Absolute Returns Or CAGR: What’s Your Choice?

When it comes to evaluating the performance of mutual funds, two important terms often come up: absolute returns and compound annual growth rate (CAGR) returns. Understanding these two metrics is crucial for investors to make informed decisions about their investments. While both measure the growth of investments, they do so in different ways. The article explains the methodologies and how they benefit the investors [EasyDNNnews:PaidContentStart]

Returns are exactly what we want from our investments. We invest not only to save our hard-earned money and protect it from inflation so that the rupee’s value doesn’t depreciate, but also to get returns on it. The first goal is generally ignored, and investors usually focus on the returns. Well, it’s obvious that we, as investors, love to see good and consistent returns in our portfolio. Returns not only give us immense satisfaction and keep reminding us that starting to invest was a good decision, but they also boost our confidence to continue investing until our goal is achieved. 

Whether its mutual funds, stocks, or any asset class, calculating returns has become easier, thanks to advances in technology. We now have applications where we can check almost everything, including returns like CAGR, absolute return, point-to-point return, rolling returns, and so on, which were not as easily accessible before. However, too much data can also make investors confused about which metric to rely on and which indicator or return type is most important for making informed investment decisions. 

When it comes to evaluating the performance of mutual funds, two important terms often come up: absolute returns and compound annual growth rate (CAGR) returns. 

Understanding these two metrics is crucial for investors to make informed decisions about their investments. While both measure the growth of investments, they do so in different ways. In this article, we will explore two widely used concepts of return calculation that we regularly use to calculate our investment returns, such as in equity or mutual funds: absolute return and CAGR return. Let’s start with the former. 

Absolute Return in Mutual Funds
Absolute return is a straightforward measure of the total return an investor earns on their investment over a period of time, without taking into account the effect of compounding. It is simply the percentage change in the value of the investment from the initial investment to the final value over a specified period. It is the total return from a mutual fund from the date of investment. Absolute returns are expressed as a percentage and show how much the investment has grown or depreciated in value. 

While calculating absolute returns, the tenure of the investment is the least important. Only the actual investment and the current value of the investment are considered while estimating the absolute return. Let’s explore absolute returns with an example. Suppose an investor invests ₹10,000 in a mutual fund, and after a certain period, the investment grows to ₹25,000. The absolute return for this investment can be calculated using the following formula: ■ Absolute return = (25,000 | 10,000 – 1) * 100 In this case, the absolute return is 150 per cent. It’s important to note that the duration of the investment is not factored into this calculation 

Let’s consider another scenario where you have invested ₹10,000 in the mutual fund, but your investment was made in January 2022. Over time, your investment grew to ₹25,000, reflecting the same 150 per cent return. While the return is the same as in the previous example, the key difference here is the investment’s tenure. The period for which the money has been invested – whether it’s a few months, years, or decades — becomes significant when analysing the overall performance. In this case, simply using the absolute return figure of 150 per cent doesn’t give you enough information about how quickly or slowly the investment grew. 

The tenure is crucial because it helps assess whether the return was achieved in a short span or over an extended period. Without considering the time factor, you can’t fully evaluate the investment’s performance or make a proper comparison between investments made at different times. Thus, while absolute return reveals how much an investment has appreciated or depreciated, it doesn’t provide insight into the speed at which this change occurred. As a result, absolute return is not quite suitable for comparing different investments as it doesn’t account for varying timeframes. 

Talking about the advantages and disadvantages of absolute returns in mutual funds, one of the main benefits is its simplicity. Absolute return is a clear and straightforward metric that doesn’t require complex calculations, making it easy for investors to understand. However, there are also some limitations to this approach. Absolute return lacks context, as it doesn't consider the investment timeframe or prevailing market conditions. It also does not offer a benchmark comparison, making it difficult to gauge how the fund performed relative to the broader market. This can make it harder for investors to determine - whether the fund is truly outperforming or underperforming in a broader context. 

So, when is the right time to use absolute returns? The right time to use absolute returns is when the duration of the investment doesn’t play a crucial role in your analysis. It’s particularly useful when you want to understand how much the value of your investment has appreciated or depreciated without factoring in the timeframe. Absolute returns are better suited for calculating the returns of investments with a holding period of less than a year. 

CAGR Returns in Mutual Funds
Compound annual growth rate (CAGR) returns are often referred to as CAGR returns, which are not only used in stocks but also in mutual funds. CAGR is one of the most widely used metrics to evaluate the performance of mutual funds over a specified period of time. It gives investors a smooth and consistent rate of return, assuming that profits are reinvested back into the fund, which helps in compounding the investment. 

