When you invest in an asset you would like to know the growth rate of that particular investment. There are various ways of doing the calculation. Let’s learn more about Compound Annual Growth Rate and how this is useful in measuring the growth of mutual fund investments.
What is CAGR (Compounded Annual Growth Rate)?
CAGR is the commonly used acronym for Compounded Annual Growth Rate. It is the cumulative measure of the performance of a product over a period of time. It is expressed in terms of percentage and is quite often used to denote the increase in the earnings or revenue or sales of a company or investment product. This measure is one of the main parameters which is looked at while making investment decisions as it considers the time.
How is CAGR Calculated?
There are three aspects or pointers used in the calculation of CAGR. The CAGR formula is given below.
CAGR = [(End Value/ Beginning Value)] ^ (1/n) – 1
As per this formula, for calculating the CAGR of any investment, the end value of the investment along with the beginning value and the period of investment are considered. CAGR values can also be used to calculate absolute returns which is another measure of evaluating the investments.
Let us consider an example to understand CAGR better.
Given below are two funds Fund A and Fund B. Let us evaluate the performance of each fund based on CAGR.
Initial Investment in each fund- Rs. 1,000
Period of holding – 3 years
| Years | NAV Fund A | NAV Fund B |
| 1 | 1000 | 1000 |
| 2 | 1500 | 800 |
| 3 | 2000 | 2400 |
CAGR of each fund at the end of 3 years is
CAGR Fund A = [(2000/1000)^⅓]-1 = 25.99%
CAGR Fund B = [(2400/1000)^⅓]-1 = 33.89%
Based on CAGR, we can see that Fund B has performed better. However, it does not consider the dip in the NAV in the second year. This indicates that CAGR considers only absolute values of final investment without considering the fluctuations during the period of investment.
Importance of CAGR in Investment Analysis
CAGR is an important tool which is used to measure the performance or profitability of any investment. As it considers the period of investment, it helps in providing a better understanding of the performance of the investment or the company in comparison to another. This helps in making accurate investment decisions which can result in higher profitability for the investor.
Limitations and considerations of CAGR
While CAGR is widely used as a tool to evaluate performance of any company or portfolio of investments, it has some limitations. These limitations are discussed below.
- CAGR does not consider market fluctuations or market volatility while evaluating the performance of any stocks. This is a hurdle in getting the true picture of the performance of such stock and can mislead the investor in making any investment decision.
- CAGR cannot be used as the sole basis to make investment decisions related to stock markets. Investors have to consider other parameters that incorporate the risk involved on account of market volatility and have to accordingly make their investment decisions.
- CAGR does not reflect on the short-term variations in the market and hence cannot be used as sole yardstick to make an investment decision between two funds or portfolios.
What is the difference between CAGR and IRR in mutual funds?
CAGR and IRR are the two important mathematical tools that are used to calculate or measure the performance of any company or any investment. CAGR can be used to calculate the returns on an annual basis. IRR on the other hand can be used to calculate returns after accounting multiple inflows or outflows.
When it comes to evaluating two mutual fund portfolios, CAGR can be used to evaluate the fund where the investor has made a one-time investment or a lump sum investment.
When the investment is made in the form of SIPs, IRR or XIRR (which is an advanced mathematical tool available in excel) can be used to provide effective analysis of the performance of the fund.
Conclusion
While CAGR cannot be considered to be a sole parameter in evaluating the performance of any fund or investment portfolio, it cannot be ignored as well. CAGR is considered to be one of the important measures that has to be accounted by the investors in making investment decisions.
FAQs on Compound Annual Growth Rate
1. What is a CAGR calculator?
CAGR calculator is a tool available on a few online websites which can help in calculating the CAGR of any investment or company by providing the necessary inputs like Initial investment, final value of investment and period of holding.
2.Does CAGR consider the time value of money?
Yes. CAGR is a better tool of performance as it considers the time value of money.
3. Can CAGR be used as a sole parameter to evaluate between two investments?
No. CAGR does not consider the market fluctuations and hence cannot be considered to be the sole parameter for evaluating between two portfolios or investments.
4. What is the use of CAGR calculator in analysing mutual funds?
CAGR calculator is an effective tool in analyzing mutual funds performance based on year on year analysis. CAGR can be used in the following manner while analysing mutual funds.
- Investors can use CAGR to evaluate the performance of the fund each year. The investor can then use this data to understand whether the performance of the fund is following an upward or downward trend over the period of investment. This data can be used by the investor to move away from the fund without wasting further time and resources if the fund performance is found to be steadily on a decreasing trend.
- This tool can also be used to measure the performance of the fund against its peers or the benchmark. The data generated in this process can help the investor in making better investment decisions like moving to a better fund or increasing the investment in the existing fund if its performance is better than its powers or the benchmark.
5. What are the additional mathematical tools that can be used to analyse mutual funds?
Some of the additional mathematical tools that can be used to analyse mutual funds are internal rate of return (IRR), annualized returns, average annual returns (AAR), trailing returns or returns since launch.
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