Why do we invest in mutual funds? We want to get returns in the form of capital appreciation or income or both. Return on investment is a metric used to measure the performance of a mutual fund scheme. In this blog post, we will discuss about different type of returns and how you can use them to evaluate the performance of a scheme.
Absolute return is the growth in your investment expressed in percentage terms. Suppose you invested Rs 1 lakh in a mutual fund scheme. A few years later, the value of your investment is Rs 1.5 lakhs. The total capital gain made by you is Rs 50,000. The absolute return in percentage terms is 50%. A major weakness of absolute return as a performance measure is that return ignores the time over which the gain was achieved.
Compounded annual growth rate (CAGR)
Compounded annual growth rate or CAGR, in simplest term, is how much your investment grew in value on an annual basis. An important thing to note in CAGR is that the effect of compounding is included in CAGR. Compounding is profits earned on profits. If you invested Rs 1 Lakh in a mutual fund scheme and the value of your investment after 3 years is Rs 1.5 Lakhs, then the CAGR return will be 14.5%. The formula of CAGR = (Final Value / Investment) ^(1/Investment tenure) -1. CAGR- is one of the most important return measures in mutual funds. Mutual fund returns for investment periods exceeding 1 year are always expressed in CAGR.
CAGR is the annual return you get on your investment with compounding effect i.e. at the end of each year you will earn return not only on your investment, but also on the accumulated profit like compound interest. In the above example, your mutual fund scheme earned a profit of Rs 0.5 lakhs on Rs 1 lakh investment i.e. absolute return of 50% over 3 years. This means that, on an annualized basis, you earned return of 14.5%. Your actual returns may have been different every year because mutual funds are market linked investments, but over your investment tenure you earned returns that are equivalent to annualized returns of 14.5%.
Point to Point Return
Point to point return measures the return of a mutual fund scheme between two specific dates. If the period between the two dates i.e. start date and end date, exceeds 1 year then point to point return are expressed in CAGR. For example, you invested Rs 1 lakh in a mutual fund on 1st January 2018 and its value on 1st September 2021 was 1.5 lakhs. The period (in years) between 1st January 2018 and 1st September 2021 is 3.67 years. The point to point return over this, expressed in CAGR, was 11.7%. The formula of point to point return is the same as CAGR. You can compare point to point returns of two mutual fund schemes in your portfolio, provided both are over sufficiently long investment tenures to see which may have performed better.
A variant of point to point return is known as trailing return. Trailing returns measure investment returns as on a specific date for various investment periods e.g. 6 months, 1 year, 3 years, 5 years etc. For example, if you want to calculate trailing returns of a scheme as on 31st August 2021, then start date for 1 year return will be 1st September 2020, start date for 3 year return will be 1st September 2018, start date for 5 year return will be 1st September 2016 etc. Mutual fund monthly factsheets present performance in terms of trailing returns (as on the last business day of the month).
Point to point returns can be used to measure investment performance for investments, where there are two cash-flows i.e. one cash-inflow (investment) and one cash-outflow (redemption). However, point to point return cannot be used in instances where there are multiple investment date. e.g. SIPs or multiple redemption dates e.g. SWPs. There can be several other instances of multiple cash-flows e.g. dividend (IDCW) payouts, additional purchases, partial redemptions etc. The performance metric, XIRR is used in such cases.
XIRR is a variant of a financial term known as Internal Rate of Return (IRR). Without going into the mathematical complexities of IRR calculation, IRR measures the annualized return of a series of cash-flows (cash inflows and cash outflows). Investors can calculate XIRR using Microsoft Excel. Investors need to enter the transaction date and the cash-flows in the spreadsheet. Cash outflows (e.g. SIP instalments, additional purchases, one-time investment etc.) should be entered as negative values, while cash inflows (e.g. redemptions, dividend pay-outs, SWP payments etc.) should be entered as positive value. XIRR can be used to calculate returns of SIPs, SWPs or any other investment which has multiple cash inflows or outflows.
One of the criticisms of point to point return is that it is biased by the market conditions prevailing on the end date. For example, if the market is high on the end date of point to point return, then the return of the scheme will be high. However, the scheme may not have performed well in relative terms when the market was low. Rolling return solves this bias problem by calculating returns for a certain investment period e.g. 1 year, 3 year, 5 year etc., in different market conditions.
Rolling returns are the annualized returns of the scheme taken for a specified investment period e.g. 1 year, 3 years and 5 years etc. over a sufficiently long period across different market conditions. The returns may be rolled daily, monthly or yearly.
For example, let us assume that the performance period for rolling returns is last 10 years ending 31st August 2021. The period from 1st September 2011 to 31st August 2021 covers different market conditions e.g. bull markets, bear markets, flat markets etc. To calculate daily rolling returns, we will calculate returns for all 1 year investment periods (rolled daily) starting 1st September 2011, then 2nd September 2011, till we reach 31st August 2021. If we are calculating monthly rolling returns, then the investment periods will be rolled monthly i.e. 1st September 2011 to 31st August 2012, 1st October 2011 to 30st September 2012 etc. till we reach 31st August 2021. It is fairly intuitive that rolling returns will cover different types of market conditions.
Rolling returns of a scheme are usually compared with its market benchmark index. You can see how the scheme performed versus its benchmark index in different market conditions. Rolling returns will tell you if the fund manager of the scheme was able to beat the benchmark across different market conditions. Rolling return is a measure of consistency of the scheme’s performance.
Total Returns Index
Total return is actual return on investment which includes both price appreciation and dividends. Let us assume that the share price of a stock one year back was Rs 100. One year later, the share price is Rs 110. During the year, the stock also paid Rs 2 / share as dividend. Then the total return will be 12%. A Total Return Index (e.g. Nifty 50 TRI) factors in both the appreciation of the parent index (Nifty 50) and the dividends paid by the constituents (underlying stocks) of the parent index. You should always compare the performance of your mutual fund scheme with the TRI returns of the benchmark index. As such, benchmark performance shown in scheme related documents like SID and monthly fund factsheets are TRI returns (as per SEBI’s requirements).
How to use different kinds of returns?
In this blog post, we have discussed different types of mutual fund returns. You should use these depending on your needs:-
- To see how a scheme in your portfolio has performed, you can see its point to point return based on when you invested in the scheme
- For SIPs, SWPs, folios where you had multiple transactions e.g. additional purchase, partial redemptions etc., XIRR should be used
- For scheme selection for your portfolio, you can look at the trailing returns of the scheme versus the benchmark. For equity schemes however, you should also look at the rolling returns.
- Finally, mutual fund returns on a standalone basis, is not very informative for performance evaluation because mutual funds are market linked instruments. You should always compare the relative performance of the scheme versus its benchmark index (TRI).
You should consult with your financial advisor if you need help in calculating returns of schemes in your mutual fund portfolio.
Issued as an investor education initiative by HSBC Mutual Fund.
You may like to read an infographic on Different types of returns too.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.