One of the major motives of an investment is to earn returns and accumulate wealth. Higher the earning potential of an investment, the better it is. A major challenge would be in measuring your investments correctly to understand their earnings potential, especially when the investments are of a recurring and compounding nature.
Returns generated are an indicator of the mutual fund’s performance. There are various ways through which the returns of mutual funds are computed. Let us understand the types of returns that are widely used and try to figure out the type of return that would best suit in analyzing the funds based on your requirement.
Absolute return calculates the growth in value from the date of your investment. It is expressed as a percentage and shows how much the investment has grown or depreciated in value, taking only your investment’s initial and current value into consideration.
WHY SHOULDN’T YOU USE ABSOLUTE RETURNS TO GAUGE YOUR LONG-TERM INVESTMENTS?
Let’s assume an investment of Rs. 1,00,000 is made. After five years, the investment value grows up to Rs. 3,00,000. Then, your absolute return earned would stand at 200%.
This shows that absolute returns just give us an idea about how much the investment value has appreciated or depreciated without taking into consideration the tenure or various cash flows in between if any.
Absolute returns would be an accurate method of assessment when it comes to fixed income products that have a defined annual payout or for investments where the holding period is less than one year and not for products that don’t have a pre-defined or fixed return.
Let’s presume you have invested Rs.50,000 in a Fixed Deposit and after 5 years, the value grows out to be Rs.65,000. Similarly, you have invested Rs.50,000 in a debt mutual fund and after 4 years, the value compounds to Rs.62,000.
If you compare the return generated from FD with the Debt mutual fund using absolute returns, FD would look attractive, but the tenure of the investment avenues and cash flows are different. Hence, it is advised not to use absolute returns when it comes to comparing dynamic-return products as they don’t give you the full picture and are also not accurate in determining your return from an investment if the holding period is more than one year.
Total returns are often used as synonymous with Absolute Returns, but there’s a slight variation when it comes to Total returns as it also takes into account the dividend amount received along with the initial investment while computing returns.
The annualized return measures the amount of growth in the value of your investment on an annual basis. It shows the amount of money that you have earned per annum.
Annualized returns would be a good measure of returns when you keep reinvesting your gains. But it doesn’t consider the factor of investment risk and volatility.
CAGR (Compound Annual Growth Rate) – The concept of CAGR is straightforward and requires only three inputs: an investment’s beginning value, ending value, and the time duration. CAGR considers the assumption that the investment is compounded over time. This can be the best measure for your Lumpsum investments.
XIRR (Extended Internal Rate of Return) - XIRR is a method to calculate returns when multiple transactions are involved. It works best when your cash flows (investments or redemptions) are spread over a period of time. If you’re investing through SIP or redeeming through SWP or lumpsum, XIRR can help you calculate a consolidated return considering all the timing of your returns and withdrawals. XIRR is nothing but an aggregation of various CAGRs.
Trailing returns are the returns generated over a specific period ending today.
Trailing returns measure the performance of a mutual fund for the past specific periods, such as inception-to-date, year-to-date, one-year, three-year, etc. Trailing returns would tell your annualized return over the time duration, anchored to the current date, majorly taking the entry and exit timing into consideration. It gives the investor an idea about whether or not the mutual fund has generated wealth or reduced wealth over the selected tenure.
However, the fund’s performance towards the end of the period considered might have an undue influence on the returns calculated and it also doesn’t take into consideration any fluctuations in the fund value over the period.
For example, if we compare the 1-year trailing return of a fund as of October 19, 2021, right after the market rally, and the trailing return as of, let’s say, April 19, 2022, when the markets were a little volatile and bearish, the one year trailing returns as of October 2021 would look attractive when compared to the returns as of April 2022. This is because the end period that is considered while calculating trailing returns can skew the overall annualized returns for the tenure.
Rolling returns evaluate the performance of funds over the chosen period. They focus on the holding period instead of the time of entry and exit, as in the case of trailing returns.
Let’s say, we want to see the 5-year return performance of a fund over 15 years from 2005 to 2020. To calculate rolling returns, a range of 5-year blocks like 2005-2010, 2006-2011, 2007-2012, and so on would be taken into account. Through rolling returns, several blocks of 3, 5, or 10 years at various intervals can be used to see how a mutual fund performed for that period which would help investors to manage their expectations from the fund.
It measures returns of mutual funds at different points of time, thereby eliminating any bias associated with returns calculated at a particular point in time.
The above were some of the widely prevalent measures of mutual fund returns. While returns may be one of the major factors to review before choosing a mutual fund, it cannot be the sole factor based on which you choose your fund. Past performance might not be an indicator of future returns.
If you would like to know more about the suitable portfolio and funds that would align with your goals, kindly get in touch with our financial analysts.