Fixed vs Variable returns in Mutual Fund

Understanding the returns calculation in mutual funds

Fixed and Variable Returns

There is a basic difference between Fixed and Variable returns. In the former, we will get a fixed amount of money as interest from our investments on a fixed date. In case of the latter, the amount of money we receive as profit and the date on which we receive that money is not fixed. Fixed Deposits in banks is an example for fixed return investment. Mutual Fund and Share Market investments are examples for variable return investments.

Investment Realities

Most of us like fixed rate return investments, but at the same time, we are not happy with the low interest earned from these bank deposits. We constantly are looking for greener pastures. On the other side of the fence is mutual funds and equity markets, where the published return in social media and fund house portals are very lucrative, but they are not fixed. Some investors after seeing 10-year return of a particular scheme invest in the same with dreams of similar high return, but instead of staying in the scheme for ten years, on seeing lower returns or losses they redeem the fund prematurely within a couple of years and their dreams get shattered. Blame game starts here. This is mainly because of our poor understanding of how returns are calculated, rather than the fault of the stock market. It is also because of misunderstanding the returns published in the public domain. Instead of blaming others, let us understand how returns are calculated. In order to avoid pitfalls in our investments, let us first understand how investment calculations are made with respect to maturity amount and the rate of return. This will help us to decide suitable investments for reaping better profits in a more informed way.

Basis of calculation

In our school days, maybe in class 10 or so, we would have learnt how to calculate simple and compound interest. Irrespective of wether we remember them or not, most of us are not able to use those calculations suitably with respect to our investments. These are the basic calculations for finding the proper maturity amount or to arrive at the rate of return. Maybe because of lack of memory or poor understanding of the basics, in recent investors awareness programs, most of the questions raised revolved around how compound interest is calculated? and how it is impacting mutual fund returns?

For getting answers to the above questions, we should understand the following four ways in which returns are calculated. They are:

1. Simple Interest

2. Compound Interest

3. Compounded Annual Growth Rate – CAGR

4. XIRR

Now let us see one by one with respect to how the calculation is being done to get a clear picture of the Returns Calculation and also to understand which are fixed and which are variable.

I.   Fixed Returns

     1.      Simple Interest

When we are able to get a periodical fixed interest on our investments, it is called as simple interest. For example, we are investing Rs 1,00,000 for 3 years at a 7% interest rate. This investment will provide interest income of Rs 7,000 per year on a fixed date every year for a period of 3 years. Total interest received is Rs 21,000. The formula for calculating simple interest is given below:

PNR / 100

Total interest received = (1,00,000 *3*7)/100 = 21000

        2.      Compound Interest

Instead of getting periodic interest payments, if the interest is paid along with the principal at the end of the investment period, it is called compound interest. The total interest received by this method is Rs 22,504. This amount is higher than the interest received by simple interest calculation. The reason for higher interest in compounding method than the simple interest method is because of the interest being paid on the accumulated interest. i.e. At the end of the first year, the interest received is added to the previous principal, thus making a higher new principal. In the second year, the interest is calculated based on the new principal. In this way, interest earned every year is added to the previous principal thus making a new principal on which the new interest is calculated. This process is called compounding. The formula for calculating compound interest is given below:

Amount received at the end of the period = P + (1 + R) ^ N

                                                                = 1,00,000 + (1 + (7 / 100)) ^ 3 => 1,22,504

Total interest received = Rs 22,504

As indicated above, in compounding process the interest earned at the end of the year is added to the previous principal, thus making a new higher principal and higher interest for the next period. Hence previous period calculation is very significant in compounding process. We can do this compounding process repeatedly for every year, for every half year, every quarter, every day or even every hour. In this way the interest earned in compounding becomes higher and higher when the compounding period becomes lower and lower. Refer the table below for how compounding affects different compounding periods for the same investment amount and total holding period.

