What is CAGR in Mutual Funds: Compound Annual Growth Rate Calculation
Whenever an individual invests in any financial product, a certain return is expected from that product. When the investment timeline in the same financial product spans over multiple years, then there is an average annual growth rate expected from that investment. This annualised growth rate is nothing but the compounded annual growth rate. In this article, we will understand what is CAGR in mutual funds and its calculation.
What is CAGR?
The term CAGR stands for compounded annual growth rate. CAGR is the annual growth rate at which an investment product is expected to grow over a specified time horizon. For example, assume that an investment of Rs. 50,000 in a particular financial product is expected to grow to Rs. 75,000 in 3 years. In this case, the investment is expected to grow at a CAGR of 14.47%.
In other words, the investment is expected to grow at an annualised rate of 14.47% over the next three years.
Table: How does compounding work annually
|Investment amount at the start of the year||Annualised growth rate||Investment amount at the end of the year|
|Rs. 50,000||14.47%||Rs. 57,235.71|
|Rs. 57,235.71||14.47%||Rs. 65,518.53|
|Rs. 65,518.53||14.47%||Rs. 75,000|
The above table shows how an investment of Rs. 50,000 grows at a CAGR of 14.47% for three years to Rs. 75,000.
CAGR in mutual funds
In mutual funds, the growth of a lump sum investment over a specified time horizon (more than a year) is calculated in CAGR. In the above section, we saw how an investment grows at a fixed annual growth rate over a period of time. But in mutual funds, specifically in equity mutual fund schemes, the returns will never grow at a fixed annual growth rate.
In all equity mutual funds, the growth rate in some years will be high, while in some years, it will be low, and finally, it will even be negative in some years. So, you may read a headline saying an XYZ Equity Fund gave a CAGR return of 20% over five years. While this is an excellent return, please remember this is the average annual growth rate.
The headline does not tell you the volatility that the equity fund experienced in those five years. During the five years, in a particular year, the fund may have generated high returns, while it may have generated low returns in a particular year. In a particular year, it may have even generated negative returns. To know how the fund performed in each of the five years, you will have to study the 5-year returns chart.
Chart: Nifty 50 two years performance
The above chart shows the performance of the Nifty 50 Index for 2-years (December 2019 – December 2021). In December 2019, the Nifty was around 12,245 levels, and in December 2021, it was around 17,072 levels. Thus, the Nifty has given a CAGR of 18% in the last two years.
However, when you look at the 2-year Nifty chart, it shows you how the Nifty had a big fall in March-April 2020 from levels of around 12,000 to 7,500. After the big fall, during April 2020 – December 2021, the Nifty had a big one-way rally to 17,000 levels. So, while CAGR gives you the annualised growth rate of 18%, it does not tell you the volatility (one of the biggest falls in its history) that the Nifty experienced during these two years.
How to use CAGR to analyse a fund?
Now that we understand what is CAGR in mutual fund, let us see how we can use it to analyse a fund. People usually choose equity mutual fund schemes for investing for long-term financial goals like building a fund for a child's higher education or their own retirement. While analysing an equity mutual fund for investment, you need to study the past CAGR returns of the fund. More importantly, you need to analyse the future expected CAGR of the fund.
Also, while comparing two or multiple equity mutual funds for investment, you need to compare the past CAGR and the future expected CAGR of these funds to select the appropriate fund for investment. When finalising the fund for investment, you also need to match the expected CAGR of the fund with your expected CAGR. For example, if your expected CAGR for your financial goal is 12%, you need to choose a fund that is expected to generate returns of a minimum of 12% CAGR or higher.
Calculation of CAGR
You can calculate CAGR using the RRI function in an Excel sheet. In the earlier section of the article, we saw how an investment of Rs. 50,000 grows to Rs. 75,000 in 3 years, at a CAGR of 14.47%.
You can do this CAGR calculation using the RRI function in Excel. The RRI function requires three parameters:
- Nper: It is the investment time horizon. In our example, it is three years.
- Pv: It is the initial investment amount. In our example, it is 50000.
- Fv: It is the future expected amount. In our example, it is 75000.
Once you input the above three values in the RRI function in Excel, you will get the output as 0.1447. Thus, you will get a CAGR rate of 14.47%.
Relation between CAGR and mutual funds
Mutual fund houses display the returns of their various schemes in CAGR. They show 1-year, 3-year, 5-year, since inception, etc., returns in CAGR. When comparing returns of similar schemes from different fund houses, you can use CAGR returns for comparison.
As seen in the above image, an investor can choose the investment time horizon (1-year, 3-year, etc.) to see the CAGR returns given by the scheme in the past.
What investors should know about CAGR
When analysing the past returns of a mutual fund scheme, the CAGR returns tell you how the annualised returns of the scheme have grown for a specified period. However, CAGR does not tell you the volatility (ups and down in NAV) experienced by the scheme during that period. In the earlier section, we have seen this phenomenon with the Nifty 2-years (Dec 2019 – Dec 2021) performance. To understand the volatility in the net asset value (NAV) of any mutual fund scheme for a specific period, always check the NAV chart of that scheme for the specified period.
Other ways to determine returns
Apart from CAGR, you can determine mutual fund returns using other ways such as absolute returns, XIRR, etc. Absolute returns tell you the point-to-point returns given by a mutual fund for a specified period. Absolute return is appropriate when the investment period is one year or less. XIRR return is appropriate when you are using the SIP mode of investing.
Compounding is the world’s eighth wonder
You should always aim to earn a higher CAGR on your investment portfolio as an investor. A higher CAGR can help you reach your financial goals faster. CAGR works on the principle of compound interest. Albert Einstein had once quoted: "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it".
To get recommendations on mutual fund schemes that have the potential to generate a decent CAGR in future, download the Glide Invest App from Google Play Store or Apple App Store and get started.