Don’t get fooled: Mutual funds have no compounding benefit!

Published: December 15, 2018 at 11:00 am

Last Updated on

There is no compounding in mutual funds! Do not get fooled by “power of compounding”, “miracle of SIPs” and “8th wonder of the world” illustrations!  The term “compounding” has no separate meaning than to represent compound interest. Since mutual funds offer no interest, the notion of compound interest or compounding does not apply to them. Here is why.

What does compounding mean?

Interest also earning interest is referred to as compounding. For example, Rs. 1000 invested in a 10% FD becomes Rs. 1100 after one year = 1000 + 10%(1000). After two years, it becomes Rs. 1210 = 1100 + 10%(1100) and so on.

That is for each year, the amount invested earns 10% interest and all the accumulated interest in the previous years also get the same 10% interest.

What is the power of compounding?

Since the entire interest accumulated in previous years also earns interest in the next year, the value of the investment increases dramatically with time and that increase comes from the gain in the interest as shown below. The fact that the value of the investment becomes significantly higher than the investment itself is known as the power of compounding.

 

power of compounding illustration

Did Einstein actually say “compounding is the 8th wonder of the world?”

He never did. There is no proof. Some salesman who wanted to mis-sell probably did.

don't be fooled! There is not compounding in mutual funds!

Why is there no compounding in mutual funds?

First of all, it is important to understand that any market linked product has a chance to “grow” (or dip) significantly above (or below) the invested amount. This growth has nothing to do with compounding simply because the daily/monthly/annual gain or loss in the value of a mutual fund is never the same. There is no concept of an interest in mutual funds (even debt funds), unlike an FD where the interest rate and maturity value is known even before we start investing.

There is no power of compounding in mutual funds or stocks because the value of a mutual fund or stock investment can be, in the long term or short term or any no of years, be above or below or equal to the value of the investment. When you say “mutual funds have the power of compounding?”, you are essentially assuming that over the long term you will always get a huge profit. This is completely untrue. I have shown this again and again. This is one example: Sensex Charts 35 year returns analysis – stock market returns vs risk distribution. A 7Y or 10Y can result in a return of 0% simply because the return sequence is unfavourable. See: How the fate of your mutual fund SIPs is decided by timing luck!

If the power of compounding does not work all the time, then it has no power!! Do not confuse growth benefit (if any) with compounding benefits.

Example

Allow me to explain via an example that I use in all my talks. Rs. 10,000 invested on 1st Jan 2003  in ICICI Top 100 would have grown to  Rs. 1.19 Lakhs on Dec 31st 2014. This is an annualized Return of 22.91%. When people hear this they imagine this as the growth of that investment:

imaginary growth of a mutual fund investment

Nice and smooth is it not? This is how the growth would be if the yearly return is 22.9%. Wait, this is a mutual fund and yearly returns will never be the same. In fact, these are the annual returns of the fund.

Annual returns of ICICI Top 100 Fund

So the actual journey of your money is this:

Actual growth of a mutual fund investment

Nobody will or can sell mutual funds if they show the actual annual returns. So they cleverly take the final value and the initial value and compute the annualized return without worrying about the journey!

So we have: 1.19 lakh = 10000 x (1+ return)^12

Here the return is the compounded annualized growth rate or the CAGR and ^12 means the (1+return) term is multiplied 12 times (12 years here is the duration over the investment was made).

If we calculate the return = CAGR we get 22.9%. This is them mis-sold as the power of compounding and people then imagine nice and smooth growth. Some even assume that the fund has given 22.9% each year!!

The reality is this:

1.19 Lakh = 10000x (1+94.7%) x (1+ 13.4%) x ….. x(1-47.7%) x ….. (1+38.3%) .  This is actual journey. There is no compounding here as the returns are different each year.

Some people claim that this is compounding with variable returns! Sorry if that is the case then it is like saying: mutual fund compounding will sometimes work and sometimes not work!  The point is that mutual funds are mis-sold with the compounding premise that an investor who stays invested can never fail and this completely wrong. Mutual funds have growth benefits (sometimes). There is no justification to call this the power of compounding!

Why do we represent this

1.19 Lakh = 10000x (1+94.7%) x (1+ 13.4%) x ….. x(1-47.7%) x ….. (1+38.3%)

like this?

1.19 lakh = 10000 x (1+ return)^12

This is only because we need to compare the growth of this mutual fund investment with the growth of a risk-free instrument like an FD.

If over this 12 years, the FD has returned say 9%, I need a similar number for the mutual fund.  I can only get this number if I completely brush aside the actual journey and replace it with an imaginary number we call the CAGR.

Remember annualized return (CAGR) is not the same as an annual return for any market linked product. Only for fixed deposits is the annual return = annualized return.

This imaginary CAGR can then be used to calculate excess return over an FD for the risk taken. This is known as the risk premium

Do not confuse a tool (CAGR) use to compare growth with a risk-free instrument with actual compounding! That is delusional!

So I published a video on this a couple of days ago,

Have a look at the comments there! Do subscribe while you are there as I am trying to post a new video a day. It is amazing how people have blind faith in equity.

How do we understand mutual fund returns if there is no compounding?

First of all, why should there be compounding in a mutual fund for you to get growth benefits! You need not! Second of all, the idea of an annualized return is only for comparison with the risk-free rate. So it is a relative measure. Just as you understand 100 second is longer than 10 seconds, but one second has no meaning.

We all agree one second to be some duration and this is an arbitrary definition. Similarly, the CAGR is also an arbitrary definition for comparison. If your fund made 12% annualized and the index 10% annualized it just means you made a little more money than the index. Do not start imagining the growth like this – it is wrong

Do not compare annualized returns this way!

Also when you make multiple investments, you need to calculate the XIRR and this is an approximate measure of the CAGR (which itself is arbitrary)!!

For example, I recently wrote: After 10 years my equity return is 9% Yay! Here is why I am not worried about this gain or loss in my equity portfolio.

growth of my equity portfolio

For the first five years where was the so-called power of compounding? Or is compounding in mutual funds like the weather? It will rain sometimes and sometimes not!

Do not fool yourself and others! Mutual funds have growth benefits (sometimes) and fixed deposits have compounding benefits at all times.

Please note that I am not against mutual funds. I am only against stupidity and misrepresentation of actual risk for profit.

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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