The single constant yearly rate at which an investment would have to grow, compounding each year, to turn its starting value into its ending value over a given period is shown as a percentage a year, and it ignores the actual ups and downs in between. This is what the compound annual growth rate (CAGR) means in mutual funds.
The formula is (ending value / beginning value)^(1/years) - 1, multiplied by 100 to give a percentage. The beginning value, the ending value and the number of years are the three inputs it needs. The result is an annualised, compounded rate between two values, and the route the money took between those two values does not enter the calculation.
How a fund's CAGR is calculated and shown
For an individual who invests Rs 1,00,000 and finds it has grown to Rs 1,50,000 after 3 years, the CAGR will be about 14.47% a year. The money may have risen and fallen in between, but the calculation uses only the two end values.
Indian mutual funds show returns of one year or more as CAGR. For periods under one year, the funds show a simple absolute return, which is the plain percentage change without any compounding.
Where CAGR misleads: SIPs and short periods
A single smooth rate hides the volatility a fund went through and the start and end dates chosen for the calculation can change the figure. Two investors looking at the same fund over different periods can see different CAGR figures.
Absolute return is generally used for a lumpsum or SIP held for under a year. For longer periods, CAGR is used for a lumpsum and XIRR for SIPs. XIRR is a modified form of CAGR that takes the date of each instalment into account.
For SIPs, a fund's quoted CAGR is not the investor's own return, because the instalments went in on different dates.