Returns from an investment can be estimated using both absolute returns and CAGR. On the one hand, absolute returns are a measure of the total return from an investment, irrespective of the time period. CAGR, on the other hand, is the return from an investment during a specific period. Both absolute returns and CAGR are used for determining the return from an investment. However, both use different ways to calculate the return. This article covers absolute return and CAGR in detail and elaborates on absolute return vs CAGR.
What Are Absolute Returns in a Mutual Fund?
Absolute returns in mutual funds refer to the return from a fund over a certain period of time. 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.
Absolute returns are pure returns from the investment and don’t compare to any other benchmark. Also, absolute returns can be positive or negative. The fund managers of mutual funds seek a positive return by using multiple strategies like short selling or derivatives.
While calculating absolute returns, the tenure of the investment is the least important. Only actual investment and the current value of the investment are considered while estimating the absolute return.
The formula for Absolute return:
((Current value of the investment/ Actual investment) – 1) * 100.
Let’s understand absolute returns with an example. An investor invests INR 1,00,00 in a mutual fund. Over a certain period of time, the investment grows to INR 3,00,000. The absolute return from this investment can be calculated using the above formula.
Absolute return = (300000/100000 – 1) * 100
The absolute return of the above investment is 200%. The tenure of the investment is not considered while calculating the return from the investment. The 200% return could’ve been earned over a period of months, years or decades. Using absolute return alone, one cannot determine whether the investment is good or not as the tenure of the investment isn’t known.
Therefore, absolute returns only tell how much the investment depreciated or appreciated. It doesn’t tell how fast the investment grew or fell. Hence, absolute returns cannot be used for comparison of two different investments.
What is Compound Annual Growth Rate (CAGR) in a Mutual Fund?
CAGR (Compounded annual growth rate) is the rate of return from a mutual fund during a specific period of time, assuming the profits are reinvested. In other words, CAGR shows how much the investment has grown from the beginning to ending value over a period of time.
CAGR shows the rate at which the investment grows each year to reach the investment’s final value. It smoothes out the performance of a fund so that it can be easily understood and becomes comparable to other investments. One can use CAGR to compare two investments and determine which has performed better during a specific period of time.
The formula for Compounded Annual Growth Rate CAGR
CAGR = ((Ending value/ Beginning value) ^ (1/n)) – 1
Where, n is tenure of the investment
Let’s understand CAGR better with the help of an example. An investor invested INR 2,50,000 lump sum in a mutual fund. And the investment grew to INR 4,00,000 in 3 years. The CAGR of this investment can be calculated using the above formula.
CAGR = ((400000/250000) ^ (1/3)) – 1
CAGR = 16.96%
This means the investment grew 16.96% every year for three years for it to grow to INR 4,00,000. In other words, the average return from this mutual fund is 16.96%. The absolute return from this investment is 60%. But the CAGR is 16.96%.
CAGR enables investors to compare multiple investments and help them plan their financial future. Let’s say an investor has an opportunity to invest in stocks and bonds that have a CAGR of 18% and 15%, respectively. The investor will choose stocks as it has a higher CAGR when compared to bonds.
Moreover, CAGR can be used to estimate the average growth of an investment. Due to market volatility, the investment might grow by 10% one year and grow only by 2% the other year. CAGR helps smoothen out the returns and gives a better picture of an investment’s overall growth.
Calculating CAGR can be a time taking process. Hence one can use a CAGR calculator to estimate returns from a mutual fund investment. Scripbox’s CAGR calculator is a simple online tool that helps in calculating the CAGR of investment to analyze an investment opportunity.
All one has to do is enter the initial value, final value, and investment tenure. The calculator will estimate the CAGR within seconds.
Difference Between Absolute Return Vs CAGR
Investments are made to earn profits. There are different ways to represent returns from an investment. Absolute returns is a simple method that helps in determining the return from an investment, irrespective of the period or tenure of the investment. Absolute returns simply take the initial investment amount and the maturity amount. On the other hand, compounded annual growth rate takes into account the investment duration or tenure. Hence, it gives a more accurate and comparable earnings percentage.
The formula for Absolute return
((Current value of the investment/ Initial investment) – 1) * 100.
The formula to calculate CAGR
CAGR = ((Ending value/ Beginning value) ^ (1/n)) – 1
Where, n is tenure of the investment
Example for Absolute Return Vs CAGR
To understand the difference between absolute return and CAGR better, let’s take an example of Mr Krishna who invested INR 5,00,000 lump sum in a mutual fund in 2010. He withdrew the investment in 2020, and the value of the investment is 8,00,000.
The absolute return for Mr. Krishna is ((8,00,000/5,00,000) – 1) * 100
Absolute Return = 60%
While, the CAGR is ((8,00,000/5,00,000)^(1/10)) – 1
CAGR = 4.81%
While the above absolute return looks promising, the investment has actually grown only 4.81% every year for ten years.
Absolute returns tell how much an investment depreciated or appreciated. And, it doesn’t tell how fast the investment grew or fell. Therefore, absolute returns are not ideal for comparing two different investments.
On the other hand, CAGR can be used to determine an investment’s average growth. With markets being volatile, the returns are never the same over the years. For example, an investment might grow by 12% one year and grow only by 5% the other year. Therefore, CAGR addresses the volatility and smoothens out the returns. Hence, it gives a clear picture of an investment’s overall growth. Also, it is a good measure to compare different investments.
In short, if absolute return is the distance your investment has travelled, then CAGR is the rate at which your investment has travelled or grown.
CAGR Vs Absolute Return – Which is Better?
Both absolute returns and compounded annual growth rate are useful in determining the returns from an investment. However, the difference between the two lies in the aspect of time consideration. For investments with longer durations, the CAGR value is a better measure. CAGR determines an investment’s annual growth rate, whose value usually fluctuates over the investment tenure. While on the other hand, absolute returns consider only the purchase value and sale value of an investment to calculate returns.
For investments with a duration of less than a year, one can consider the absolute return. While, for investments with tenure greater than a year, CGAR gives a better picture. Also, with CAGR, one can compare two or more investments held for different periods. When it comes to tenure less than one year, CAGR may inflate or shrink the returns therefore, not giving the actual return.
Frequently Asked Questions
Annualized return is the measure of an investment’s performance during a specific period. In other words, annualized return shows how much your investment has grown from the beginning to ending value over a certain period of time. It is the same as CAGR.
To convert absolute returns to CAGR, one should take the nth root of (Current value of the investment/ Actual investment) and subtract 1 from it. In other words,
((Current value of the investment/ Actual investment)^(1/n)) – 1 will give the CAGR value.
CAGR considers the tenure of an investment and helps in determining the annual growth rate. On the other hand, absolute return considers only the investment value and the maturity value. Therefore, the absolute return cannot be used for comparison of different investments. Hence, CAGR is a good metric that helps investors compare the performance of different investments. It also gives a complete picture of the gains made from your investments. Furthermore, for investments with a tenure of more than one year, CAGR gives a better picture of the returns. Finally, CAGR determines the return from an investment over a specific period of time while taking into consideration the market volatility.