Easing into 2025 - SIP your way into the top mutual funds

One of the key metrics to evaluate the historical performance of a mutual fund is its CAGR or Compound Annual Growth Rate. The higher the CAGR of a mutual fund, the better returns it has generated for investors over time. Read on to understand how you as an investor can identify and invest in top mutual funds based on their CAGR.

What is CAGR?

CAGR or Compound Annual Growth Rate is a mathematical formula that calculates the annualised average return generated by an investment over a specified time period. It takes into account the effect of compounding, which is the reinvestment of earnings back into the original investment to generate further returns.

For example, if you invested Rs. 10,000 in a mutual fund and it grew to Rs. 14,400 in 2 years, the CAGR would be around 20%. This means your investment grew at an average annual rate of 20% over the 2-year period compounded annually.

CAGR smooths out fluctuations in returns over time and gives you a consistent measure to compare performance across different time periods. The longer the time horizon, the more relevant the CAGR becomes to evaluate long-term returns.

Read More: What is CAGR in Mutual Funds?

Why CAGR matters for mutual funds

• It measures actual growth rate adjusted for compounding over time. This helps determine if a fund has consistently performed well.
• CAGR helps compare returns across funds of different categories like equity, debt, hybrid, etc. The fund with the higher CAGR has delivered better compound returns over time.
• It can be used to compare a fund’s historical returns over different time periods like 3 years, 5 years, 10 years. The relative CAGR can show if performance is improving or declining.
• CAGR can indicate how well the fund has performed compared to its benchmark index over time. Consistently exceeding benchmark CAGR is a good sign.
• For long-term goals like retirement, higher CAGR mutual funds have greater potential to grow capital significantly over decades.
• It helps investors set realistic return expectations about a fund based on its past performance CAGR.

Using CAGR to evaluate and compare mutual fund performance

• Always look at CAGR values over longer time horizons like 5 to 10 years rather than just 1 or 3 years. This evens out short-term volatility.
• Compare CAGR of a fund with its category peers to assess how well or poorly it has done. For example, compare large-cap equity fund CAGR with other large-cap funds.
• Compare CAGR with appropriate benchmarks to check if the fund has beaten the benchmark. For example, compare a diversified equity fund’s CAGR with Nifty 50 CAGR.
• Look at the fund factsheet to assess year-wise returns and check if CAGR growth has been consistent without wild fluctuations.
• Opt for funds that have demonstrated the ability to maintain high CAGR over market cycles. Do not purely extrapolate past CAGR into the future.
• For debt funds, compare CAGR values with returns from fixed-income options like bank FDs to assess performance.
• Consider portfolio composition and fund management aspects too for a holistic evaluation along with CAGR.

Step-by-step process to select top mutual funds for SIP

1. Determine your investment goal, time horizon, and risk tolerance. This will help shortlist appropriate fund categories to consider. For example, for retirement it may be diversified equity funds, for child education 5 years away it can be balanced advantage funds, and so on.
2. Within the selected categories, screen funds with at least 5 years of CAGR history. This will exclude newly launched funds with no track record.
3. Compare CAGR of shortlisted funds with their respective category averages to identify consistent outperformers. For example, an equity fund with 15% CAGR vs. a category average of 12% CAGR over 10 years.
4. Assess CAGR vs. relevant benchmarks. For example, a large-cap equity fund’s CAGR can be compared with Nifty 50 CAGR over 10 years.
5. Analyze year-wise returns to check if high CAGR has been achieved through volatility or steady performance. Prefer the latter.
6. Ensure portfolio composition matches the fund category. For example, large-cap equity funds should predominately hold large-cap stocks.
7. Evaluate the fund manager’s capability, experience, and performance across market cycles, along with the fund house pedigree.
8. Consider costs like expense ratio, exit load, etc. Opt for reasonably priced funds. Avoid very high costs.
9. Limit selection to 1-2 funds per category to avoid over-diversification.
10. Allocate investments across selected funds in a manner aligned to your risk profile and goals.

Read More: 10 Essential Tips for Selecting the Right Mutual Fund?

Things to keep in mind when using CAGR

• Past performance may not sustain in the future and is not guaranteed. Do not solely depend on past CAGR.
• It assumes reinvestment of earnings. Check if the fund has consistently paid dividends and enabled compounding.
• Very high CAGRs over short durations can be misleading. They may indicate volatility rather than sustained growth.
• Mean reversion means exceptionally high CAGRs tend to normalize over longer periods. Sustainable decent CAGR is better.
• CAGR should not be the only factor. Also assess portfolio, fund manager pedigree, costs, and risk measures.
• Choose funds with strategies and philosophies aligned to your goals rather than blindly chasing past CAGR.

Conclusion

Identifying mutual funds with a strong past CAGR track record can be a prudent starting point for your mutual fund investment selection process. CAGR helps quantify actual compounded returns generated by funds over time. Comparing CAGR values across relevant time periods, peer categories, and benchmarks can give insights into relative fund performance.