What is the Compound Annual Growth Rate?
Compound Annual Growth Rate (CAGR) is a numeric figure that tells us about the growth of a particular investment over a specific time period, of more than one year. It takes into account the interest earned on principal investment as well as the interest earned on accrued interest.
Any financial instrument, be it stock or equity funds, have the tendency to deliver volatile returns over a period of time, owing to fluctuations in the market. CAGR averages down the volatile returns over a given time.
How Does CAGR Feature in Mutual Fund Returns?
Mutual Funds have become a popular investment instrument in recent times, owing to the myriad of advantages that they offer. While choosing a suitable mutual fund for investing, it is recommended that the investor checks out the past CAGR during different time spans, such as 3 -year and 5 – year. It gives us an idea of how the specific fund under consideration has grown annually.
CAGR for a mutual fund essentially tells us how the fund has performed during the given tenure, if we average out the volatility, and provided the returns are reinvested. Since CAGR follows the compound interest method, the returns should have been reinvested.
What is the Formula for CAGR?
CAGR essentially is the annual growth rate required to make the initial value of investment reach its final value, in a given time period. To calculate the CAGR, we use the following formula:
CAGR = (Final Value/ Initial Value)1/n – 1
Where,
Final Value = Value of investment at the end
Initial Value = Value of principal investment
n= Number of years for which the money is invested
Let’s understand this with an example. Suppose, you’ve invested Rs. 1,000 on January 1, 2018, and decide to redeem the whole accrued amount (investment + interest) after 2 years, on January 1, 2020. The final value you receive is Rs. 1,500. If we put the aforementioned values in the formula, CAGR comes out to be 22.47%. At an absolute level, the investment has gained 50%. If we directly divide it by 2, the annual returns comes out to be 25%. However, this 25% doesn’t factor in interest earned on interest accrued in 1st year of investment. That is why, it is recommended to use CAGR while calculating the annualized returns, as it reflects the true growth picture.
How is CAGR useful for investors?
- In case of mutual funds, you can compare the CAGR of that fund with the benchmark returns to get an idea about the performance of that fund, to know if the fund has performed better than the market or not.
- Investors can use the CAGR calculator to know at what rate their investment needs to grow to reach the final value. The final value would be later used to achieve any of the investors’ financial goals. Now once the investors know the expected rate of return, they can pick that financial instrument for investment, whose CAGR is equal to or more than the expected rate of return.
- Instead of using absolute returns while investing in equity funds, it is recommended to use CAGR, so as to get a better idea of the annual performance of the fund. Absolute returns do not factor in market volatility.
SIP and CAGR
Investors also have an option to invest via Systematic Investment Plan (SIP) in mutual funds. SIP involves regular investment of small amounts of money in a mutual fund scheme at predefined intervals. When the investment stretches over a span of time with installments at irregular intervals, it becomes difficult to calculate CAGR. Instead, Extended Internal Rate of Return (XIRR) is used to predict returns on investment via SIP.
XIRR refers to aggregation of multiple CAGRs on each SIP Investment. For this, it is best to use a SIP calculator rather than individually checking CAGR for each investment you make via SIP.
It is also helpful when there are irregular cash flows via Systematic Investment Plan (SIP) and Systematic Withdrawal Plan (SWP). It incorporates the complexity of all the investments and withdrawals and gives a consolidated return value.
For instance, consider the following investment where an investor makes an investment of ₹ 2,000 at regular intervals for 5 months. The total principal amount comes out to be ₹10,000. However , at the end of 5 months, she gets an amount equal to ₹11,000.
| Date of SIP | Amount deposited |
| March 1, 2019 | ₹2,000 |
| April 1, 2019 | ₹2,000 |
| May 1, 2019 | ₹2,000 |
| June 1, 2019 | ₹2,000 |
| July 1, 2019 | ₹2,000 |
| Final return amount redeemed | ₹11,000 |
Extended Internal Rate of Return for the above investment = 45.27% per annum
To calculate Mutual Fund SIP Returns, please refer to: SIP Calculator