CAGR Vs. Absolute Returns Which is Better for Mutual Fund Investors

CAGR vs Absolute Returns: Which is Better for Mutual Fund Investors?

In assessing mutual fund performance, two frequently utilised metrics are Compound Annual Growth Rate (CAGR) and Absolute Returns. Both provide insights into investment growth but serve different purposes. Understanding their meaning, difference between CAGR vs absolute returns and knowing when to use each is essential for making informed decisions.

What is CAGR?

The Compound Annual Growth Rate (CAGR) quantifies the yearly rate of return over a particular timeframe, presuming the investment increases at a steady rate each year. It considers compounding, which is essential in long-term investments.

Formula:

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

Advantages of CAGR

CAGR can be used across various industries, from finance to business growth, providing a versatile tool for long-term evaluations. Here are some of the advantages of CAGR.

Time Adjusted Returns

Provides a realistic picture of how an investment performs annually over multiple years.

Suitable for Comparisons

Ideal for comparing mutual funds with different time horizons.

Captures Compounding

Reflects the power of reinvested earnings, which is a critical factor in mutual fund growth.

Consistent Growth Measure

CAGR provides a clear view of consistent growth over a period, helping to eliminate fluctuations that may distort year-to-year comparisons.

Simplicity and Ease of Use

The formula for CAGR is straightforward, making it easy for investors and analysts to calculate and understand.

Ideal for Long-Term Analysis

CAGR helps assess performance over a long-term horizon, making it ideal for investments, portfolios, and financial planning.

Removes Volatility Impact

Unlike other growth metrics, CAGR smooths out the effects of short-term volatility and market cycles.

Benchmark for Investment Performance

CAGR serves as a reliable benchmark to evaluate the performance of investments and compare them against other opportunities.

Limitations of CAGR

CAGR assumes a steady rate of growth, which may not reflect the actual irregularities or risks in real-world performance. Here are some of the limitations of CAGR.

Ignores Volatility

It smooths out fluctuations and doesn’t show year-to-year variations in returns.

Restricted Short-Term Application

Ineffective for investments maintained for under a year.

Ignores Short-Term Volatility

CAGR smooths out fluctuations, which means it overlooks important short-term variations that could impact decision-making.

Doesn’t Account for External Factors

It doesn’t consider external variables like market conditions, economic events, or changes in strategy that could influence growth.

Inapplicable for Non-Linear Growth

CAGR is less useful for investments or situationns where growth patterns are highly erratic or non-linear over time.

Limited to Historical Data

CAGR is based only on past performance, offering no insight into future growth potential or changing market dynamics.

What are Absolute Returns?

Absolute returns indicate the total percentage change in an investment over a specific period, disregarding elements such as time or compounding.

Formula: {(Final Value – Initial Value) / Initial Value} * 100

Advantages of Absolute Returns

Absolute returns apply to all kinds of investments, whether stocks, bonds, or real estate, providing a universal metric of performance. Here are some of the advantages of absolute returns.

Simplicity

Easy to calculate and understand, especially for short-term investments.

Direct Growth Indicator

Shows how much the investment has grown over a particular period.

Simple to Understand

Absolute returns are straightforward, reflecting the total gain or loss without needing complex calculations or comparisons to benchmarks.

No Benchmark Dependency

Unlike relative returns, absolute returns do not rely on a market index or competitor performance, making them easy to assess on their own.

Clear Measurement of Profitability

Absolute returns provide a direct measure of how much an investment has gained or lost in real terms, offering clarity on profitability.

Flexible for Different Timeframes

This measure can be used across various time periods, from short-term to long-term, giving flexibility in performance evaluation.

Limitations of Absolute Returns

In highly volatile markets, absolute returns can be misleading since they fail to reflect the underlying market conditions or changes in value. Here are some of the limitations of absolute returns.

No Time Context

Doesn’t indicate annualised growth, making it unsuitable for long-term comparisons.

Ignores Compounding

Overlooks the reinvestment effect, which is crucial in mutual funds.

Lacks Context for Comparison

Absolute returns provide no context relative to market performance, making it difficult to assess if the return is good or bad without a benchmark.

Ignores Risk Factor

It doesn’t account for the level of risk taken to achieve the return, which could lead to misleading conclusions about an investment’s true performance.

No Insight into Consistency

Absolute returns only measure total performance and don’t show whether the returns were consistent or volatile over time.

Limited for Multi-Asset Comparisons

This metric doesn’t allow for easy comparisons between different asset classes or investment strategies, which may vary in volatility or risk.

CAGR vs. Absolute Returns: Key Differences

AspectCAGRAbsolute Returns
Time factorConsiders the time periodIgnores the time duration
ApplicabilityBest for long-term investmentsBest for short-term gains
CompoundingReflects compoundingDoes not reflect compounding
VolatilitySmoothens volatility, showing an average rateFails to account for market fluctuations

While the total return indicates overall growth, the CAGR emphasises the annual rate of growth.

Which is Better for Mutual Fund Investors?

For mutual fund investors, relative returns are often more useful because they show how a fund performs compared to its benchmark or peers, providing better context. However, absolute returns can still be valuable to gauge the actual gain or loss on the investment over time.

Use CAGR for Long-Term Analysis

CAGR is more appropriate for long-term investments, such as equity mutual funds or retirement portfolios. It helps in comparing different funds and understanding the actual growth trajectory over time.

Use Absolute Returns for Short-Term Assessment

Absolute returns work well for short-term investments, such as debt funds or investments with a tenure of less than a year. They offer clarity on total gains but don’t provide a comprehensive annualised perspective.

Conclusion

When analysing mutual fund performance, neither CAGR vs. absolute returns alone is enough to provide a complete picture. Instead of viewing them individually, investors should use both metrics. Absolute returns give an immediate snapshot of growth, while CAGR offers a deeper understanding of annualised performance over time. The key lies in aligning these insights with your investment goals. By balancing short-term growth with long-term consistency, you can make informed decisions to maximise returns while staying on track with your financial plan.