Measuring returns is a critical part of any investment strategy. For those investing in mutual funds, especially through a Systematic Investment Plan (SIP), understanding how returns are calculated is essential to track progress and make informed financial decisions. Unlike lump-sum investments, SIPs involve periodic investments, making the calculation of returns slightly more complex due to varying purchase dates and market values. In this article, we will explain how SIP returns are calculated using different methods, helping you evaluate your investments effectively and improve your financial planning.
1. Absolute Return
Absolute return is the most straightforward method to understand returns, especially for short-term investments. It simply calculates the percentage gain or loss based on the initial and final investment values, without considering the time period. Investors might also use a SIP Return Calculator to calculate the SIP returns.
Formula:
Absolute Return = [(Final Value – Initial Value) / Initial Value] × 100
Example:
Ms. Rina invested Rs 80,000 in a mutual fund. A year later, the investment’s value grew to Rs 96,000.
Absolute Return = [(96,000 – 80,000) / 80,000] × 100 = 20%
While this shows a 20% gain, it does not indicate how long the investment took to grow, making it unreliable for comparing different funds over different timeframes. As absolute return does not consider the investment period, so it fails to capture the true growth rate.
2. Compounded Annual Growth Rate (CAGR)
CAGR offers a clearer view by factoring in the time it took for an investment to grow. It shows the average annual growth rate assuming the investment grew at a steady rate.
Formula:
CAGR = [(Final Investment Value / Initial Investment Value) ^ (1/n)] – 1
Where:
n = investment period in years
Example:
Mr. Dev invested Rs 1,50,000 in a mutual fund scheme. After 4 years, the value grew to Rs 2,25,000.
CAGR = [(2,25,000 / 1,50,000) ^ (1/4)] – 1 ≈ 0.1087 or 10.87%
This means the investment grew at an average rate of 10.87% per annum. CAGR shows yearly returns for one-time investments but isn’t accurate for SIPs because it doesn’t account for regular payments over time.
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3. Extended Internal Rate of Return (XIRR)
XIRR is the most accurate method to calculate SIP returns because it accounts for multiple investments made at different times and their individual growth. XIRR calculates a single rate of return from multiple cash flows that occur at different dates. It is essentially a more flexible version of the internal rate of return (IRR).
Formula:
XIRR may be calculated using the below formula:
XIRR = (NPV of Cash Flows / Initial Investment) × 100
Example:
Mrs. Leena invests Rs 5,000 every month in a mutual fund via SIP. After 24 months, the total fund value is Rs 1,40,000.
Since each Rs 5,000 instalment was invested on different dates, and the investment grew to Rs 1,40,000, it’s not practical to use simple formulas. Instead, she may also use Excel’s built-in function:
=XIRR (values, dates,guess)
Or she may use a mutual funds app that automatically calculates the XIRR. This method considers the exact investment dates and maturity value, giving a highly accurate picture of returns over the investment period.
Key Terms Related to SIP Returns
Understanding the basic terminology helps understand SIP return calculations more effectively:
- Net Asset Value (NAV): The per-unit price of a mutual fund. It determines how many units you receive for your SIP amount.
- Absolute Return: The percentage increase in investment value, without considering the time period.
- CAGR: The average annual growth rate of an investment, suitable for lump-sum investments.
- XIRR: The most accurate return metric for SIPs, as it accounts for cash flow timings and compounding.
Conclusion
Selecting the right method to calculate your SIP returns is crucial for evaluating investment performance and making better financial choices. While absolute return and CAGR offer insight in specific scenarios, they don’t reflect the dynamic nature of SIP investments. XIRR, on the other hand, delivers a more realistic and precise return calculation by considering time-based cash flows. Using tools like a SIP return calculator available on any modern mutual funds app may help streamline the process. The Axis MF app, for instance, enables users to track and calculate SIP performance easily, helping investors stay on track with their financial goals.
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