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Returns are the first thing that attracts investors to a mutual fund, but it’s equally crucial to understand how that return is determined. Your investment outcome would be influenced by several factors, including the amount invested, holding period, NAV movements, and whether you opt for a lump sum or SIP.
Understanding how mutual fund returns are calculated can help you better understand actual performance, compare investments over time, and make more informed investment decisions. This article will help you learn it.
Key Takeaways
- Mutual fund returns are affected by changes in NAV and amount invested.
- Lump sum and SIP investments have various performance metrics.
- Absolute returns are the overall return or loss over a period.
- CAGR and XIRR are used to measure annualised performance across different investment horizons.
- Returns should be viewed in the light of risk, fees, investment horizon, and financial objectives. Past performance is no guarantee of future returns.
What are Mutual Fund Returns?
A mutual fund’s return is the profit or loss on an investment over a period of time.
You invest in a mutual fund and get units based on the Net Asset Value (NAV) of the scheme. The NAV of the fund will change as the value of the securities in the fund changes.
If the NAV increases after you invest, your investment may grow in value. If it drops, the value of your investment can decrease.
Any distributions you receive from the plan may also affect your returns, depending on the option you choose and the restrictions that apply.
How are Mutual Fund Returns Calculated?
The underlying notion is a simple one. When you value your investment, compare the value with what you initially invested, taking into account the applicable investment period and cash flows.
With a single, lump sum investment, the return indicates how much the investment has gained or lost in value compared to its initial purchase price.
For example, if you invest ₹50,000 into a mutual fund and the value of the fund increases to ₹55,000 after that period of time, your investment's value has increased by 10%, which amounts to ₹5,000.
This is called an absolute return. The computation gets a little bit complicated in the case of investments made through many instalments, like an SIP.
What is Absolute Return?
Absolute return is essentially the total increase or decrease in investment as a percentage over a given period. These are useful if you want to know by what percentage an investment has grown over the entire investment period.
For example, an investment of ₹1 lakh that has grown to ₹1.15 lakhs represents a total increase of ₹15,000, which signifies an absolute return of 15%.
This metric is easy to calculate but does not account for the length of investing time.
This makes it less useful for comparing investments held over different periods of time.
What does annualised return mean?
An annualised return is the average rate of return per year on an investment over a period.
This can make comparisons easier when investments have been held for different periods of time.
Consider an investment that earns 20% over 2 years and one that earns 20% over 5 years. The absolute returns are identical, but the annualised returns differ.
Investors often utilise Compound Annual Growth Rate (CAGR) to comprehend the annualised growth rate for lump sum investments held for more than 1 year.
What is CAGR in Mutual Funds?
CAGR is the compounded annual growth rate that a single-amount investment would have earned over a period of time if it had grown at a steady rate.
It is especially beneficial in evaluating one investment across multiple years.
For example, if ₹1 lakh becomes ₹1.5 lakh in three years, CAGR helps to represent the entire development in terms of an annual rate rather than just presenting the total gain of 50%.
Remember that CAGR is a calculated representation of growth that has already happened. It does not indicate that the fund truly earned the same return every year.
Other Ways to Measure Annualised Returns: Trailing vs. Rolling Returns
While CAGR measures a fund’s growth between a specific start and end date, investors and fund managers also use trailing and rolling returns to assess annualised performance over different periods.
- Trailing Returns: These measure a fund’s annualised return over a fixed period ending today, such as 1, 3, or 5 years. They are useful for understanding how the fund has performed over a particular historical period. However, the results can be influenced by the market conditions on the specific start and end dates.
- Rolling Returns: These calculate annualised returns for multiple overlapping periods, such as every 3-year period measured monthly or daily over a 10-year timeframe. Since they consider several different entry and exit points, rolling returns provide a better view of a fund’s consistency and reduce the impact of market timing on a single date.
How is SIP return calculated?
The calculation of returns from an SIP is different, as you are investing money at multiple points in time.
For example, if you invest ₹5,000 per month, each instalment is invested for a distinct period of time. The earliest tranche may have been invested for many years, and the last tranche may have been invested for only a few months.
The investments were made on different dates; therefore, a simple comparison of total invested vs. current value does not provide a clear picture of annualised performance.
XIRR is often used here.
What is XIRR in Mutual Funds?
When there are different dates of investment in a mutual fund, Extended Internal Rate of Return (XIRR) is used to compute the annualised return.
