When it comes to evaluating mutual fund performance, investors often come across two important metrics: CAGR (Compound Annual Growth Rate) and Absolute Returns. Both these metrics help measure returns, but they do so in different ways. Understanding the difference between CAGR vs Absolute Returns is crucial to make informed investment decisions that align with your financial goals.
CAGR is ideal for measuring returns over a specific period, accounting for the power of compounding. On the other hand, absolute returns give you a simple percentage gain or loss without considering the time factor.
In this blog, we will break down the meaning of CAGR, absolute returns, and explain which one is better for mutual fund investors.
What is CAGR in Mutual Funds?
CAGR (Compound Annual Growth Rate) is the rate at which an investment grows annually over a specific time period, assuming the returns are compounded every year. It provides a smooth, annualised growth rate, making it easier to compare the performance of mutual funds.
Key Features of CAGR:
- Annualised Growth: CAGR shows the average annual growth rate of your investment.
- Considers Compounding: It factors in the effect of compounding over the investment tenure.
- Fixed Period: CAGR works over a specific duration, which could be 1 year, 3 years, 5 years, or more.
- Performance Comparison: It allows investors to compare the returns of different mutual funds or other investment options over the same period.
Formula for CAGR:
[{(Ending value/ Beginning value) ^ (1/n)} – 1] X 100
Where:
- Ending Value = Value of the investment at the end of the period
- Beginning Value = Initial investment amount
- n = Number of years
Example of CAGR:
Suppose you invested ₹10,000 in a mutual fund, and after 5 years, its value grows to ₹20,000. The CAGR can be calculated as:
This means your investment grew at an average rate of 14.87% per year over 5 years.
When to Use CAGR:
- Long-Term Investments: CAGR is ideal for analysing mutual fund performance over a longer period.
- Comparing Funds: It helps compare mutual funds or other investments that have been held for the same duration.
- Measuring Growth: CAGR offers a more realistic measure of growth, especially when returns fluctuate over time.
In short, CAGR gives a clear picture of how much your investment has grown annually, making it a reliable metric for long-term mutual fund evaluation.
What is Absolute Returns in Mutual Funds?
Absolute Returns refer to the total percentage gain or loss on an investment over a specific period, without considering the effect of compounding or the time duration. It measures the overall growth of your investment from the beginning to the end.
Key Features of Absolute Returns:
- Simple Calculation: Absolute returns are calculated as a percentage of the total gain or loss.
- No Time Factor: It does not consider the time taken to achieve the returns.
- Ideal for Short-Term Analysis: It is most useful for investments held for shorter durations.
- Direct Gain or Loss: It gives a clear picture of the overall change in the value of your investment.
Formula for Absolute Returns:
[(Current Value / Initial Investment Value) – 1] X 100
Example of Absolute Returns:
Suppose you invested ₹10,000 in a mutual fund, and after 2 years, its value grows to ₹15,000. The absolute return can be calculated as:
This means your investment has grown by 50% over 2 years.
When to Use Absolute Returns:
- Short-Term Investments: Absolute returns are ideal for evaluating short-term investments.
- One-Time Investments: It helps measure the performance of a single, lumpsum investment.
- Simple Comparisons: It provides a quick, straightforward way to measure gains or losses.
In summary, absolute returns are perfect for short-term analysis but do not provide insights into annual growth or the power of compounding.
Comparison of CAGR vs Absolute Returns
Here is a quick comparison of CAGR vs Absolute Returns to help you understand their differences:
| Feature | CAGR | Absolute Returns |
| Definition | Annualised growth rate with compounding | Total percentage gain or loss on an investment |
| Time Factor | Considers the time duration | Does not consider time duration |
| Ideal For | Long-term investments | Short-term or one-time investments |
| Calculation Complexity | Requires a formula, involves compounding | Simple percentage calculation |
| Use Case | Comparing mutual funds over fixed periods | Measuring direct growth or loss |
| Accuracy Over Time | Accurate for fluctuating returns | Not suitable for long-term fluctuating returns |
Summary of CAGR vs Absolute Returns:
- Use CAGR for long-term investments where compounding and annualised growth matter.
- Use Absolute Returns for short-term or one-time investments where you want to measure the direct percentage gain or loss.
CAGR vs Absolute Returns: Which is Better?
The choice between CAGR and Absolute Returns depends on the nature and duration of your investment:
- For Long-Term Investments: If you are investing for a long duration, CAGR is better because it accounts for annualised growth and compounding, offering a clearer picture of the fund’s performance.
- For Short-Term Investments: Absolute returns work better for short-term or one-time investments since they give a straightforward measure of overall growth.
- Market Volatility: CAGR is more reliable when returns are uneven or fluctuate over time, whereas absolute returns may not reflect actual growth in volatile markets.
- Comparing Funds: For comparing mutual fund returns over the same period, CAGR provides a more accurate metric, while absolute returns are less suitable for fluctuating time frames.
Final Takeaway:
- Choose CAGR for long-term investments with fluctuating returns.
- Opt for Absolute Returns for simple short-term performance evaluations.
Conclusion
Both CAGR and Absolute Returns are valuable tools for measuring mutual fund performance, but they serve different purposes.
- CAGR is ideal for long-term investments, offering an annualised growth rate that accounts for compounding.
- Absolute Returns are better suited for short-term analysis, providing a quick and direct measure of gain or loss.
Understanding when to use each metric will help you make better investment decisions, evaluate mutual fund performance accurately, and align your choices with your financial goals.
FAQs
1. What is CAGR in mutual funds?
CAGR (Compound Annual Growth Rate) is the annualised growth rate of an investment, assuming it grows at a steady rate and compounds annually over a specific time period.
2. What are absolute returns in mutual funds?
Absolute returns measure the total percentage gain or loss on an investment over a specific period without considering the time factor or compounding.
3. When should I use CAGR?
CAGR is ideal for analysing long-term investments where annualised growth and compounding are critical for evaluating performance.
4. When should I use absolute returns?
Absolute returns are best for short-term or one-time investments where you want to measure overall growth without accounting for the time period.
5. How is CAGR calculated?
CAGR is calculated using the formula: [{(Ending value/ Beginning value) ^ (1/n)} – 1] X 100
Where n is the number of years.
6. How are absolute returns calculated?
Absolute returns are calculated using the formula: [(Current Value / Initial Investment Value) – 1] X 100
7. Which is better for long-term investments: CAGR or absolute returns?
CAGR is better for long-term investments as it accounts for compounding and annualised growth, providing a more accurate performance measure.
8. Which is better for short-term investments: CAGR or absolute returns?
Absolute returns are better for short-term investments as they provide a direct percentage gain or loss without considering the time factor.
9. Can I compare mutual funds using absolute returns?
You can compare funds for short-term periods using absolute returns, but CAGR is more reliable for comparing long-term performance.
10. Does CAGR consider market volatility?
Yes, CAGR provides a smoother annualised growth rate, making it reliable for evaluating performance during fluctuating market conditions.
