How Are SIP Returns Calculated?

Vijay Bhargava is vexed. A year ago, he started an SIP (Systematic Investment Plan) of Rs 3,000 per month into UTI MNC Fund. An initial purchase and 12 SIP instalments later, his fund value (against an invested amount of Rs 39,000, stands at Rs 42,906 today – a profit of Rs 4,206. Heading into an annual review of his investments with his Financial Planner, he has calculated his returns to be 10.43 per cent, which he considers a tad disappointing, as he had started his SIP with an expectation of 12 per cent per annum.

To his surprise, Vijay’s Financial Planner proudly informs him that his SIP returns from this fund over the past one year have been 20.8 per cent! Vijay feels he is being misled. Is this a case of misrepresentation, or is Vijay unclear on how SIP returns are calculated?

Why Absolute Returns Are Misleading In Case Of SIPs

What Vijay calculated as 10.43 per cent are in fact, the “absolute returns” earned from his investment. His calculation was rather simple – divide the profits earned by the capital invested, and convert it into a percentage figure.

There’s an inherent flaw in this method, though. The absolute return figure has limited applicability in case of SIP’s for a simple reason – the fact that the cash flows have been staggered into the portfolio and not invested in one shot. Put differently, had Vijay invested Rs 39,000 as a lump sum and earned Rs 4,206 as a profit over a year, his assessment of a 10.43 per cent return would have been spot on.

In case of a SIP, though, the entire invested capital did not spend a full year in the fund. One tranche had a holding period of 380 days; another – 340 days, and so on and so forth. Therefore, each SIP tranche would, in fact, have to be viewed in isolation in order to correctly assess the returns earned on Vijay’s investment.

The Concept Of CAGR

CAGR or “Compound Annualised Growth Rate” is nothing but a hypothetical annualised rate of return for an investment that has either been in play for less than a year or more than a year (for a holding period of precisely a year, CAGR will equal the absolute return number). For instance, Vijay’s June 2017 SIP tranche has been invested for 128 days, and has earned an absolute return of 5 per cent. This translates to a CAGR of 15 per cent for this particular tranche. Similarly, his first SIP tranche (September 2016) has grown by 13.1 per cent in 380 days – a CAGR of 12.6 per cent.

How To Correctly Assess SIP Returns

The correct way to evaluate returns from your SIP would be to consider the CAGR of each unique SIP tranche in isolation, and thereafter average them. Since a SIP consists of equal-sized instalments, a weighted average calculation wouldn’t be necessary – a simple average would suffice.

In doing so, you’ll be taking into account the fact that each SIP tranche is, in fact, a unique investment in itself. By calculating the CAGR for each tranche, you’ll be condensing each tranche to a common frame of reference, thereby eliminating the impact of the time differential for each SIP instalment.

Don’t fret, most software systems employed by Financial Planners have an inbuilt system to compute SIP returns in this manner! You’ll not need to do it yourself. As an investor, what’s important is that you have the awareness of how SIP returns are calculated, more than anything else.