When what you see isn’t what you get

The financial industry has come up with a truckload of complicated ways to calculate and present it

Financial gurus urge us to look at a variety of metrics when choosing investment options. But when asked to choose, most of us make a beeline for only one metric — investment returns. But simple as the concept of returns may appear to be, the financial industry has come up with a truckload of complicated ways to calculate and present it. Here are some situations in which what you see can be a misleading indicator of what you’ll actually get.

Inconstant CAGR

Lately, many bank fixed deposit investors have been writing in to ask why they shouldn’t switch from their 8 per cent fixed deposit to the balanced fund that has clocked a 12 per cent CAGR. This query clearly stems from a misreading of the CAGR, or compounded annual growth rate, used to describe mutual fund returns.

The CAGR is derived from the compound interest formula that we all pored over at school. It is the annual rate at which an investment needs to compound over a number of years to reach a certain maturity value. While the CAGR is a mathematically correct representation, when applied to a volatile asset class such as stocks or mutual funds, it can give the impression of steady returns where none exist.

The balanced fund mentioned here, the one sporting a five-year CAGR of 12 per cent, has effectively grown a ₹10,000 investment made five years ago to ₹17,623 today. But it would be a mistake to infer that those returns were earned in an even fashion. This balanced fund, for instance, shot up by 25 per cent in its first year, gained only 6 per cent in its second year, zoomed by 40 per cent in year three, lost 10 per cent in year four and, finally, inched up by 6 per cent in its fifth year to get the investor to that final figure of ₹17,623.

This brings us to two caveats in interpreting the CAGR. One, the CAGR creates an optical illusion of regularity even if the asset delivers a very bumpy ride. Two, CAGR describes the final result of the investment journey, but does not capture the ups or downs during it. In the above example, the bank FD investor, if he terminated his deposit midway during the five years, would have still earned an 8 per cent return. But the balanced fund investor would have earned far more or far less than 12 per cent had he exited mid-way. In fact, there was not a single year in which he actually earned a 12 per cent return!



Confusing IRR



To decide if they should invest a lumpsum into their favourite fund or opt for a systematic investment plan (SIP), investors often compare lumpsum returns with SIP returns. That’s a comparison of apples with oranges.

To illustrate, for a popular microcap fund, a lumpsum investment held over the last five years has delivered a 31 per cent CAGR while the SIP return for this five-year period is 33.3 per cent. Does this mean that the monthly SIP investor is now richer than the one-shot investor? Not by a long shot. While the ₹60,000 put in by the SIP investor (spread over five years) grew to just ₹1.37 lakh till date, the ₹60,000 put in by lumpsum investor is worth a cool ₹2.31 lakh.

To know why this is so, you need to understand that SIP returns are expressed in IRR (internal rate of return). The IRR is the discounting rate at which the present value of all future cash outflows from the investment, equals the present value of his maturity amount.

To simplify, if the CAGR describes the rate at which a one-shot investment compounds over time, the IRR blends together the growth rate for multiple instalments held for different time periods to arrive at a single effective rate of return.

Now, in the above illustration, the investor who put in a lumpsum of ₹60,000 into the microcap fund five years ago has allowed this entire sum to compound at 31 per cent for the five-year period. But the SIP investor, by spreading out his investment over 60 instalments stretched over five years, has let his money compound for far shorter time periods. This is why, despite an optically higher ‘return’ and an identical investment value, he is left with a lower sum on maturity.



Fairy-tale yields



Ever come across bank or corporate fixed deposit advertisements showcasing a mouth-watering ‘yield’? A three-year FD offering an 8 per cent interest rate will boast an ‘annualised yield’ of 8 per cent for one year, 8.32 per cent for two years and 8.65 per cent for three years.

So does this mean that this FD gives you higher returns, the longer you hold on? Not at all. The annualised yield calculation is just a mathematical sleight of hand to dress up the ordinary compound interest calculation.

As you know, if a FD with annual compounding offers an 8 per cent interest rate, an investment of ₹100 would grow to ₹108 in in first year, ₹116.64 in the second year (8 per cent interest on ₹108) and to ₹125.97 in the third year (8 per cent on ₹116.64).

To arrive at the ‘annualised yield’, financial firms simply divide ₹16.62 by 2 (8.32 per cent) or ₹25.97 by three (8.65 per cent). But that’s only the magic of compounding you’re seeing, and not the banks’ generosity for locking into a longer term deposit.

If you’re investing in an 80C instrument, returns may be dressed up by citing a ‘pre-tax yield’ as well. But don’t get taken in by the double-digit pre-tax yield. Assume you deposit ₹10,000 in a five-year tax saving deposit offering 8.5 per cent interest. If you are in the 30 per cent tax slab, you get to immediately save income tax of ₹3,090 for the year.

Now, pre-tax yield calculators assume that this saving reduces your initial investment to ₹6,910. At the end of five years, you will receive a final maturity value of ₹15,228 with accumulated interest. Now, calculating the compounded return of ₹15,228 on a deposit of ₹6,910 leads to an effective ‘yield’ of nearly 17 per cent.

But there are problems with taking this yield at face value. One, while the mathematical yield may indeed be high, you will not get a 17 per cent interest on your deposit every year.

The interest earned remains at 8.5 per cent as you’ve pocketed the rest of that ‘yield’ upfront as tax savings. Two, if you’re not in the 30 per cent tax slab but in the 20 or 10 per cent ones, your pre-tax yield will be far lower. Finally, this calculation factors in tax savings on your deposit but doesn’t reduce the tax outgo on your interest receipts. What you see, clearly, isn’t what you get.

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