Evaluating mutual fund returns is a complex task. Several parameters need to be assessed before choosing a fund. Many investors often get confused by the various types of returns displayed on broker apps and websites, as they do not fully understand how to interpret them. In an exclusive conversation with ETMarkets, Chirag Muni explained these return parameters, providing insights to help investors select the right fund with the appropriate type of returns.

Why is it important to understand different types of returns as an investor? How do these numbers mislead investors?

Chirag Muni: Understanding the different types of returns is crucial. Returns can be misleading, either because of how they are presented or because they are not viewed objectively. For example, an absolute return over a long period might look like a substantial gain but it is not taking into account how much it has given every year. So, it might be quite misleading for many of the investors to look at the right set of returns and then make informed decisions as to where they need to invest. These are very small nuances that you need to know about what kind of returns you need to evaluate when you are looking at an investment or a fund and that would give you the right way to look at it and then make an informed decision on investing into it.

Okay, so we have a lot of returns out there. Let us start with the basics first. What is the difference between absolute and annualized returns? How do these two work?

Chirag Muni: Calculating absolute return is a no-brainer, it is a simple subtraction of the amount invested in the present value of the investment.

For instance, if an investment grows from ₹1L to ₹2L over 5 years, the point-to-point return would be 100%.

This math being simple, is easy to compute. However, this may not be the return that you would always want to look at, let us understand why.

Let's delve into a simple annualized return, which gives a yearly perspective of the growth of your investment. It breaks down the total return over multiple years into an average annual return.

For example, if your investment grows by 100% over 5 years, you can calculate the simple annualized return by dividing the total return by the number of years. The formula looks like this:

Simple Annualized Return = Total Return / Number of Years.

Using our example:

Simple Annualized Return = 100 %/ 5 = 20 %

So, the fund would have an annualized return of 20%. This means, on average, your investment increased by 20% each year over the 5 years. However, this measure assumes a consistent return each year, which may not reflect the actual fluctuations in your investment’s value over time. Absolute to my mind is more relevant when the time is less than one year. So, when the time is less than one year, you can easily say how much I have made. But if it extends more than a year, then the annualized return is very important because that is how you will compare several instruments and then finally take a call on where to invest.

CAGR is one of the most common metrics when it comes to any mutual fund’s performance. So, what is CAGR and how does it work?

Chirag Muni: CAGR is nothing but a compounded annualized growth rate. It measures your average return for a specified period taking into impact the compounding effect as well over a period of time.

CAGR is a more accurate measure for understanding the mean annual growth rate of an investment over a specified period longer than one year. In simple terms, it determines returns for anything that can rise or fall in value over time.

The formula is:

CAGR=(( Beginning Value/Ending Value)^1/n )-1

N= number of years

For example, if an investment grows from ₹1L to ₹2L over 5 years, the CAGR would be 14.87%. This is how CAGR helps us understand the true picture. Looking at absolute return in such a scenario might be misleading.

Let us tweak this example to understand better, say you would have generated the same return in a 10-year timeline, the return will be close to 7.43 percent, and in a 15-year timeline, the return would be close to 4.5%. However, in all three instances, the absolute return would always be 100 percent.

Therefore, CAGR is an important return parameter to check. However, in case of more than one cash flow, it may not be an effective measure.

Now, let us move to XIRR and IRR. What are these two and how different are these two types of returns?

Chirag Muni: IRR, or Internal Rate of Return, measures the performance or profitability of an investment with regular cash flows at regular intervals. For example, if you invest Rs 1,000 monthly through an SIP, totaling Rs 12,000 for the year, and the portfolio value at the end of the year is Rs 12,800, the IRR would be 13%. This means each installment has yielded a 13% return for the time it was invested.

When it comes to XIRR or Extended Internal Rate of Return, it accounts for irregular cash flows and time periods since portfolio transactions don't always occur on the same date. Unlike a SIP, where investments are regular, portfolios often involve lump sum investments and withdrawals. To calculate the most accurate portfolio return, XIRR is the best method. You input your cash flows and dates into the XIRR formula, which then calculates the return for every rupee invested over its specific time period, whether still invested or redeemed. This provides the exact return value and is the most precise way to evaluate portfolio performance. Many investors are often misled by other methods, but XIRR offers a true representation of returns.

The last type of return I want to discuss is a rolling return. Many might not be aware of it, but it is very useful when considering market fluctuations, as it helps evaluate how returns are affected by the market's ups and downs. Can you elaborate on this?

Chirag Muni: When evaluating investment opportunities, especially in mutual funds, rolling returns are crucial. Unlike trailing returns, which only show performance from a specific start to end date (e.g., one-year returns from June 30, 2023, to June 30, 2024), rolling returns measure the average performance over multiple intervals within a specified period.

For example, to calculate a one-year rolling return, you would start from June 30, 2022, to June 30, 2023, then move to July 30, 2022, to July 30, 2023, and so on. This gives multiple observations, showing how the fund performed during different one-year periods.

Rolling returns eliminate recency bias and provide a clearer picture of a fund's performance across various market cycles. They are a more reliable method for evaluating consistency and selecting funds compared to point-to-point returns.