on how money has grown over a period. 

But keep in mind: While it is an excellent tool piece of the puzzle, distressing the investment application. This ratio should be applied alongside risk ratios, fund manager history, consistency and so on when making proper investment decisions. Whether you are investing in a lump sum or slowly accumulating wealth through SIPs, you should be familiar with Compound Annual Growth Rate to stay confident, focused and on target throughout your investing journey.

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Disclaimer – This article is for educational purposes only and does not intend to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.