When investing in a mutual fund, it is commonly found that people tend to focus more on the CAGR generated by the mutual fund. But are they really reliable? We take a look at why you shouldn’t depend only on CAGR and the pitfalls of depending on it. Advertisements for mutual funds always highlight the CAGR generated by the mutual funds. Many financial publications also rate the funds with the highest CAGR as the best ones to invest in. Taken in by all this publicity, people invest in these funds. But the question arises: should CAGR be the sole selection criterion to for mutual funds?
What is CAGR?
Compounded Annual Growth Rate (CAGR) is the growth achieved by an investment, at a constant rate of returns. In simple terms, it is the evening out of the value of investment during its tenure. As per SEBI guidelines, the performances of the funds for periods exceeding a year must be compounded annually , denoted as CAGR. How is CAGR computed? CAGR is computed as CAGR = {(Current Value of Investment/Cost of Purchase) ^ [1/(Duration)] - 1}
Why is CAGR reliable? CAGR evens out the highs and lows of the NAVs and shows a steady rate of growth. Say you have invested USD 10,000 in a mutual fund on January 1, 2004 for a period of 3 years. On January 1, 2007 the value of the investment is USD 30,000. So your investment has earned a return of 44.2% CAGRfor a period of 3 years. This means your investments grew at the rate of 44.2% annually. But the problem with this approach is that it does not reveal the instances when the growth rate was lower or higher than CAGR. So you don’t get a clear picture of the funds’ volatility. Hence, if the fund is an average performer in certain periods but then shot up during the bull-run, it still shows a higher CAGR. Also, a fund with a good track record can hit a rough patch, thus showing a lower CAGR. Investors tend to believe that the funds with a higher CAGR have managed to turn in superlative performances due to their smart stock selection instead of the fact that the NAVs of these funds have skyrocketed due to bull market, when even the most mediocre funds clock an impressive performance. How do I prevent being misled by CAGR? CAGR is important, but don’t base your investment decision only on it. Other factors should also be considered. Check out the fund’s performance vis-à-vis its peers. Find out the fund’s volatility control and risk-adjusted return. Determine if the fund follows its investment philosophy and has a consistent investment style that has allowed it to perform over the different market cycles, particularly down turns.
Have you ever invested in a mutual fund solely on its CAGR? Did your fund outperform the market as well as its peers?
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