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
Aspect | CAGR | Absolute Returns |
Time factor | Considers the time period | Ignores the time duration |
Applicability | Best for long-term investments | Best for short-term gains |
Compounding | Reflects compounding | Does not reflect compounding |
Volatility | Smoothens volatility, showing an average rate | Fails 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.