As investors, we all want to know how much profit can we earn from an investment before investing it. We often tend to invest in asset classes, such as equities, with a high probability of giving good returns. Though stock market investing is a popular way of getting exposure to equities, mutual funds are gaining traction in the last few years. This is mainly due to high average returns on mutual funds in India and diversification. However, in a volatile market situation like the current one, choosing the right mutual fund with market-beating returns can be difficult.
Here we evaluate different kinds of mutual fund returns that will help you choose the right investment.
Mutual funds are investment products that give an investor the benefit of investing in the markets with a small investment amount. They are professionally managed instruments that give decent returns in a bull run. They also have low downside risk when compared to direct equity investments during a bear market.
The average mutual fund return varies between 5%-15%, depending on the category of mutual funds. It is important to note that this is just a ballpark range, not the exact return from mutual funds.
Mutual fund returns vary based on market conditions, and so does the average annual return. A mutual fund giving a 5% annual return might not seem desirable in a positive market condition. However, the same can be considered an excellent return when the market is down.
Categories with more equity exposure have higher returns during positive market conditions than the ones that don’t. In other words, it means when the market goes up, equities can give market-beating returns. However, with high return comes high risk, so investors need to practice caution while choosing the right fund.
To choose the right fund, defining the investment horizon is very important. In the long term, investment risk is considerably lower compared to the short term.
Mutual funds are generally categorized as long-term investment products as, historically, they have given market-beating returns in the long term. Though historical returns don’t guarantee anything, they can help gauge the fund’s performance during different market cycles.
A mutual fund’s returns cannot be assessed in isolation. One must always compare it with the market return or its peers to understand how the fund performed. A fund consistently giving better returns than its peers year after year is likely to perform better than the fund with inconsistent returns.
Let’s take for example, of two similar funds, fund A and fund B. The returns for Fund A for the past five years is 11%, 13%, 7%, 9%, 15%. Whereas the returns for Fund B are 9%, 10%, 3%, 4%, 9%. Fund A has been consistently performing better than Fund B. This shows Fund A has better chances to perform well in the future than Fund B.
There are different kinds of mutual fund returns that one needs to understand before they kickstart their investment journey. The most popular ones are annual and annualized returns.
Annual return is the rate of return that an investment made in a year. It is the most popular indicator among investors as they usually check the latest returns from investment to assess its performance in the current market situation. Moreover, it is very easy to calculate compared to other mutual fund returns.
Annual return = (Value of the investment at the end of the year – value of the investment at the beginning of the year)/(Value of the investment at the beginning of the year).
A positive return indicates the fund has given profits in that year, while a negative return indicates losses.
Though the annual return is easy to calculate, it simply shows how much an investment has grown in one year. Hence one cannot use it to compute the return of the investment throughout the investment tenure.
Annualized return is the average return per annum. In other words, it is the amount an investor earns from the investment per annum. Though it is a little difficult to calculate, it helps compare the returns of multiple investments over different periods.
Below is the formula for calculating annualized returns.
Annualized return = ((1+ ending value/beginning value) ^ (1/n)) – 1
where n is the number of years.
Let’s understand this better with an example. Let’s say a mutual fund’s net asset value (NAV) is Rs 10 at the beginning of the investment tenure. After three years, the NAV of the fund is Rs 40. The annualized return for a period of three years is 10%. This means the mutual fund has given an average return of 10% per annum for three years.
In a mutual fund’s fact sheet, the returns under one year and above timelines are all annualized returns. By comparing the annualized returns of different mutual funds, one can easily understand how a fund is performing against its peers and its benchmark and make a rational investment decision.
Investors usually compare their investment returns with that of the market or benchmark index. They are satisfied if their return is either equal to or higher than the benchmark. Investors usually consider Nifty 50 and BSE Sensex benchmarks, but different investments have different benchmarks.
For a mutual fund, a benchmark index is already mentioned in a fund’s factsheet. Suppose the fund is consistently performing better than the benchmark over its tenure. In that case, there are high chances it will continue to beat its benchmark in the future too. Picking such a fund will help an investor earn an above-average return on mutual funds in India.
Apart from the benchmark index, investors must also consider a fund’s performance with respect to its category.
As per SEBI’s categorization of mutual funds, there are several categories of mutual funds under different asset classes, such as equity and debt. Each category has several funds offered by different fund houses, all of them having a similar purpose of investment. With such a wide variety of choices, it’s not a surprise if an investor gets confused with the investment decision.
However, by comparing a mutual fund’s returns with its category average, one can pick the best fund for investment. Suppose a fund’s returns are higher than its category average. In that case, we can conclude that the fund is giving above average return. On the other hand, if the fund’s returns are lower than its category average, the fund is giving below-average returns.
In the last five years, the small-cap category has been leading with an annualized return of 14.2% per annum. This means the average return of small-cap funds in the last five years is 14.2%. An investor who wants to invest in the small-cap category for a minimum of five years can compare the five-year return of a small-cap fund with that of this category average and choose the fund with a similar or high return.
Mutual funds primarily invest in equity, bonds, cash, and cash equivalents. Under these asset classes, there are several categories of mutual funds for every investor’s need.
For example, under equity, there is a large cap for investors who prefer low volatility and stable returns and a small cap for people willing to take more risk for a higher return. There are also debt mutual funds that give better returns than an FD with very low risk. In other words, mutual funds have alternatives for several types of investments.
The small-cap category averaged about 14.2% for the last five years, while the return from a five-year FD is around 5.5%. Returns from mutual funds are also higher than the return of popular government risk-free investments such as PPF, NPS, and senior citizen savings schemes (SCSS), which are in the range of 7%-10%. Moreover, mutual funds have always given inflation-beating returns. Apart from higher returns, mutual funds also rank high in terms of liquidity for these investments.
This shows that mutual funds are a better investment choice than most of the investments in the market. However, it is important to note that mutual funds invest in equities and debt, which are prone to market volatility and credit risk, respectively. Hence it is always best to monitor mutual fund investments regularly.
It is essential to check the rate of return on mutual funds before investing, along with its performance against its peers and benchmark. However, checking other factors is also important before selecting a mutual fund. For example, checking the fund’s portfolio, and the fund manager’s experience will filter out the good ones from the bad. Also, along with this, defining investment goals, horizons, and risk tolerance levels will help filter out the right funds.
Remember investing in the right mutual fund will fetch more returns than investing in the best mutual fund.
A mutual fund’s returns are annualized for a period of one year and above. This means the return shown is the average return the investor earns per annum for a given time period. So, a 5-year return is the average return of the fund for a period of five years. For example, a fund’s 5-year return is 20%. This means the investor of the fund is making a 20% return every year for a period of five years.
For an investment to double every seven years, the expected rate of return per annum from it should be 10.28%. This is calculated using the rule of 72. Under this rule, one can find out the number of years it will take to double an investment. Alternatively, one can also find out the expected rate of return from it.
Expected rate of return = 72/number of years to double
Using the above formula, one can easily determine the expected rate of return to double an investment in seven years.
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