Mutual funds are everywhere. Am I wrong? I don’t think so. Even the people who have never thought about investing have thought about choosing Mutual funds as an investment instrument. Why, though? Have you ever thought about what gave it such a big upfront in recent years? Please do not say it’s Warren Buffet, though that’s partly true. There are plenty of others making a lot of money here too. Tell me if I’m wrong. Aren’t at least one of your friends making money through Mutual funds? Obviously, they are. Mutual funds are like Facebook when it first came out; whether an active user or not, everyone has an account.
But have you ever wondered how these returns are calculated? Don’t just say you haven’t. Because everybody has. We calculate returns and interest on everything. For instance, I am not buying a car right now, but I would make use of HDFC loan EMI calculator to know how much I would be paying as EMI every month if I bought my dream car (I have been using HDFC for a long time; you can use any other bank’s calculator). I use SIP calculators, home loan calculators, and everything else that can give me speculation of how much I will make or how much I would be paying as interest.
It is always good to know what you owe and what you have been rewarded. It keeps you financially prepared. The same applies to Mutual funds. Just like other asset classes. Mutual funds are too calculated by computing the value appreciation of an investment over a certain period of time. Let us understand the types of returns in mutual funds.
Types of Mutual Fund Returns
- Absolute Return
Such returns refer to how much a mutual fund scheme has changed in value at the time of redemption. Consider A, who invests 1 lakh in a fund scheme at the start of 2016. The mutual fund scheme was worth Rs.1.25 lakhs in January 2016. A decides to keep his investment for three years. As a result, the absolute returns obtained by A on his investment over a three-year period can be calculated as follows:
Absolute Return = (Final Investment Value — Initial Amount Invested)* 100/Initial Amount Invested
- Annualized Return
These forms of returns are those received by a mutual fund on a yearly basis. Annualized returns are based on the premise that one’s mutual fund has grown at a steady rate, which is not always the case.
They do, however, provide a reasonable indication of what an investor can expect in terms of returns throughout a year of investing. The following formula is used to compute annualized returns.
Annualized Return = (Final Investment Value – Initial Investment Amount) 1/1 (number of years) — 1
Using the above-mentioned example, if we enter all of the numbers, we get a rate of return of roughly 8.5% each year.
- Compounded Annual Growth Rate
CAGR, or compounded annual growth rate, is a third way to evaluate mutual fund performance. CAGR represents the growth of a specific investment over a specific time period. CAGR also considers the interest gained on one’s principal investment as well as any interest collected on the interest itself.
Because it incorporates the time worth of money, CAGR has become a crucial tool for measuring the returns on one’s investments. CAGR, as opposed to absolute returns, provides investors with a more complete picture of how excellent investment in a specific mutual fund scheme might be.
It allows one to average down how erratic one’s results can be over a certain investing horizon. Calculating CAGR gets difficult when one’s investment spans a period of time and is paid in irregular intervals in installments. In such instances, especially for SIPs, the Extended Internal Rate of Return is frequently employed to forecast investment returns.
- Extended Internal Rate of Return
The Extended Internal Rate of Return (XIRR) is used to determine mutual fund returns for the SIP investment style. SIPs, or systematic investment plans, involve investing small amounts of money into a mutual fund scheme on a regular basis at certain intervals.
If a person chooses to pay monthly installments and redeems their invested amount on a specific date, the returns on their SIP will vary depending on their holding duration. When you invest through SIPs, you acquire the mutual fund plan depending on its NAV on that particular day of the month.
When you redeem your invested amount, you receive the amount equal to the number of units you held overall multiplied by the NAV of your fund on the day you choose to redeem it. The XIRR is essentially the sum of several CAGRs on each SIP investment you make.
Because calculating XIRR by hand is difficult, it is recommended that you utilize a SIP calculator rather than attempting to check the CARG of each investment you make in your SIP. If you have a systematic withdrawal strategy in addition to your SIP, XIRR adjusts for unpredictable cash flows. Your return value will be calculated using both your investments and withdrawals.
Mutual Fund Calculation Formulas
- For Lump Sum Investment: M = P (1 + r/100)n
- ‘M’ stands for the Maturity amount
- ‘P’ stands for Principal amount
- ‘r’ stands for Estimated rate of return
- ‘n’ stands for Holding period (in years)
- For SIP Investment: M = A [(1 + i)n – 1] x (1 + i)/i
- ‘M’ stands for the Maturity amount
- ‘A’ Stands for SIP contribution per period
- ‘i’ stands for Rate of return
- ‘n’ stands for Holding period (in months)
You Can Also Use a Mutual Fund Calculator
They are easily available and free to use on third-party portals. All you need to do is enter your investment, choose the fund, and you can find your return.
There are a whole lot of mutual funds to look through, and it can be an overwhelming process to choose one. These calculations can actually help you out and play a vital role in finding out how much you would be earning even before you start investing.