There are various ways to measure investment returns such as Absolute Return, Compounded Average Growth Rate (CAGR), Internal Rate of Return (IRR) etc. In addition, you can look only at prices (Price Return) or also at dividends (Total Return). In this article, we will explain the different ways of measuring investment returns and which method works best for which purpose.
This is the simplest type of mutual fund return. You simply deduct purchase price from sales price and divide it by the purchase price. For example, if you bought a fund 6 months ago for Rs 100 and it is now Rs 105, your absolute return is (105-100/100) which is 5%. Absolute return gives you a broad picture of what is happening with your fund and is useful for very short spans of time (a few days or weeks).
In most other cases, it is important to convert it to annualised return in order to understand the true return given by the asset. In the above example, a 5% absolute return over 6 months converts to 10.25% annualized. This is the return you would get if this rate of return continues for the entire year. Similarly an absolute return of 50% over 5 years converts to an annualised return of 8.44%.
CAGR (Compounded Annual Growth Rate)
This is the best measure of annualised return. It tells you the annual return on an asset you have held for several years. For example, if you stock doubles in 5 years, your CAGR is 14.86%. This return assumes an annual compounding rate. Most mutual funds statements and websites will give you CAGR of a particular fund.
IRR (Internal Rate of Return)
Internal Rate of Return or IRR, is a measure of return that assumes that dividends are reinvested in the fund. IRR will be the same as CAGR if the fund does not declare any dividends. For example. If you select the growth option, IRR will be equal to CAGR. However if dividends are declared, CAGR will be lower than IRR because mutual fund net asset values (NAVs) drop by a corresponding amount, as soon as a dividend is paid.
This only takes into account the difference in price or NAV in computing returns. For example, if you buy a fund at NAV of 10 and sell it an an NAV of 11, your return is 10%. Price return is then annualised to give CAGR. Price return (converted to CAGR) is accurate if you are investing in the growth option of a mutual fund.
Total Return takes assumes that dividends are reinvested in the fund, upon declaration. Hence, if you invest in the dividend option of a fund, a total return will give you a more accurate picture than price return.
In previous times, mutual funds would consider price return of benchmarks like the Nifty or Sensex while comparing themselves to these benchmarks. This method would not give a like-for-like comparison for mutual fund growth options (where dividends are reinvested) compared to benchmark price returns (where dividends are not reinvested). However SEBI has now mandated that mutual funds be benchmarked to a total returns index (TRI) so that investors get a more accurate picture.