When you read that a fund has 11% over five years, what does it mean? Does it simply mean that if a person invests in that fund for five years, they will get an 11% return? Or is it indicative of something else?
It is difficult to understand the different types of mutual fund returns. But it is absolutely necessary to understand that all of the mutual fund performance tools, including CAGR and XIRR, only report the historical aspect of a mutual fund: its past performance trends. Through them, you get to know the performance of a fund during a particular period. They are not the predictions of future returns.
CAGR – Compounded Annual Growth Rate – is the most widely used tool to monitor the average annual growth rate of funds. The average annual growth rate represents the average annual return on an investment in a mutual fund over a period of time.
So, when you invest in a fund over five years, CAGR represents the fund’s average return in each of the past five years. However, CAGR does not give a clear picture of the volatility of the market. Linear growth, as highlighted by CAGR, is not accurate for any fund.
Periodic investments are not included in the CAGR calculation; thus, it cannot give more accurate return figures on systematic investment plans (SIPs). In short, CAGR is suitable for a lump sum, but when the investment becomes sporadic and periodic, it fails to help your investment return planning.
Extended Internal Rate of Return (XIRR)
The Extended Internal Rate of Return, abbreviated as XIRR, is a measure that depicts the profits on your recurring investments like SIP. With SIP, you invest money sporadically. Even if you make some bad bets in investments at different periods, XIRR gives the correct returns for such moves.
XIRR is the summation of CAGR for individual investments. All investments in SIP programs are different. When you see XIRR, the CAGR of each category is calculated and added at the end to determine the average annual growth rate.
Example
Suppose Person X started a monthly SIP of Rs. 4000 for five years in 2015. For simplicity, let us assume that there is no redemption of the investments under the SIP. Person X invested a different amount each month, and the duration of each investment became different.
This difference is critical in impacting the yearly returns and thus the overall return. When XIRR is calculated, each investment’s CAGR is considered, and then all will be added.
Suppose Person X starts investing from Rs. 4000, and receives Rs. 5500 at the end of 5 years. Then, the XIRR calculation will be as follows:
Amount Invested = Rs. 4,000
Amount at Maturity = Rs. 5,500
Investment Time Period = 5 years
XIRR (or Annualised Return) = 6.58%
Total Return = 37.5%
So, XIRR is an excellent function for calculating returns when your cash flows (investments or redemption) are spread over a while. In the case of mutual funds, if you are investing via SIP or lump-sum or redeeming through the same channels, XIRR includes all those scenarios and helps you calculate an aggregate return considering the timings of your investment and withdrawals.
Difference between XIRR vs CAGR
Absolute returns represent the capital income of the previous year. You should not choose a fund based on absolute returns analysis. It would help if you considered CAGR or XIRR, which give you an idea of funds returns over the long term before making the investment plan. Absolute returns show the gain or loss for short term investments.
Absolute returns => (FV – IV/ IV) x 100, where FV = Final Value, IV = Initial Value
XIRR vs CAGR – which one should you choose?
You should choose either of these processes (XIRR or CAGR) solely based on your investment type and strategy. If you invest through a once-and-for-all mode, CAGR can give you the portfolio’s return earnings. In the case of SIPs where investments are cyclical, XIRR provides detailed and more accurate information.
