Mutual funds are a collective scheme of investment, which pools money to buy securities from investors. Although there is no legal definition, mutual fund is a common term applied to the investment vehicles that regulate the sales of the funds to the public.
Mutual funds are often open ended. It means the investors or stockholders have the option to buy and sell shares of the funds at any time. Mutual funds have both advantages and disadvantages when compared with individual securities.
Understanding mutual funds is important for any investor. Unlike the stock prices that depend on the supply and demand curve, the mutual fund pricing takes place at one time during the day, mostly during the end of the day.
How to calculate mutual fund returns
Calculating mutual funds returns is important, as millions of people invest to gain a significant profit within a short period. The return on the investment of the mutual fund for a given time is the capital increase and generated income divided by the total investment amount.
The value is a percentage and the entire calculation results in the total return.Unfortunately, many investors in a mutual fund do not understand the importance of the total return. There is always confusion between the net asset value, yield and capital gains.
Hence, it is easy to rely on the total return. A better understanding on the achievement of the mutual funds will measure the required investment process for an individual and investor.
Usually, investors calculate the average annual return of the fund, which is the arithmetic mean of the total returns earned over a particular period. However, most investors misuse the indicator to display unrealistic returns to lure new investors.
For example, an individual invested Rs. 1 Lakh in a mutual fund. The first-year records a growth of 100% and the second year marks a drop of 50%. At the completion of two years, the investor did not receive any gain. However, by adopting the average annual return, the investor receives a return of 25%.
The end calculation is often intimidating. Nonetheless, calculating the individual growth for the stated period is necessary to access the overall outcome of the return on mutual funds.
The above table provides information on the invested amount and the return on the mutual fund. It is usual for the market to express loss or gain as a percentage. Absolute return is the term referred to the reflection of the percentage in the portfolio.
The above table follows the calculation of the difference between the current price and cost price, divided by the cost value. Although it returns a figure of 64.14%, one should look at the time taken to earn, which is more than a year. If the holding of the mutual fund is over a year, it is crucial to calculate the compounded annual growth rate (CAGR).
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The compounded annual growth rate calculates the year-on-year returns. It further gives a better picture about the growth and fall of the mutual fund price. The formula for calculating CAGR is [(F/S) ^ (1/n)]-1, where F = Final value, S = Initial Value and n = holding period. Consider the following table:
The compounded annual growth is at 22.65%. According to this, there was a reinvestment of the returns every year. Calculating mutual funds returns annually gives a better picture rather than considering the entire outcome. It is because of the arithmetic mean adopted by the fund management authorities to attract new investors.
According to the calculation, the investment increased to Rs. 122,646 in the first year, Rs. 150,422 in the second year and Rs. 164,136 in the third year. However, this is not correct. The return on the mutual fund may have increased drastically in one period and fallen in the other.
However, the CAGR displays a different picture as it calculates the overall returns without considering the instability occurred in the holding period. Nonetheless, the value provides the chance to compare it with other funds.
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In another scenario, where the calculation of cash flow is important, adoption of XIRR calculation takes place. XIRR gives a detailed report of the inflow timing and CAGR. Calculating the XIRR is helpful for mutual funds that follow the SIPs or Systematic Investment Plan.
For example, in the table above the XIRR is 25.25%. However, investors calculate the return on the investment as 13.33%. The interpretation is wrong, as the method does not include the different times of cash inflow. Furthermore, there are several cases where there is reinvestment of the return after first year. Moreover, the rate are fluctuating and do not remain constant either.
Calculating the return on the mutual fund depends on the holding period. If the period is more than one year, it is essential to choose the compound annual growth rate and XIRR. However, if the period is one year, choosing the quoted returns is the best choice. It is because the annual return uses the annual calculation.
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Understanding absolute and relative return of mutual funds
The common entity to measure the performance of a mutual fund is its absolute return. However, it provides only half the entire story of the funds. It is important to obtain the answer in both the relative and absolute terminology.
The calculation of the absolute return is direct, expressed in percentage and uses the following formula:
Absolute return = (current value – original investment)/original investment
The following is an example of absolute return:
Let us say, an investor invested Rs. 50,000, which grew to Rs. 75,000 after two years. Using the above formula, we get:
Absolute return = (75,000 – 50,000)/50,000 = 0.50 or 50%
If the division is for individual holding periods, then the absolute return is 25% per annum.
Relative returns offer analysis of the invested amount and its performance relative to a stated benchmark. For example, an investor has the option to compare a domestic mutual fund with that of index fund to obtain a better understanding about the functioning. However, calculating relative return is a bit complex due to the presence of the benchmark.
Relative return = Absolute return of the investment – absolute return of the benchmark
The above formula provides an insight into several factors and the relationship between the two measuring units.
For example, let us say the absolute return of the benchmark is 10%. By using the above example and its values, we get:
Absolute return on the investment = 50%
Absolute return on the benchmark = 10%
Relative return = 50% – 10% = 40%
Again, if the investor wishes to have a year-on-year calculation, he/she can divide the return by the number of years. In the above case, the relative return is 20% per annum. In investment terminology, the fund outclassed the benchmark by 20%.
Mutual funds are attractive, although they are subject to the market conditions. Calculating mutual funds returns and comparing it using proper measuring tools will help the investor choose the best option to invest in mutual funds.
The above-mentioned opinion offers insight into the two different concepts. In the end, it is the choice of the investor to choose an appropriate concept, based on their investment-holding period. Hope calculate mutual funds returns helped you. Voice your opinion below if this post was useful.