The concepts above were for Fixed Returns investments. The classical example for this type of investments are the Fixed Deposits in banks. In both cases the principal, interest rate and the holding period are visible. Maturity amount can be easily calculated using the given formulas.

II.    Variable Returns

1.      Compounded Annual Growth Rate – CAGR

When we are investing in mutual funds, stocks, etc. unlike in other examples given above, the rate of return is not visible to us. To arrive at the rate of return, we have to use the maturity amount received at the end of our investments or we have to assume or derive the maturity amount to arrive at the rate of return realized for our investments. The formula for calculating simple interest is given below:

 Compounded Annual Growth Rate = {(Maturity Amount / Principal Amount) ^ (1 / n)} – 1 = (122504 / 100000) ^ (1 / 3) - 1 = 7%

Compounding and CAGR are similar with respect to fixed rate return investments. Whereas in the case of mutual funds / stock market returns, this is not true. Even though both investments earn the same 7% return at the end of the 3 year period (refer to the table), in the case of fixed rate return, the year-end accumulated amount will be increasing in a straight line, whereas the year-end amount in the case of variable return is not in a straight line and subject to market fluctuations. If Someone invests Rs 1,00,000 expecting Rs 1,14,490 at the end of second year, they may get surprised seeing a value of Rs 1,01,243.31. This investment is also giving 7% CAGR for a three-year period. The reason is, CAGR is calculated based on initial and final value and the intermediate values are not considered.

When fund houses publish their 1, 3, 5, 10 year period returns using CAGR method, the returns are always calculated using the initial and final NAV for the given period. These will not reflect the in between market fluctuations of the NAV.

2.      XIRR

Point to point return can be easily arrived using two NAV. Whereas when our investment is happening over irregular periods, arriving at the return becomes complicated. Here simple CAGR will not work. Advanced XIRR method is used for arriving at returns for various investment periods, like SIP and other mutual funds / stock investments. These returns are based on cash flow and date. We can use Microsoft Excel or any other spreadsheet and use the XIRR function to arrive at the returns from mutual fund investments. They are similar to compounding and CAGR. Refer to the table. We are investing Rs 25,000 in SBI Magnum Multicap every quarter for one year and no investments after that. At the end of around 43 months, we should be getting Rs 1,34,537 against our investment of Rs 1,00,000. Using Excel’s XIRR function, the rate of return we get is 9.6%.

Return calculation using uneven cashflows

Fund Name - SBI Magnaum MulticapPeriod - Around 43 monthsInitial Principal Amount  - 4 * 25000  = 1,00,000
Redeemed Final Amount - 2857.023 * 47.09 = 1,34,537

Date	Investment	NAV	Units	Date	Cash flow
01-Jan-16	25000	33.84	738.7707	01/01/16	-25000
01-Apr-16	25000	32.54	768.2852	04/01/16	-25000
01-Jul-16	25000	35.64	701.459	07/01/16	-25000
30-Sep-16	25000	38.55	648.5084	9/30/2016	-25000
14-Aug-19		47.09	2857.023	8/14/2019	134,537
				Xirr	9.60%

Important points to note when using variable returns:

    1. Only initial and ending values are considered - Intermediate volatility is not part of calculation. Returns generated every period may or may not be the same.

   2. While calculating the rate of return, we are using only invested and redeemed amount. Risk parameters which affect the redeemed amount is not part of return calculation. For example, risk factor like beta, standard deviation, etc. are not part of this calculation. However, they may affect the return we get in some way or other.

Conclusion

Hence, while choosing schemes for investments, it is very important that we should not blindly follow only XIRR or CAGR, but we should evaluate other risk parameters and decide depending upon the scheme. Like an informed investor, invest after understanding the effects of return calculation.

Sample excel file

if you wish to get the sample working excel file with these examples, which can be used as template - write to us with your  name /mobile no / email, using the "contact us" form given in the right side / top tabs.

If you like this article, please share this on your WhatsApp / Facebook / Twitter. This would be a special gift which you would be giving to our blog.