Analyzing potential investments requires a lot of thought. One of the most important elements influencing your decision is expected return.
Generally, you'll compare different investments based on their final performance -- usually either an interest rate or a percentage gain. By studying various products' literature, brochures, websites, calculators and more, you should start to understand how different measurements of return are calculated and how they're used to help you evaluate 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.
Types of Return Measures
Let’s look at some of these types of return measures.
Absolute returns are the growth or decline in your investment. They are expressed as percentage of value. The fact that we don't take time into account when calculating absolute returns is often misleading. Generally, this method of calculating returns is used for periods less than 1 year. 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.
Annualized returns measure how much your investment grew in value each year. The total return of the investment is averaged out or spread over a number of years, and one "return" is calculated. One important thing to note about annualized returns is that the effect of compounding is included. If a number doesn't look very attractive at first, over longer periods it can have a big impact on your return. Investors should keep this power from compounding in mind when looking at annualized 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% times five is 75%, so 85% is a great deal. However, considering the power of compounding, 15% gives you a much higher effective return of 101.14%. Over time, this difference in returns will grow to astounding numbers.
Taking into account all forms of inflows and appreciation, the total return is the actual rate of return earned from an investment. Capital gains and dividends would be included in the total return calculation for mutual funds / stocks. Considering the total returns of an investment is important when there are multiple forms of income/return from the investment to realise its true value.
For example, say you invest at the price/NAV of Rs. 20 and after a year, the price/NAV grew to Rs. 22. Sometime in the year you also received a dividend of Rs. 2 per share /unit. If you sum up, you are standing on a profit or return of Rs.4 and the total return is 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.
Compounded Annual Growth Rate (CAGR)
CAGR is a 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.
Extended Internal Rate of Return (XIRR)
If we have multiple cashflows - inflows and outflows, as in the case of SIP, which measure should we use if CAGR is not suitable? XIRR is the answer.
The Internal Rate of Return (IRR) is a very common measure used to calculate the returns from a series of cash-flows. The extended version of IRR, XIRR, is used to calculate returns on investments where multiple cash flows occur at different times. In XIRR, the CAGR of each cash flow is calculated, and then they are combined to give you the overall CAGR.
Regulations for Mutual Funds
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.
After knowing these measures, there are a few things to keep in mind when evaluating investments. The first thing is that you need to compare apples to apples; the product categories you're comparing should be the same (the period and measure matter too). Another consideration is that past returns may or may not happen in the future. Returns are important, but they’re only a small part of any decision. A willingness to take risks, liquidity, short-term vs. long-term investment needs, and personal factors like risk appetite and investment objectives need to be considered as well. An understanding of all these factors - not just returns - will help you succeed as an investor.