We all make investments with the common objective of generating the desired returns. Whenever we have to decide on any investment, the return expectation is one critical element that influences our decision. We often compare the performance of multiple investments based on their returns. Note that often returns are expressed or calculated in different forms and have different purposes. We can notice different return measures when we
browse through various product literature, brochures, websites, return calculators and so on. Most investors may make mistakes or get confused with the way these returns are measured, used and represented. Therefore, it’s important to understand these types of return measures to draw better, informed conclusions about your investment/portfolio.
Broadly, the returns measured from an investment are calculated by comparing the cost paid to acquire the asset (outflow) to what is earned from it (inflows) and computing the rate of return. The inflows can be from periodic payouts such as interest from fixed income securities and dividends from equity investments and capital gains or losses from a change in the value of the investment. In mutual funds, investors enjoy returns in the form of dividends and capital gains. While the forms of returns may differ, almost every fund or investment’s performance is calculated in the form of standard return measures. Let’s look at some of these types of return measures.
Absolute Returns, as the name indicates, is the absolute growth or decline in your investment, expressed in terms of percentage. The time taken for this change is not accounted for. Generally, this method of calculating returns is used for periods less than 1 year. For instance, the current market value of the investment is Rs. 1,40,000 and the amount originally invested was Rs.1,00,000. In this case, the absolute return would be 40%. People often use absolute returns to measure the returns on real estate, like how many ‘x’ times has your property value grown? Since we are not considering time here, often absolute returns can be very misleading over one year and the longer the period, the more misleading it gets.
As the name suggests, Annualized returns measure how much your investment grew in value ‘annually’ or yearly. The absolute returns of the investment are normalised or spread out over yearly periods and a single ‘return’ is derived. An important thing to note in annualized returns is that the effect of compounding is included. Hence, even if the number may not look very attractive at first, over longer periods, it can greatly impact returns. Investors should be careful in not discounting this power of compounding inherent in the annualised returns.
Let us see with an example - what is better? 15% annualised returns for 5 years or 85% absolute returns? Normally, people think that 15% by 5 times is 75% and hence 85% is a great deal. However, considering the power of compounding, the 15% option gives you a much higher effective return of 101.14%. This difference in returns can grow to astonishing numbers over longer periods.
The total return is the actual rate of return earned from the investment, considering all forms of inflows and appreciation. For mutual funds /stocks, it would include both capital gains and dividends. Total returns are important to consider when there are different forms of return/income from a given investment to realise its true value.
For instance, you invested Rs 1,00,000 at NAV of Rs. 20 and you purchased 5,000 units (Investment/NAV) of a scheme. After a year the NAV of your scheme grows to Rs.22 hence the value of your units grows to Rs. 1,10,000. Here, capital gains made by you are Rs.10,000. Now in the very same year, your scheme declares a dividend of Rs.2 per unit, hence the total dividend received by you is Rs.10,000 (units by dividend). If we sum up all the returns we get a total return earned by you of Rs. 20,000 which makes your total return 20%.
Point to Point Return:
As the name suggests, the point-to-point returns measure annualized returns between two points in time. To calculate point-to-point returns of a mutual fund scheme, you necessarily need to have a start date and end date. Often, we see that returns are expressed in terms of fixed periods of say 1 year, 5 years, 10 years and so on. Here the ‘To Date’ is always the present or the date of the report /calculation and the ‘From Date’ is the period before the ‘To Date’. Investors should understand that the choice of ‘To Date’ makes all the difference to returns, and may or may be truly reflective of the quality/performance of the investment.
CAGR or Compounded Annual Growth Rate:
CAGR is the most common mutual fund return used when a fund’s performance, usually seen for longer holding periods. While Annualised returns is generally used to convert less than one-year returns to an annual return, CAGR is used for longer periods to give compounded annual returns. CAGR considers the start and end value of the investment and the period concerned while normalising all highs & lows of the investment during the period. One important point to note is that CAGR does not consider periodic investments or multiple cashflows. Thus, if there are multiple investments in a year at irregular dates, CAGR may not provide a good picture. It works best on a point-to-point basis where we are considering one-time investments.
XIRR or Extended Internal Rate of Return:
What if we have multiple cashflows - inflows and outflows, say in the case of SIP? Which measure to use if CAGR is not suitable? The Answer is XIRR.
The Internal Rate of Return (IRR) is a very common measure used to calculate the returns from a series of cash-flows. XIRR, as the name suggests, is the extended version of IRR, used to calculate returns on investments where multiple cashflows are happening at different times. In XIRR, the CAGR of each cash flow is calculated, and then they are considered together to give you the overall CAGR.
When we talk about mutual funds in India, we have clear guidelines on what has to be disclosed w.r.t. scheme returns. Importantly, regulations do not allow anyone to promise any returns unless it is an assured returns scheme. Regulations require the scheme performance to be compared and shown against the scheme’s benchmark. The returns are required to be calculated based on ‘Total Returns’ Index values and when the scheme age is +3 years, point-to-point returns and CAGR as on a particular date, both are required to be disclosed. This can be seen in scheme related documents.
Well, after knowing these measures, there are a few things to be kept in consideration. When evaluating any investment or even mutual funds performance, one must not be misled by a return figure in isolation. One must always compare apples to apples, the period, the measure and the product categories being compared should match. A good understanding of how to evaluate returns can assist in evaluating and making investment decisions. However, as it is widely known, past returns are only indicative in nature and may or may not sustain in the future. In any investment decision, returns are just a small part of it. Other factors like risk, liquidity, investment horizon, taxation and more importantly personal factors like risk appetite, investment objective and requirement, etc are more critical to evaluate. An understanding of all these factors, not just returns, is important to succeed as an investor.