# Decoding Mutual Fund Returns! This is a guest post authored by the research team at Quantum Mutual Fund. It is one of India’s premier asset management companies with 1,440.45 Cr of Assets under Management as of 30th June 2020.

Every mutual fund aims to create wealth for its investor by generating superior risk-adjusted returns. Return is an important determinant of performance. It gives a good idea about the performance of a fund compared to the benchmark or other schemes in the category.

There are different ways to calculate mutual fund return based on your holding period, and the type of investment: lumpsum or SIP. Absolute, Annualized, CAGR, XIRR & Rolling return are some common methods of calculating return. It is important to have a clear understanding of these terms for a better evaluation of the return from a mutual fund.

Let’s understand different ways to calculate mutual fund return-

##### 1/ Absolute return (point to point return):

Absolute return is a fairly simple method to calculate mutual fund return. It measures the change in the value of an asset over a specific investment period. So, to calculate the absolute return from a fund, you need the present value of the investment and the originally invested amount. The formula is-

Absolute Return = (Present value – Invested amount)/ Invested amount x 100

When to use: If you have been investing in a fund since a short time (say, less than 1 year) then you can use absolute return approach. Using absolute return to calculate returns over a long time-frame can give misleading results. For instance, if an investment of Rs 10,000 grows to Rs 15,000 in five years, then the absolute return will be 50%. However, the return earned in each of these five years could be much lower.

##### 2/ Annualized returns:

It is a geometric average that calculates return from investment on an annual basis.

While absolute return shows how much the investment has grown from the initial value, annualized return calculates the average pace by which the fund grew annually to reach the current value.

To calculate annualized return we need to first calculate absolute returns.

Annualized Return = ​((1+r1​) × (1+r2​) × (1+r3​) ×⋯× (1+rn​))1/n  ​− 1​

When to use: Performance in a given year can deviate significantly from the previous year due to market fluctuation. Hence, the annualized return approach helps to compare the performance of various mutual funds over different periods.

##### 3/ Compounded Annual Growth Rate (CAGR):

This is a commonly used method to calculate mutual fund return. It gives insight into a fund’s continued performance as it takes into consideration the effect of compounding. In other words, it assumes that the profits remain invested in the fund.

So, CAGR essentially calculates the rate at which investment has gone up or down annually to reach the current value.

CAGR = (Final value/Initial Value) 1/n – 1

When to use: If you have lump sum investment in mutual funds since more than a year, then you can use CAGR to calculate return. You can also compare return on your investment with other funds in the same class by using CAGR.

##### 4/ Extended Internal Rate of Return (XIRR):

Your investment in mutual funds could be recurring when you invest multiple times- either monthly or at different intervals. In such a case, CAGR does not deliver accurate results. Here XIRR is a more suitable method to measure the return, as it takes into consideration the inflows (investment) and outflows (redemption) at different times.

When to use: When there is a series of transactions such as purchase, switch, redemption, etc. XIRR is a better alternative to calculate the rate of return.

##### 5/ Rolling return:

Rolling returns is a method to evaluate a fund’s average annualized return for a specific time-frame. This eliminates bias towards a specific period. With the rolling return, you can look at the annualized performance of a fund during various intervals.

For example, if an investment of Rs 10,000 done a year ago, is worth Rs 15,000 today then your absolute return is 50%. But in case the value drops to Rs 14,000 tomorrow, your 1-year absolute return will come down to 40%. Rolling return takes into account this volatility. It considers returns between specific periods, say 1st August to 1st September, 2nd August to 2nd September, and so on. It takes an average of these returns. Hence, rolling return ensures that returns are not skewed by the most recent data.

When to use: The consistency of a fund’s performance can be analyzed using rolling return. It is also useful in analyzing how a SIP would impact returns over a specific time-frame.

Once you know how to evaluate a fund’s return, you can also review the risk parameters associated with the fund. Here are some useful risk parameters-

##### 1/ Standard Deviation:

Standard deviation is a measure of evaluating the risk caused by the volatility. It tells how much a fund’s performance deviates over a time-frame. Higher the standard deviation, the higher the risk taken by the fund.

It refers to the amount of risk taken by a fund to earn the return and is a useful parameter to select mutual funds. Risk-adjusted returns help in comparing funds within a particular category.

##### 3/ Sharpe Ratio:

Sharpe ratio compares the return an investor is getting with the level of risk taken by fund. To calculate Sharpe ratio you have to find the difference between the return of a fund and the risk-free return. Then, divide the result by the standard deviation of the fund.

Sharpe Ratio = (Fund return – Risk-free return)/Standard deviation of the fund

##### 4/ Sortino Ratio:

Sortino ratio helps to determine a fund’s ability to contain the downside risk during a depressing market condition. Unlike the Sharpe ratio, Sortino uses only downside deviation for calculating the volatility.

Sortino Ratio = (Portfolio Return – Risk Free Return)/Downside Deviation

##### 5/ Treynor Ratio:

Treynor ratio determines the excess returns earned for the risk taken by the fund. It is also called the reward-to-volatility ratio. Treynor ratio uses the ‘Beta’ of the fund (volatility of a fund compared to the systematic market risk). The idea is to evaluate the value added for the risk taken by the investor.

Treynor Ratio = (Fund return – Risk-free return)/Beta of the fund

In addition to the above, you should also adjust for inflation and taxes to arrive at the actual in-hand return. If you had a fund earning 11% per year and inflation was at 5%, your inflation-adjusted return (real rate of return) would be 6%. This would further reduce if the gains on it are taxable.

Mutual funds are a worthy investment avenue for wealth creation and achieving financial goals. It is prudent to understand the risk and return potential associated with a fund while taking an investment decision.

Happy Investing!

The opinions expressed are those of the authors and should not be construed as advice from Kuvera.

###### Disclaimer, Statutory Details & Risk Factors:

Risk Factors: Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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