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How CAGR can be misleading

November 19, 2007 08:14 IST

For most investors, a fund's performance on the net asset value appreciation front is sacred i.e. returns is the only parameter to be considered while making an investment decision. Its showing on other parameters like volatility control and risk-adjusted return is almost never taken into account; also, the fund's portfolio management style and the fund house's pedigree are ignored. Making an investment decision based solely on the NAV performance is a flawed approach, since a fund's showing on the returns front can be misleading.

Yes, you read that right! A fund's NAV appreciation figures can be misleading. How can simple numbers mislead, you might ask. The answer -- compounded annual growth rate or CAGR as it is better known. The performances of mutual fund schemes over longer time frames (i.e. over 1-Yr) are expressed in CAGR terms.

You have probably come across this term in mutual fund fact sheets and performance-related advertisements. As per guidelines issued by SEBI (Securities and Exchange Board of India), performances of funds for time frames more than a year are required to be compounded annualised i.e. expressed in CAGR terms.

What is CAGR?

Simply put, CAGR computes the growth clocked by an investment, assuming that it occurs at a steady rate. In other words, the CAGR smoothens the highs and lows between the investment tenure. An example should help us better understand the same. Assume that you invest Rs 10,000 in a mutual fund on September 28, 2004, and stay invested for a period of 3 years. As on September 28, 2007, the investment is worth Rs 30,000. This gives you a return of 44.2 per cent CAGR over the 3-Yr investment tenure. In other words, your investment grew at 44.2 per cent every year, during the 3-Yr period.

This is how you calculate CAGR:

CAGR = {(Present Value of Investment/Purchase Price) ^ [1/(Number of Years)] - 1}

Why CAGR can be misleading

As mentioned earlier, CAGR smoothens the highs and lows and puts forth a steady growth rate. In the example above, the 44.2 per cent CAGR doesn't reveal the instances when the growth rate dipped below or rose above 44.2 per cent. Hence, the volatility in the fund's performance is concealed, thereby not providing a complete picture.

Let's take an example to understand this better.

CAGR demystified

 

Sep-2002

Sep-2003

Sep-2004

Sep-2005

Sep-2006

Sep-2007

NAV

10.0

11.0

13.0

15.0

24.0

41.0

YoY Growth (%)

-

10.0

18.2

15.4

60.0

70.8

In the table above, we have an equity fund that was launched in September 2002 at an NAV of Rs 10. As can be seen, the fund has fared modestly in the first 3 years, clocking growths of 10.0 per cent, 18.2 per cent and 15.4 per cent in the first, second and third year respectively. However, fund has performed extremely well in the fourth (60.0 per cent) and fifth (70.8 per cent) years. Over a 5-Yr period, the fund has clocked a growth of 32.6 per cent CAGR, which can be termed as a competitive growth rate.

However, what the 32.6 per cent CAGR fails to reveal was that the fund was a mediocre performer in the initial years of its existence. It's only over the last two years, that the fund has made a turnaround and delivered impressive returns. This recent performance has cloaked the modest performance over the initial years and made the fund look like a competent long-term performer.

Generally, thematic/sector funds show a similar trend. These funds tend to perform well in shorter time periods when the underlying theme/sector hits a purple patch. However, the performance in the aforementioned periods is good enough to mask the lackluster showing in the past.

Then, there are funds that have capitalised on a bull run by taking on higher risk. For example, a fund that is a dud in the normal course could take on aggressive stock and sectoral bets and make the most of a bull run. The result – an impressive showing based on CAGR for longer time periods. Fund houses are happy to showcase the 'impressive' CAGR numbers of these duds in a bid to draw in investors.

Let's not forget that the converse is true as well. A fund which has a track record of being a consistent performer, could hit a rough patch for some time. The result -- a poor showing on the CAGR front.

As a research house, at Personalfn we have come across numerous instances of very mediocre funds featuring higher up in the rankings on the back of just one good rally. In fact, the 4-Yr-long runup in stock markets has served to 'improve' the performances of most equity funds regardless of their investment processes, philosophy and approach (Remember a rising tide lifts all boats).

Unsuspecting investors are likely to believe that the fund (with impressive CAGR numbers) has performed well consistently over the years based on intelligent stock picking, while it's just that the latest rally has improved its CAGR numbers. In fact, most NFOs (new fund offers) that were launched over the last 4 years have very impressive CAGR numbers thanks in no small measure to the stock market rally. These funds have yet to witness a bearish phase and it's anyone's guess how they will fare over a sustained market downturn (It's only when the tide is out, do you see who has been swimming naked).

The solution

So, how can you ensure that the CAGR doesn't mislead you into making an incorrect investment decision? Quite simple. Don't accord the past performance numbers more importance than they deserve. Sure, it's an important parameter, but certainly not the only one or the one to be considered in isolation.

Past performance is not everything

Find out how the fund fares when compared to its peers and benchmark index. Evaluate the fund on parameters like volatility control and risk-adjusted return. Study the fund's portfolio over longer time frames. Find out if the fund has adhered to its investment mandate and if it has a steady investment style that has worked for it over the long-term and across market cycles (particularly the downturns).

Evaluating a mutual fund is easier said than done. Ensure that factors like past performance and CAGR don't mislead you.

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