How are Mutual Fund SIP Returns Calculated?

Sriniwas Kumar (name changed), a FinEdge client, recently called his Financial Planning Manager in a confused state of mind. A year ago, inspired by AMFI’s “Mutual Funds Sahi Hai” campaign, he had started a SIP (Systematic Investment Plan) of Rs. 3,000 per month into a Mutual Fund. A year later, his fund value (against an invested amount of Rs. 39,000 in thirteen instalments, stands at Rs. 42,906 today – a net profit of Rs. 4,206. Heading into an annual review of his investments with his Financial Planning Manager, he had calculated his returns to be 10.43%, which he considered below expectations as he had started his SIP with an expectation of 12% per annum.

To his surprise, Sriniwas’s Financial Planner Shivdutt happily informs him that his SIP returns from this fund over the past one year have been 20.8%! Sriniwas feels he is being misled. But in reality, is he unclear on how SIP returns are calculated?

Mutual Fund SIP’s: Absolute Returns are Misleading!

What Sriniwas calculated as 10.43% are the “absolute returns” earned from his investment; and for most investors, this is the only type of returns that they actually understand. He simply divided the profits earned by the capital invested, and convered it into a percentage figure.

There’s a flaw to this method, though. The absolute return figure has limited applicability in case of SIP’s for a simple reason – that is, all the money (Rs. 39,000) was not invested in one shot, at one point in time. Put differently, had Sriniwas invested Rs. 39,000 as a lump sum and earned Rs. 4,206 as a profit over a year, his assessment of a 10.43% return would have been accurate.

However, in Sriniwas’s case, the entire invested capital did not spend a full year in the fund. One tranche had a holding period of 380 days; another – 340 days, and so on and so forth. Therefore, each SIP tranche would, in fact, have to be viewed as a separate, distinct investment in order to correctly assess the returns earned on Sriniwas’s investment.

CAGR to The Rescue!

CAGR or “Compound Annualised Growth Rate” is a hypothetical annualised rate of return for an investment that has a holding period not equal to a year. For instance, one of Sriniwas’s SIP tranches had been invested for exactly 128 days, and had earned an absolute return of 5%. This translated to a CAGR of 15% for this particular tranche. Similarly, his first SIP tranche hadgrown by 13.1% in 380 days – a CAGR of 12.6%.

How to Correctly Assess SIP Returns

The accurate method of assessing returns from your SIP would be to consider the CAGR of each Mutual Fund SIP tranche in isolation, and then calculate the weighted average of these returns. Except - since a SIP consists of equal-sized instalments, a weighted average calculation wouldn’t really be necessary – a simple average would suffice.

In doing so, you’ll be taking into account the fact that each SIP tranche is, in effect, a different investment. By calculating the CAGR for each tranche, you’ll be condensing each tranche to a singular frame of reference, thereby eliminating the impact of the fact that each SIP instalment has a different investment time period.

Financial Advisors such as FinEdge have an inbuilt system to compute SIP returns in this manner – so you don’t need to worry about doing these calculations by yourself. As an investor, what’s important is that you have the awareness of how SIP returns are calculated, more than anything else.