mutual fund terms top 10 jargons to know before investing

We can now say that we have an awareness of the different categories of mutual funds, as well as what lies in store for each type. Though not every fund has been discussed, the key equity and debt investments have been thoroughly explored.

I’m not certain why I neglected to mention the Balanced Fund, but I think we have established an approach for intelligent reasoning with regards to funds and their requirements. Thus, I recommend that you take a gander at some information sheets on Balanced Funds, scrutinise them alongside SEBI’s classification, so you can comprehend how these funds work. If not, don’t hesitate to post your inquiries here and I will gladly answer them.

We are on the right track to comprehending how to construct a mutual fund investment portfolio for various goals. Before advancing the process, we need to devote enough time to comprehend a few essential mutual fund metrics that would aid us in distinguishing ideal funds from less suitable ones.

The Mutual fund factsheet and external websites like Morningstar and Value research can guide us to choose the right set of metrics which provide important information. We ought to ignore those that are inconsequential.

In the upcoming sections, we’ll become familiar with the measures that Asset Management Companies (AMCs) typically publish for their various schemes.

1. Returns – Absolute, CAGR, XIRR
2. Rolling Returns
3. Expense Ratio
4. Benchmarking
5. Exit load
6. Portfolio turnover ratio
7. Standard Deviation
8. Beta
9. Sharpe Ratio
10. Capture ratios

Of course, along the way, if I feel I’ve missed an important metric, then I’ll just add that to the list and discuss the same.

So as you can see, we have a lot to cover, so let’s get started.

– Measuring MF investment performance

Mutual fund investors often struggle with understanding returns across investments. Applying the same measurement technique across all types of investment leads to incorrect calculations and faulty analysis. Hence, correctly gauging return is an essential part of examining a mutual fund. We should begin our exploration with the fundamentals of return measurement.

For this conversation, I will presume that you are already aware of the Systematic Investment Plan, or SIP. The Asset Management Companies and authorities have completed an outstanding job in making sure most taxpayers in the country understand the concept.

Therefore, I will not waste time talking about the huge benefits of investing through a Systematic Investment Plan. If you are unfamiliar with them, I suggest taking a look online; you can find plenty of informative articles with SIP calculators to help demystify the concept and guide you on how to begin.

To emphasise the importance of this discussion, I will discuss two commonly used investment approaches.

In a lump sum investment, an investor chooses to invest a certain amount of money – based on their budget – all at once. As an example, I receive a yearly bonus of Rs.1,00,000/- and opt to put Rs.75,000/- into a mutual fund.

Systematic Investment Plans (SIPs) require regular investments set at a fixed amount, on a predetermined monthly date. You can opt to invest weekly, bi-weekly, monthly, quarterly, or even semi-annually. For example, I started off my SIP journey with a Rs.2,500 investment on 5th of each month into the Sundaram Midcap fund. There is no timeline for ending the plan; you can keep going as long as financially possible.

Measuring the return of these two investments requires a different approach. Most investors assess their investment by calculating its starting and ending value, but this is not the only option. Making an accurate assessment also necessitates taking time into account.

Surely, your response to finding out that I made an 80% return on a certain investment would be one of amazement.

What if I told you I made an 80% return over 15 years? Doesn’t sound particularly appealing, does it? When measuring our investment performance, time is of the utmost importance. It’s vital to take it into account.

We can divide these investments into two distinct time frames.

The table above helps us to understand the different types of investment and the kind of return we should calculate for each. For instance, an absolute return calculation must be done for a lump sum investment which has been made for less than one year, while XIRR should be used to measure the performance of a SIP that is older than one year.

Even though you don’t necessarily need to know how to calculate absolute return, CAGR or XIRR as an investor in mutual funds, there are several free calculators accessible on the web. It’s worth investing a little of your time, though, just to become more knowledgeable about this process.

Let’s start with the absolute return.

If an investment is for less than a year, investors should always consider the absolute return. Whether it is a lump sum investment or a Systematic Investment Plan (SIP), the absolute return should be taken into consideration.

The calculation is straightforward. Here is an example –

On Jan 1st 2020, I invest Rs.25,000 in a Mutual Fund. On July 7th, the value of this fund is Rs.30,000/-. What is the return generated?

You should recognise that this is a lump sum invested and is under a year.

The absolute return can be calculated as –

[Ending Value/Beginning Value] – 1

= 30,000/25,000 – 1

= 20%

Let’s look at another example. An investor puts in Rs.5,000/- a month in a Mutual Fund and after six months, the value of their holding is Rs.35,000/-. How did it turn out?

We know that this is a case of SIP investments.

Monthly investment – Rs.5,000/-

Number of months – 6 (less than one year)

Total investment value = 5000 * 6 = Rs.30,000/-

Current value of investment = Rs.35,000/-

We need to apply the absolute value calculation here –

=35,000/30,000 -1

=17%

For SIPs shorter than one year, it is certainly possible to calculate XIRR, however my experience is that most investors struggle to understand this figure due to its counter-intuitive nature.

Let’s re-examine why investing for less than a year with a SIP may not be the most desirable option later on. For now, just bear in mind that absolute returns must be used if your investment period – whether it’s lump sum or SIP – is less than one year.

Next up is the CAGR.

CAGR measures the rate at which an investment expands over a period of time. As an example, let us consider a closer look at this.

I invested Rs.25,000/- on the 1st of July 2017 in a particular Mutual Fund and three years later that investment has grown to Rs.40,000/-. What would be the return on this particular investment?

