Excellent Question.

A lot of people talk about compounding as a benefit of Mutual Fund without

knowing how does it work.
Let me try to explain how does compounding works in Mutual Funds. Let's start with
Compounding itself. Compounding is simply an activity in which the earnings of the original
investment also earn the same rate of return as an original investment.
Now in the case of Mutual Funds let's say you invested in the fund when the NAV is Rs. 20. Now
assume NAV goes up by 25%, in that case, the New NAV will be 25. Again markets go up by
20%. Now the new NAV will be Rs. 30 which is 20% above Rs 25. If there were no
compounding than the return would be 20% over Rs 20 which was an original investment. This
is compounding in Mutual Funds for you.
Now if you think about it in Mutual Funds there is continuous compounding, unlike other fixed
income instruments which there is half yearly or yearly compounding.
In fact, all the Equity instruments the compounding is continuous as your latest return is over the
latest market price.
This is great, but it has a flip side also. This continuous compounding works well in your favor
when markets are positive, but works against you when markets are negative.
Here is how
In above example let's say the NAV is Rs. 30 and market went down by 20%. Now the loss is Rs.
6 (20% on Rs 30). The new NAV now is Rs. 24. Here if you recollect when NAV was 25 it
required 20% returns for it to go to 30. But now with 20% loss, it has gone to Rs. 24 which is
less than Rs 25.
But having said that I would like to say is that because over long terms markets go upwards only,
for a long-term investor compounding will work in his / her favor. In fact, I must say
compounding is the magic which magnifies your return over the long term.
Hope this made sense.
Thanks for asking such a good question.
Ashish
Compounding in this sense does not apply to mutual funds. The value of a mutual
fund is determined daily by adding up the market value of all the assets held,
including cash, after all transactions occurring in the fund that day are accounted

for. Transactions includes operating expenses pro-rated that day, income from
dividends paid by holdings, other incomes, inflows, outflows, investments made,
investments sold, and distributions of dividends and capital gains when they occur.
The net result will be a daily gain or loss. That result can be expressed as a daily
return, and since each daily return is expressed relative to the value at beginning of
day, one could say that the return compounds daily. However, it should be
understood that in a savings account there is contract to pay interest on principal
and previous interest at a set interval, called compounding. The situation for a
mutual fund is just a way of doing arithmetic to report the accumulating value of the
fund. One can say that mutual funds do not compound, but that one can calculate
the compound average daily/weekly/monthly/annual return of a fund using the
appropriate math. One could even express that average as a continuous compound
return using the appropriate formula.
I should add that the issue of dividends paid out by the fund can be confusing. The
net asset value of the fund, aka the share price, will lose value as dividends are paid
to share holders and capital gains distributed. A price chart as seen at Yahoo, etc.,
will just be a history of the share price and will lose the value of the distributions
made. However, when financial companies report the return produced by the fund,
paid out distributions are accounted as if reinvested. A chart that would show that
would be the "growth of $10,000" often presented. The return of stock funds will be
dividends earned plus capital growth in the market, capital growth being greater
than dividends on the whole. The return of bond funds, on the average, is just the
interest paid on the bond holdings, reinvested.

Mutual Fund Returns

RANGA CHAND
From Ranga Chand's Getting Started with Mutual Funds
A return is a measurement of how much an investment has increased or decreased in value over
any given time period. In particular, an annual return is the percentage by which it increased or
decreased over any twelve-month period. Suppose you invest $1,000 today and twelve months
later your investment is worth $1,070. The annual return on your original investment of $1,000 is
7%, or $70. The real return, however -- the annual return less the rate of inflation over the
investment period -- will be lower.
Calculating a Fund's Total Return
For those with a mathematical bent, figuring out the return on a mutual fund is not difficult. For
the rest of us, a calculator comes in handy. Suppose the XYZ Fund has a net asset value (NAV)
of $10 at the beginning of 1995. During the year, distributions of $2 per unit are made to
investors. At the end of the year, the NAV is $13.50. To figure out the fund's total return, you

start with the year-end NAV of $13.50 and add on the distribution of $2.00. This gives you a total
of $15.50. Next, subtract the original NAV of $10.00. That leaves you with $5.50, the fund's
profit for the year. Finally, divide the $5.50 by the starting NAV of $10.00, which gives you 0.55.
To arrive at a percentage, simply multiply by 100. The total return for the XYZ Fund for 1995
was 55%.
(Final NAV + Distributions - Original NAV) / (Original NAV) X 100
= ($13.50 + $2.00 - $10.00) / ($10.00) X 100
= ($5.50) / ($10.00) X 100
= 0.55 X 100
= 55%
How to Calculate Your Return
Let's say you have invested $1,000 in a mutual fund and reinvested all distributions of $200. (If
you received any distributions in cash, remember to include them.) At year's end, your account is
worth $1,200. To calculate your return, first subtract your initial investment of $1,000. Then take
the difference of $200 and divide by your initial investment of $1,000. Multiply the answer, 0.2,.
by 100 to arrive at 20%.
(Current value of units - Initial investment) / (Initial investment) X 100
= ($1200 - $1000) / ($1000) X 100
= ($200) / ($1000) X 100
= 0.20 X 100
= 20%
These calculations can be used for any twelve-month period, or any other period.
When calculating your own return, keep in mind that any sales commissions or transaction costs
(see Chapter 3) have to be deducted from the current value of your units and will therefore
reduce your return.
Compound Average Annual Returns
Compounding means that on top of earning a return on your original investment, you also earn
returns on your returns. The compound average annual return quoted in mutual fund brochures
and advertisements shows the total a fund has returned, taking into account all capital gains (or
losses) and dividends, expressed as an average yearly growth percentage.
For example, in its advertising, a certain fund quotes a three-year compound average annual
return of 7.6%.
This does not necessarily mean the fund delivered this figure in any one of those three years. In
fact, this particular fund delivered -8.8% for the year ending December 31, 1994, +21.6% for the
year before, and +12.4% for 1992. Only if you had invested at the beginning of 1992, and
reinvested all distributions, would your compound average annual return for the three years have

been 7.6%. If you had invested at any other time, your rate of return might have been higher or
lower.
The compound average annual return is an important measurement, as it shows the rate at which
wealth grows over time. This is something that you, as an investor, clearly need to know.
A Final Word
Returns on any fund will reflect the particular market it invests in. For example, you cannot
realistically expect an equity fund to deliver a return of 25% if the stock market is down 10%.
Moreover, even if a fund shows a positive return, you might not; it may take you some time to
recoup any transaction costs.
Key Points to Remember

Returns show how your investment has increased or decreased in value.

Compounding earns returns on your returns.

Compound average annual returns sh