Why looking at just the CAGR can be deceiving
Premium- CAGR uses only the end & initial values for calculation of a mutual fund’s performance
For most investors, the appreciation in a fund’s net asset value (NAV) is sacrosanct. But, making an investment decision primarily based on past performance is a bad idea, because a fund’s performance on the returns front can be deceiving. That’s correct! You might be wondering how basic numbers can deceive. The answer is CAGR, which stands for compound annual growth rate. It is a representative figure, not a genuine average. Simply put CAGR is a tweaked version of the compound interest formula which makes it simple for investors to gain a broad picture of the performance of a mutual fund or stock.
CAGR = ((Final Investment / Initial Investment) ^ (1 / number of years) – 1) X 100
Consider a mutual fund that grew at 10% annual rate in the first year, 15% in the second year, 13% in the third year, and so on. So, rather than considering yearly growth, an investor might like to understand how that mutual fund has fared in the past, and CAGR comes to the rescue. But, the CAGR does not provide a comprehensive picture of a mutual fund’s previous performance because it eliminates volatility during the period and only uses the end and initial values in the calculation. As a result, by removing volatility, it fails to provide investors with a holistic picture. CAGR smooths out highs and lows, resulting in a steady growth rate.
Take a midcap fund from a large AMC, for example. Between 2012 and 2021, the fund generated returns of 47.7%, 13.6%, 71.9%, 14.9%, 4.9%, 33.5%, -17.9%, 0.1%, 30.5%, and 52.3%. The fund grew at a CAGR of 22.5% over a 10-year period. This hides the volatility of the returns throughout those 10 years. The fund fared well in the last two years, possibly pushing the CAGR up. This recent surge disguises the fund’s lacklustre performance in previous years.
So, how can you avoid being misled by the CAGR? Don’t give past performance figures more weight than they deserve. Here are a few key factors that investors should consider.
Annual returns:
This shows how the fund has performed year after year. While we all invest in equity for the long term, we watch our portfolios at shorter intervals. Underperformance of a fund can lead to an investment decision that was not part of the plan. Invest after analysing a fund’s annual performance trend and overall return.
Fund manager pedigree:
This allows us to better assess a fund manager’s capacity to outperform the market and generate alpha for investors.
Sectoral composition:
For a mutual fund to be fully diversified and not overweight on any sector, it must contain a sufficient mix of companies from several sectors. By diversifying your funds across sectors, you are reducing your risk of sector underperformance. Also, make it a point not to over diversify.
Fund allocation:
An investor should evaluate the allocation of funds in the large cap, mid cap, and small cap segments. It’s been already proven that asset allocation drives 90% of returns and hence it is important to get market cap allocation right. This is due to the risks and volatility associated with a segment.
Risk tolerance:
Investors must first determine their risk tolerance level before selecting a fund. Do not invest in funds just because of their past returns. The fund’s volatility may not suit you.
So, to avoid being deceived by the CAGR, investors must consider the variables listed here before shortlisting a mutual fund.
Anand K Rathi is founder partner of Augment Capital Services LLP, a boutique investment management firm.