I have highlighted the query to garner your focus on it. We shall look into it again shortly.

This investment is a lump sum, so we can use the compound annual growth rate (CAGR) to compute its return over more than a year. The CAGR formula is straightforward.

[Ending Value / Starting Value ]^(1/n) – 1

Where n is time in years. Let us apply this formula –

= [40,000/25,000]^(1/3)-1

= 16.96%

The investment in this fund has seen a 16.96% rise year on year – it’s an impressive growth rate.

The most common confusion for the investor is this –

I invest 25,000, which has grown to 40,000, which means a profit of 15,000. The return should be about 60%, i.e. 15K profit on 25K investment.

Of course, there is nothing wrong with this calculation. After all, this is the absolute return we are calculating here.

Which year did you get the 60% return? Did you achieve it all in the first year or was it spread out over three years with no return in the first two? Or did it come in the third year?

If we delve more into this, we can understand the details. But if not, we rely on the average year-on-year growth – the higher it is the better our investment.

To gain a better understanding of the concept, consider a car trip from Delhi to Jaipur.

I want to know what your average speed was, so can you tell me how fast you drove from Delhi to Gurugram, then on to Panchgaon and Neemrana? Was it around 80 kmph, 110 kmph or 90 kmph?

You won’t grant me a division; rather, you’ll provide me with an average rate.

When looking at a multi-year investment period, the years in between are like different parts of a journey. Depending on how the market performs (which is similar to the flow of traffic) different results (similar to varying speeds when driving) may be achieved – some positive and some negative.

As a long-term investor, we take an average return of the investment, called the CAGR. This growth rate ignores yearly variations and offers an overall assessment of the investment.

Now, go back to the initial question, which was intentionally kept in bold. Do you think that is the right question?

One should have asked – ‘What is the rate at which my Mutual Fund investment of Rs.25,000/- made on 1st July2017 has grown to Rs.40,000/- in three years?’

I wish for you to understand the subtle but meaningful distinction between these two queries.

Going back to Delhi and Jaipur, if we take the average speed as 100 kmph, then how long will it take us to get to Ajmer – which is 150 km away from Jaipur?

I’m aware of the typical speed, so you should be arriving in Ajmer in approximately 1 and a half hours.

I am aware that my investment has grown by 16.96%, and I am curious to know what it would be worth if I left it for one more year.

Quite easy –

Current value at the end 3rd year = Rs.40,000

Growth Rate – 16.96%

Tenure – 1 yearExpected value = 40,000*(1+16.96%) — > I’m basically incrementing 40,000 by 16.96%

= Rs.46,784.28/-

What could be the potential returns if I keep this investment for another three years?

The formula is

Current value *( 1+ growth rate)^(time in year)

= 40000*(1+16.96%)^(3)

= Rs.64,000/-

This is also called the future value of the investment given a certain growth rate.

It is important to note that when assessing an investment that is more than one year, the CAGR must be taken into account rather than just the absolute return. Hopefully this explains why.

When it comes to travel and investments, the higher the average speed or CAGR, the faster you’ll reach your destination. However, with increased speed or growth rate comes an increased level of risk. A downturn in price of the underlying asset could cause significant losses.

I trust you now understand which one to employ between absolute return and CAGR.

Now, our attention turns to XIRR, which is particularly useful when conducting SIPs over various years.

XIRR, or Extended Internal Rate of Return, can be handy in assessing the growth rate of investments made through SIPs (Regular Investment Plan) over a longer period.

If you began investing Rs.5000 on the 10th of every month commencing in December 2018, up to June 2020, then this is how the SIP table would look:

Over the course of 19 months, Rs.95,000/- has been allotted as an outlay from your bank account. This expenditure clearly illustrates a cash flow.

Today, 10th July 2020, the value of this investment is Rs.1,10,000/-. It is perplexing to ascertain its growth rate; however, it should be clear that this is a long-term investment and assessing its absolute return does not make sense.

The traditional CAGR can be insufficient when multiple investments have been staggered across different periods. To better account for this, we employ XIRR, a tailor-made version of CAGR.

The XIRR formula may seem overwhelming at first, but there’s no need to use it. A quick Google image search of ‘XIRR Formula’ will give you an idea of what I mean.

MS Excel has an XIRR function that you can use. The function itself is quite straightforward to use –

I’ve included the present value of the investment, which I have indicated in bold (above the arrow mark). The figure is given without brackets to show that I could receive it as positive cash flow into my bank account if I choose to exit the investment now.

The excel function to calculate XIRR requires two inputs –

1. The series of cash outflows and the current value of the investment

2. The respective dates of cash flow and the date of the current value

Once you feed these inputs, excel does what it is supposed to do and throws out the XIRR or the growth rate number for you –

It’s evident that the XIRR is an impressive 18.79%.

Scroll up and you’ll see I mentioned XIRR is a viable option for returns of under one year; however, it’s not the most intuitive. It’s better to just stick with absolute return.

Let me show you why. Take a look at this –

This investment of Rs.25,000 is spread over five months with a SIP of Rs.5,000 monthly. As of 10th May 2019, the value has grown to Rs.30,000 – so let’s calculate the XIRR of this.

XIRR informs me that the investment yielded a 106% return. Can we say this is sensible? I find it hard to believe, considering a mutual fund investor will observe a 5,000 increase on his 25,000 venture. It would be difficult to persuade him that his investment’s growth rate is actually 106%.

Since many platforms display the absolute return for SIPs of less than a year instead of XIRR, the general public often find this to be more intuitive – in this case, the amount is 20%.