CAGR represents the rate at which your mutual fund grows annually, assuming that the growth is compounded over a given time. Unlike simple return calculations, which only look at the starting and ending values, CAGR reflects the consistent growth rate needed for the initial investment to reach its final value over a specific period. For instance, if, 20 years ago, you had invested ₹10,000 which has now grown to ₹2 lakhs, the absolute return of the investment would be an incredible 1,900 per cent returns. 

But this tells only half the story as the investment of ₹10,000 grew to ₹2 lakhs over 20 years. In this case, the annualised return is 16.16 per cent which means the investment is growing at a rate of 16.16 per cent return over a period of time. Let’s analyse it further by comparing two different scenarios with an investment of ₹10,000 for the next five years. 

In both the cases with ₹10,000 investment, the CAGR return is the same despite the fact that in the second scenario in the second year, the investment value falls below the actual investment value but eventually recovers by the end of the fifth year. When you review the calculation each year and determine the CAGR, you can assess the volatility experienced over your investment tenure and evaluate how well your investment performed during this period, ultimately achieving a 14.87 per cent CAGR. 

Limitations of CAGR in Mutual Fund Investing
The CAGR is widely used by investors and analysts to measure the average annual growth rate of an investment, assuming a steady rate of return over the investment period. Although it provides a useful snapshot of growth, it has some significant limitations when it comes to evaluating mutual fund performance. Here are the key limitations investors should keep in mind: 

1: Past Performance - CAGR is a backward-looking metric, relying solely on historical data to calculate average growth. While historical performance can offer insight, it does not guarantee future results. Mutual fund returns depend on numerous external factors, such as economic cycles, changes in interest rates, government policies and market trends, which can alter significantly over time. For instance, a fund that delivered high CAGR in a booming market may not achieve the same results in a downturn or bear market. Let us understand with an example. Consider the performance of the Nifty Pharma index during the three-year period from 2012 to 2015 as displayed in the table when it delivered an impressive CAGR return of around 40 per cent. 

Let us suppose you had invested ₹1 lakh into pharmaceutical funds based on this performance. However, after your investment, the pharmaceutical sector began to underperform and delivered a negative return over the next three-year period, which was your investment horizon. As a result, your capital would have reduced annually by around 10.80 per cent while the absolute drawdown was around 36.50 per cent. This illustrates that past return does not guarantee promising future returns. 

2. Ignores Volatility - One of the biggest limitations of CAGR is that it assumes a smooth growth rate, ignoring year-to-year fluctuations in a mutual fund’s performance. Mutual funds rarely grow at a steady rate; they are subject to the ups and downs of the market. For example, a fund may experience a year of strong growth followed by a year of significant decline, then recover over time. It would present the fund’s growth as stable, masking the actual volatility. 

This can be misleading for investors, as a fund with high volatility may not align with their risk tolerance, even if its CAGR is high. Look at the chart below to understand the example discussed above, looking at the journey of five years’ CAGR return and how it reached and generated 14.87 per cent in the past five years. The blue line showcases the smoothness, but the orange line gives us a glimpse of behind-the-scenes and how it reached 14.87 per cent CAGR. 

3. Avoid Risk Part - CAGR provides no information about the level of risk associated with achieving a given return. Mutual funds with high CAGRs may often be taking on higher levels of risk to achieve those returns. For instance, an equity fund investing heavily in high-growth sectors might post a higher CAGR than a balanced or bond fund, but it also exposes investors to greater market volatility and potential losses during downturns. Relying solely on CAGR without assessing the fund’s risk profile can lead to unsuitable investment decisions. Investors should review additional risk metrics, like beta and the fund’s exposure to different asset classes, to understand the level of risk involved in generating high returns. 

Conclusion
In conclusion, understanding the difference between absolute returns and CAGR is crucial for evaluating investment performance effectively. Absolute return gives a quick snapshot of the total percentage increase or decrease in the value of an investment, making it suitable for shorter holding periods typically under a year. It is suitable when the time factor is less significant. Both CAGR and absolute returns are useful metrics for assessing investment performance, yet they differ significantly in their approach to incorporating time. 

CAGR is generally the preferred metric for long-term investments, as it calculates the annualised growth rate over a set period. This gives insight into how the investment’s value changes on an annual basis, providing a smoother picture of its growth trajectory. In contrast, absolute returns measure the total percentage gain or loss by comparing the initial investment with its value at the time of sale, without factoring in the time period. 

For investments held less than a year, absolute returns may be more practical due to their simplicity. But for investments held over multiple years, CAGR is valuable for understanding the growth pattern and gauging long-term performance. Both metrics offer unique benefits depending on the investment duration: absolute returns reveal the actual profit or loss, while CAGR allows for consistent comparisons, especially across long-term investments. To make informed decisions, it’s ideal to consider both metrics, considering your risk tolerance and investment goals. 

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