One of the crucial aspects of financial planning is the periodic evaluation of investments. Whether one invests in equities, mutual funds, debt, commodities or a mix of these, a regular review ensures that there is no digression from long-term objectives.
Mutual funds are the best vehicles for long-term planning as they invest across different asset classes and offer diversification.
Moreover, historical evidence suggests that mutual funds, especially equity-oriented ones, outperform all major asset classes, on an average, in the long run.
Yet, one needs to evaluate their performance in the medium term. This is because if a fund is not performing as per its mandate or has been consistently underperforming its benchmark, an investor must exit and move to a good performer.
One way to evaluate performance is by looking at its historical returns, of which two vital ingredients are dividend or income received and/or capital appreciation.
Let's consider the following tools, which are not exclusive for mutual fund evaluation and can be used for other asset classes.
Point-to-point or absolute return:
It's one of the easiest and commonly used methods for calculating a fund's return. It considers NAV on two dates—at the beginning and end of the holding period. The return is calculated by dividing the absolute change in NAV by the NAV on the start date. It's advantage is that it can be applied to virtually all kinds of funds.
So, if you had invested on 1 January 2009 in a fund at a NAV of Rs 10 per unit and sold the units on 2 June 2011 at a NAV of Rs 18.5, the point-to-point return would be 85%.
While this formula is highly useful, it becomes irrelevant if one invests in the dividend option scheme of a fund. This is because the NAV of such a scheme falls once the dividend is paid. For such options, the total return is more relevant.
This overcomes the limitation of point-to-point return by including dividends. The total return is calculated by adding dividends that are distributed during the holding period, to the absolute change in NAV, and dividing it by the NAV on the starting date.
Where Dt is dividend received per unit.
If the investment is made at a NAV of Rs 13 in August 2009 and is sold at a NAV of Rs 19 in September 2011, and the fund declares a dividend of Rs 3 per unit during this period, the total return comes to 69.23%.
Compound Annual Growth Rate (CAGR):
It is applicable when the holding period is more than one year. It reduces the effect of volatility or short-term fluctuations on a fund's NAV. CAGR assumes that the investment is growing at steady rate. So, a 3-year CAGR of 20% implies that in the past three years, the investment has grown at an average rate of 20%.
It helps in comparing performance across different funds and schemes of the same fund. Where n is no. of years, T is the terminal or maturity value of investment, and B is the start value or amount invested.
Take the first example, where the investment is made in January 2009 and redeemed in June 2011. The 'n' in this case is roughly 2.5 years. This gives us a CAGR of 27.90%.
IRR: The above tools are useful if the sum is invested as a lump sum. If you invest through the SIP route, you need to use IRR. This tool is one of the most complicated, but an MS Excel savvy investor can use this tool easily.
Source: Economic Times