You may often notice that 1-year returns of funds are higher than 3-year returns for some funds. Very often, the 3-year returns may also be higher than the 5-year returns. Why is it so? How can a fund give more return in a shorter period than it gives in a longer period?
When we compare 1-year returns with longer periods, we first need to be aware the longer period return is the average of many 1-year returns, compounded though. And not all of these years may have delivered alike. There may be periods when markets deliver lower or even fell. For example if a fund delivered 10% in the first year, 5% in the second year and 20% in the third year, then its compounded annual return over the 3 years is 11.4% (average returns with compounding). Now that might seem lower than the 20% return in the last year but the fact is the fund delivered 11.4% on an average in each of these three years. It is just that it returned differently in different years based on different market conditions.
The average of the last 3-year returns taking into account the compounding that happens each year gives you the compounded annual growth rate (CAGR). Read this article to know more about CAGR.
So how do you know if you made more money over the 1 year period or over the longer period? Let us illustrate further with examples:
If you see the above figure, the 1-year returns are higher than 3-year returns in both cases. However, the 3-year returns are not the absolute returns, they are annually compounded.
So how do you know the actual returns?
The best way is to look at how much your money would have grown if you had invested at the beginning of the time period. Suppose you had made an investment of Rs. 10,000 three years ago and another investment of Rs. 10,000 one year ago in DSPBR Opportunities Fund. Let’s calculate the respective values:
The investment made one year ago would have grown to:
The investment made three years ago would have grown to:
We have multiplied it three times because you would have gotten 17.61% returns in each of the three years, on an average
But there may be instances where your 1-year return might actually be lower than even your 3-year return. This may be because the last 1 year may have been a poor one compared with the previous 2 years.
Let’s use another example to clear this up. As of 4th January, 2018, the returns of Franklin India Prima Plus Fund looked like this:
However, just 6 months ago, on 30th June 2017, the returns looked like this:
The 1-year return at that point was lower. After that, the markets ran up, propping up the fund’s 1-year return. The Sensex rose 9.9% during this period. The fund returns also rose accordingly.
So next time you see the shorter period returns to be higher than the longer period returns, know that you are not missing out by investing for the longer period. Shorter period returns look higher when the markets have run up. Longer period returns, average out the returns of rallying markets, volatile markets and even down markets. They normalise it by telling you how much you got on an average over the last 3 or 5 or 10 years. The longer you invest for, the higher the chances of this volatility getting smoothened out. Your returns may be high or low over 1 year, but they will be closer to the average over the longer period.
And historically, equity, as an asset class, has given inflation beating returns. So the next time you look at returns, do not be swayed nor put off by short-term returns. Simply see if longer period returns have delivered better than benchmark and better than your FDs. That will tell the true story of what your fund can deliver.