CAGR vs Absolute Return: Which is Better for Mutual Funds?

To have a comprehensive understanding of your investment's performance, it is crucial to consider both absolute return and CAGR. Absolute return and compound annual growth rate (CAGR) are the important metrics to calculate the return performance of the specific period of time. In this article, we will delve into the significant difference between these metrics, their calculation methods, and how they can help you in making a right decision on your investment.

Absolute return is ideal for short-term comparisons, while CAGR is more suitable for long-term analysis and comparing investments with varying durations.

What are Absolute Returns in a Mutual Fund? 

Absolute return refers to the total percentage change in an investment's value over a specific period. It is ideal for a small period of time. Unlike other relative measures, such as benchmarks or indexes, absolute returns solely focus on the performance of the mutual fund without adjusting for market conditions or any other factors.

Calculation of Absolute Return

The formula for calculating absolute return in a mutual fund is:

[(Current investment value-Initial investment amount)/Initial investment amount] x 100

Example

Let’s say you invest in a mutual fund with the following details:

• Current investment value (at the start of the year): $20
• Initial investment amount (after 3 month): $25

Using the formula:

Absolute Return=20(25−20)​×100= 5/20x 100 = 25%

In this example, the mutual fund has provided an absolute return of 25% which means that your investment has increased in value by 25% in a period of 3 months.

Importance of Absolute Returns

1. Simplicity: It provides you with a straightforward view of how much your investment has gained or lost.
2. Investment Evaluation: It helps investors assess the performance of a mutual fund, without comparing it to benchmarks or other funds.
3. Short-Term Focus: It is useful for a short period of time, especially for investors who want to invest for long periods.

Limitations

Absolute returns do not provide any comparison to its benchmark or its peers. Therefore, you should also consider absolute returns alongside other metrics to make any decision in your investment.

What is the compound annual growth rate (CAGR)  in a Mutual Fund?

CAGR calculates the annual growth rate of an investment over a long period of time including the compounding over that specific period of time. It is useful for investors who want to invest for a long term period. It also helps you to check the comparison of mutual funds from benchmarks indexes or peers.

Calculation of CAGR

The formula for calculating CAGR is:

[(Current investment value/Initial investment amount) ^ (1/n) – 1] x 100

Example

Let’s say you invest in a mutual fund with the following details:

• Current investment value (at the start of the year): $1,500
• Initial investment amount (after 5 years): $1,000
• n is the number of years.

Using the formula:=(1500/1000​)1/5​−1 x 100= (1.5)⅕-1x 100= 0.08447×100= 8.45%.

In this example, the mutual fund has provided a CAGR of approximately 8.45% per year which means that your investment has grown at an average annual rate of 8.45% in a period of 5 years.

Importance of CAGR

• Simplicity: It provides a clear and concise measure of growth over a long period of time.
• Long-Term Analysis: The CAGR is particularly useful for investors who are looking for long-term investments, as it is low volatile.
• Comparison Tool: CAGR is used for comparing the performance of different investments with their peers and benchmark indexes.

Limitations

CAGR does not provide any details on the fluctuations and volatility of the market in a short span of time. Therefore, you should also consider CAGR alongside other metrics to make any decision in your investment.

Difference between Absolute Return and CAGR

Now lets under the difference between the absolute return and CAGR.

CAGR Vs Absolute Return – Which is Better?

It is clear that both the CAGR and annualized returns are essentially the same metric but both metrics are used for assessing the performance of mutual funds.

For short term investments, absolute return is the more appropriate metric to calculate the performance of mutual funds in a short term period that can be less than 1 year. In contrast, CAGR is a more appropriate metric to calculate the performance of mutual funds for a long term period may be 1 year or more, as it takes into account compounding and gives a clearer idea of growth over time.