How Are Mutual Fund Returns Calculated?
Investments are done for the sole reason of creating and growing wealth. The purpose of wealth accumulation could be different though. It is advisable to set-up a different investment for each financial goal.
Mutual funds returns are calculated using compound interest including the interest gained on the amount you invested. Calculating the returns of mutual funds beforehand therefore is also critical as it will determine the amount you need to invest and the time it will take to reach the targeted amount.
1. What are absolute returns?
Perhaps the oldest way of calculating returns, absolute returns on investment plans take into account the initial and final net asset values (NAVs) to calculate profits. It does not consider the time or the investment tenure, which is the most important factor. In case the investment is for less than one year, you may go by absolute returns. But it is not the right means to calculate and compare returns on different long-term investments.
The formula to calculate absolute returns is as follows:
Absolute returns = [(Final value – Initial value)/Initial value]*100
Assume you invested INR 10,000 in 2010 and in 2015, when it matured, you received INR 20,000.
If we use absolute returns, then the returns will amount to INR [(20000 – 10000) / 10000] = 100%
However, absolute returns do not give the accurate overview when you compare mutual funds. To overcome this limitation, it is recommended to calculate the annualized returns.
2. What are annualized returns?
Annualized returns are calculated by using the compounded annual growth rate (CAGR). It compares the right metrics, gives a more holistic picture of the returns made on investments, and helps you to compare the performance of two different instruments in terms of CAGR vs absolute returns.
CAGR = [(Final Value / Initial Value) ^ (1 / Investment Tenure)] – 1
Using this formula on the aforementioned example gives a CAGR as follows:
[(20000 / 10000) ^ (1/5)] – 1 = 14.87% for the first investment instrument
Now assume that you invest INR 10000 in another investment plan for a period of three years and get back INR 20,000 at the end of the tenure. As the new instrument also earns 100% absolute returns, it would appear to be as good as the first investment, but this is not true. Here is the CAGR on this product.
[(20000 / 10000) ^ (1/3)] – 1 = 25.99%
Even though the absolute returns on both the instruments are 100%, the second instrument has a better-earning potential of 25.99% CAGR as compared to 14.87% CAGR on the first one. In other words, you get the same absolute returns from both the instruments, but the second one gives it to you within a shorter duration.
Since CAGR accounts for all factors affecting the earning potential of an investment, it is beneficial when you want to compare mutual funds.
3. What is internal rate of return?
CAGR is ideal to calculate the returns on a lumpsum investment. However, if you want to compare and calculate the annualized returns on evenly scattered investments such as multiple systematic investment plans (SIPs), then you need to use the internal rate of return (IRR) or the IRR/XIRR function of Microsoft Excel.
In order to calculate IRR, enter the data in Microsoft Excel in the following manner:
• Investment dates in the first column
• SIP payments made on the respective dates in the second column
• Maturity amount or the final value in the last cell of the second column of this table as a negative value
Here is an example to better understand this concept. Assume you had a monthly SIP of INR 2,000 and five years later, you received the maturity value of INR 1.8 lakh. Using the XIRR formula in Excel gives an IRR of 16.2%.
You may use a mutual fund return calculator to carry out the same calculations. It allows you to compare the available options more efficiently. Though comparing the annualized return is the most critical part of choosing the right investment instrument, there are other factors as well that affect the performance of the instrument, hence comparing mutual funds using absolute returns isn’t ideal. Particularly in case of mutual funds, the below-listed factors highly affect the performance of the fund.
• Diversification of the portfolio
• Prevailing interest rates
• Macroeconomic conditions
• Performance of the underlying securities or portfolio companies
A mutual fund return calculator is a useful tool. However, making the right investment decisions requires more than just comparing the returns. You may use ARQ, our proprietary investment search engine to carry out a detailed research and analysis of the best performing mutual funds available in the market, and their performance and earnings potentials thereof.
It uses scientific algorithms and quants to analyze over a billion data points to match the right mutual fund to your financial goals and risk appetite. The reports and suggestions from ARQ are free of human bias, as it is a technology-driven automated application. You may access it from anywhere, as long as you are connected to the Internet.