It is especially beneficial for:
- SIP investments
- Multiple lump sum investments
- Additional investments made at various times
- Redemptions partial
XIRR takes account of the timing of each investment and redemption and provides a more significant annualised return for investors for assets with multiple cash flows.
XIRR is often better for SIP investors than just finding the overall percentage gain.
Mutual Fund Returns for SIP vs Lump Sum
| Investment method | Common return measure | Why it is used |
| Lump sum | Absolute return | Shows overall gain or loss |
| Lump sum held long-term | CAGR | Shows annualised growth |
| SIP | XIRR | Considers different investment dates |
| Multiple investments/redemptions | XIRR | Accounts for individual cash flows |
The answer is dependent on when and how you invested.
What is the role of NAV?
NAV is a key factor in understanding mutual fund results.
When you invest, your amount is used to purchase units at the applicable NAV. NAV will vary, so will the value of the units.
Suppose you buy units at the time of NAV ₹20, and later NAV reaches ₹25. Your units become more valuable.
Your investment value is based on how many units you have and the change in the NAV. Don’t rely solely on NAV to decide whether a mutual fund is inexpensive or pricey. A lower NAV does not mean that one fund is necessarily better than another.
What about dividends or distribution of income?
The mutual fund scheme may provide options for the distribution of income, subject to the scheme structure and applicable rules.
Changes in NAV are not the sole factor to consider when analysing returns, but investors should analyse the total investment result.
The appropriate measure of return should reflect distributions and cash flows that provide a fuller picture of performance.
Why do two investors get different returns on the same fund?
Two investors can invest in the same mutual fund and achieve different realised results.
This can happen because they may:
- Invest at different times
- Invest varied amounts
- SIPs rather than lump sums
- Redeem at other times
- Make further investments
- Receive distributions at different times
Market circumstances can fluctuate, so the NAV at which an investor enters or exits can significantly affect individual results.
Factors Influencing Mutual Fund Returns
There are many elements that can affect the returns that a mutual fund generates.
- Market Overview: Equity funds are subject to stock market fluctuations, while debt funds are subject to changes in interest rates, credit conditions, and other variables.
- Investment Time Horizon: The longer you hold an investment, the more time it has to weather the market cycles, but there’s no guarantee it will be beneficial.
- Type of Fund: Different categories have different risk and return profiles. One cannot expect equity, debt, hybrid, and other funds to act in the same manner.
- Expense Ratio (ER): The fund takes its expenses from the assets of the plan, which may impact the returns that investors eventually experience.
- Costs of Entry and Exit: The exit load, if any, may cause the redemption proceeds to be less than the invested amount.
Annual Returns versus Mutual Fund Returns
Don’t mix up total returns with annualised returns.
Let's assume one investment yields 30% in 3 years and another yields 30% in 7 years. They seem the same if you only look at the overall percentage.
Annualised measurements provide further information by showing how the investment has performed on an annual basis over the relevant timeframe.
That’s why investors should constantly look at the return and the period during which it was achieved.
How Should an Investor Evaluate Mutual Fund Returns?
Returns matter, but they shouldn’t be examined in isolation.
Investors should also consider the following before choosing a mutual fund:
- Purpose of the investment
- Level of risk
- Fund category
- Portfolio construction
- Ratio of cost
- Investment timeline
- Investment strategy and fund management
- Consistency over varied market situations
The fund with the highest recent return is not always the best choice. The superior alternative is the one that has the risk and return profile that corresponds to the investor's financial objectives.
Common Mistakes in Calculating Mutual Fund Returns
- Looking only at absolute returns: An increase of 20% is meaningless without the context of the time taken to reach it.
- Ignoring dates of investments: This can result in incorrect return computations for SIPs and numerous investments.
- Direct comparison of different fund categories: Equity funds and debt funds have different objectives and risk levels; the returns need to be assessed in context.
- Past returns are treated as guaranteed: Past performance is not a guarantee of future results, and it may also be indicative of future results.
- Ignoring costs: Applicable expenses and charges may affect the actual amount received by an investment.
Conclusion
To measure the performance of their assets, investors need to understand mutual fund returns. Absolute return displays the total gain/loss. CAGR helps assess the annualised growth of lump sum investments held over longer periods. XIRR considers the time of each SIP or multiple transaction cash flows. Investors should focus not only on returns but also on risk, costs, investment horizon, and financial objectives.
