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How Compounding Works in Mutual Funds

How Compounding Works in Mutual Funds

Tulika Agrawal
Tulika Agrawal

We, as humans, work hard to earn money to meet our basic requirements and to make our living better. We tend to accumulate various assets to feel secure as well as to grow our wealth. Did we ever wonder that there is someone who can work as hard as us (or even harder) to earn money for us? It is actually our own money!!

Famous quote by Einstein- “Compounding is the 8th wonder of the world” is indeed true when it comes to long term investing. An investment of Rs. 1 lac doubles to 2 lacs in 5 years but grows to 16 lacs i.e. 16 times in 20 years @15% rate of return.

Before we discuss how compounding happens in mutual funds, let’s first see how compounding itself works.

How does Compounding happen

Compounding is earning interest on interest or having further growth on growth. If one does not withdraw gains from investments, then subsequent year gain comes on the entire amount i.e. amount invested plus the gains on the original investment, not just on principal amount. Longer the time duration, higher would be the gains and this eventually leads to much higher fund value at the end of the investment horizon.

Illustration #1 (Without Compounding)

Investment of 10 Lacs@12% with Yearly Withdrawal of Interest

Year Investment Fund Value at Beginning of Year Yearly Gain Withdrawn Fund Value at End of the Year
1 1000000 1000000 120000 1000000
2 1000000 120000 1000000
3 1000000 120000 1000000
4 1000000 120000 1000000
5 1000000 120000 1000000
6 1000000 120000 1000000
7 1000000 120000 1000000
8 1000000 120000 1000000
9 1000000 120000 1000000
10 1000000 120000 1000000
Total Gain 1200000

In the above illustration, we are getting 1.2 lacs as gains in a year. The gains every year remain same 1.2 Lacs as the investment amount remains same 10 Lacs because the yearly gain is withdrawn after every year. In this manner, the amount withdrawn in 10 years shall be 12 Lacs (1.2 Lacs withdrawn every year). The total fund value after 10 years shall be 22.2 Lacs i.e. Original investment of 10 Lacs PLUS gains of 12 Lacs.

Illustration #2 (With Compounding)

Investment of 10 Lacs@12% with Compounding Every Year

Year Investment Fund Value at Beginning of Year (a) Yearly Gain (b) Fund Value at End of the Year (a+b)
1 1000000 1000000 120000 1120000
2 1120000 134400 1254400
3 1254400 150528 1404928
4 1404928 168591 1573519
5 1573519 188822 1762342
6 1762342 211481 1973823
7 1973823 236859 2210681
8 2210681 265282 2475963
9 2475963 297116 2773079
10 2773079 332769 3105848
Total Gain 2105848

In the above illustration, we are getting 1.2 lacs as gain only in the first year. The gains in subsequent years keep on increasing as 12% gain is made not only on original investment of 10 Lacs but also on gains added in the previous years. The total fund value after 10 years shall be 31 Lacs i.e. Original Investment of 10 Lacs PLUS gains of 21 Lacs.

The above illustrations clearly show that if gains from investments are not withdrawn and if they remain invested, the fund value keeps on increasing with time. The increased fund value further makes more gains and becomes significantly large with passage of time.

Compounding in Mutual Funds

In the above example, the rate of interest has been assumed as fixed and is known when the investment is made. This type of example of compounding perfectly fits and is applicable to guaranteed income products like fixed deposits, bonds, NSCs, term deposits etc.

However, the mutual fund investments are market linked and their growth/rate of return is not guaranteed. Therefore, the compounding in mutual funds works in a slightly different manner. In Mutual Funds when we talk about returns, it is actually a growth on growth(and not interest on interest), which when converted into percentage give us compounded rate of return.

Why it is different in mutual funds?

When we invest an amount in a mutual fund scheme, units of that scheme are allotted at a unit rate called NAV (or we can say purchase price per unit) on that day. The total value of units allotted are same as the amount of investment.

The mutual fund schemes invest in certain stocks or securities, the total value of which changes everyday with the change in price of those investments. With the change in value of these investments, NAV of that particular scheme changes every day. Increase or decrease in value of these investments leads to rise or fall in NAV on a daily basis. However, over a longer period, as the values of investments grow, the NAV also grows.

An Example:

Assuming an investment of Rs.10 lacs was made in Aditya Birla Frontline Equity Fund-Growth on 29 Jan 2003, an illustration is given below with details of how fund value would have changed over these last 19 years.

Date NAV Units Fund Value Growth Gain
29-01-2003 10.04 99602 1000000
29-01-2008 70.5 99602 7021912 7 times 60 lacs
29-01-2013 101.4 99602 10100598 10 times 90 lacs
29-01-2018 228.5 99602 22753984 22 times 2.17 cr
28-01-2022 335.2 99602 33385458 33 times 3.23 cr

The above illustration shows that NAV of the fund increased from 10.04 to 70.5 between 29 Jan 2003 to 29th Jan 2008. In the same proportion, the fund value changed from 10 lacs to 70.2 lacs. Here, the growth in value is known but the rate of return is not known. To know that we use a mathematical XIRR formula, and get the compounded annual growth rate of 47.6% over these 5 year period.

As we take this example forward from 29 Jan 2008 till 29th Jan 2013, the NAV grows from 70.5 to 101.4, the fund value grows from 70.2 Lacs to 1.01 crores and the compounded growth rate over this five year period calculates to 7.5%.

We can see that once the investment of 10 lacs grows to 70.2 lacs in the first five years, it keeps on growing further to 1.01 crores. This is growth over growth, which helps the original investment to multiply 10 times in these 10 years.

As we come further from 29 Jan 2013 to 28 Jan 2022, the NAV has grown to 335.2, the investment has grown to 3.33 crores at compounded annual growth rate of 14.2%.
Overall, over a period of 19 years, the NAV of the fund has grown from 10.04 to 335.2 at a compounded annual growth rate of 20.2%.

From the above two examples, we can infer that:

  1. The compounded annual growth rate of a fixed income investment and a mutual fund is calculated in a different manner.
  2. The growth in NAV of a mutual fund scheme determines the fund’s annual growth rate.
  3. A mutual fund scheme keeps on growing at compounded rate and the gains become multiples times of original investment as the time passes. The multiplication is not just 2 times or 3 times but 10/20/30 times of the original investment if sufficient time is given to the investment.
  4. A mutual fund investment may grow at different compounded growth rate over different periods, but effectively multiplies the original investment many times.

Conclusion:

Compounding has a power to multiply investment to the extent that it crosses the point where our gains are more than the principal amount invested. Starting early and sticking to an investment while giving it an ample time to grow is key to wealth creation. The power of compounding makes many impossible looking financial goals possible. Make it your best friend and you may never be in a need of another(financial) one.

We wish you Happy Investing!

Tulika Agarwal
Co-Founder, Investguru

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