XIRR vs CAGR: Better way to calculate Return on Mutual Funds?
XIRR vs CAGR: Understanding the Best Method for Calculating Mutual Fund Returns
Calculating the returns on mutual fund investments can be a bit tricky. Investors often find themselves at a crossroads between two popular methods: Compound Annual Growth Rate (CAGR) and Extended Internal Rate of Return (XIRR). Understanding these two metrics is essential for making informed investment decisions. This blog will explore both methods in detail, highlighting their differences, advantages, and the scenarios in which each is most applicable.
What is CAGR?
Compound Annual Growth Rate (CAGR) is a useful metric for measuring the average annual return of an investment over a specified time period. It assumes that profits are reinvested and provides a smoothed annual growth rate. However, it is most effective for lump-sum investments where only the initial and final values matter.
To calculate CAGR, you can use the formula:
CAGR = (Final Value / Initial Value) ^ (1 / Number of Years) – 1
This formula gives you a percentage that represents the annual growth rate, allowing for straightforward comparisons between different investments. For example, if you invested ₹1,00,000 and it grew to ₹1,61,051 over five years, the CAGR would be 10%. This means that, on average, your investment grew by 10% each year.
What is XIRR?
Extended Internal Rate of Return (XIRR) is a more complex metric that accounts for multiple cash flows at different times. It is particularly useful for investments that involve systematic investment plans (SIPs) or other irregular cash flows. Unlike CAGR, which only considers the starting and ending values, XIRR factors in the timing and amounts of each transaction.
XIRR is calculated using the following formula in Excel:
=XIRR(values, dates)
Here, ‘values’ refers to the cash flows associated with your investment, and ‘dates’ refers to the corresponding dates of those cash flows. This flexibility allows XIRR to provide a more accurate picture of your investment’s performance, especially when dealing with varying contribution amounts and timings.
When to Use CAGR vs. XIRR
Understanding when to use each metric is crucial for investors. CAGR is best suited for simple investments where you can pinpoint the initial and final investment values. For example, if you invested a lump sum into a mutual fund and didn’t make any additional contributions or redemptions, CAGR would be appropriate.
On the other hand, XIRR shines in scenarios involving SIPs or other investments with multiple cash flows. For instance, if you invested ₹1,000 monthly in a mutual fund and after one year, the total value of your investment is ₹13,500, XIRR would give you a more accurate return of 28.7%. This reflects the actual performance of your investment over time, considering the different amounts and timings of your contributions.
Examples of CAGR and XIRR Calculations
Example of CAGR Calculation
Let’s say you invested ₹1,00,000 in a mutual fund on January 1, 2018, and by January 1, 2023, the investment has grown to ₹1,61,051. To calculate the CAGR:
CAGR = (1,61,051 / 1,00,000) ^ (1/5) – 1 = 10%
This indicates that your investment achieved a stable average growth rate of 10% over the five years.
Example of XIRR Calculation
Now, consider a scenario where you start a SIP of ₹1,000 per month:
- January 1, 2022: Invest ₹1,000
- February 1, 2022: Invest ₹1,000
- March 1, 2022: Invest ₹1,000
- April 1, 2022: Invest ₹1,000
- May 1, 2022: Invest ₹1,000
- June 1, 2022: Invest ₹1,000
- July 1, 2022: Invest ₹1,000
- August 1, 2022: Invest ₹1,000
- September 1, 2022: Invest ₹1,000
- October 1, 2022: Invest ₹1,000
- November 1, 2022: Invest ₹1,000
- December 1, 2022: Invest ₹1,000
At the end of the year, your total investment is ₹12,000, and the value of your investment is ₹13,500. To calculate XIRR, you would input the cash flows and dates into Excel:
=XIRR([-1000, -1000, -1000, -1000, -1000, -1000, -1000, -1000, -1000, -1000, -1000, -1000, 13500], [1/1/2022, 2/1/2022, 3/1/2022, 4/1/2022, 5/1/2022, 6/1/2022, 7/1/2022, 8/1/2022, 9/1/2022, 10/1/2022, 11/1/2022, 12/1/2022, 1/1/2023])
This would yield an XIRR of approximately 28.7%, indicating a much higher effective return on your investment compared to the simple percentage increase calculated using CAGR.
Key Differences Between CAGR and XIRR
Here’s a quick comparison to help you understand the key differences:
| Feature | CAGR | XIRR |
| Cash Flow Consideration | Single lump sum investment | Multiple cash flows at different times |
| Complexity | Simple calculation | More complex, requires tracking of dates and amounts |
| Investment Type | Best for fixed, lump-sum investments | Ideal for SIPs and other investments with various cash flows |
| Accuracy | Can be less accurate due to ignoring timing | More accurate as it accounts for the timing of cash flows |
Conclusion
Both CAGR and XIRR serve distinct purposes in evaluating mutual fund returns. While CAGR offers a simplified view of growth for single investments, XIRR provides a more nuanced understanding of returns, especially for investments involving multiple transactions over time. Knowing when to use each metric can significantly impact your investment strategy and help you make better-informed decisions. Ultimately, whether you are a seasoned investor or just starting out, mastering these concepts will enhance your ability to assess and optimize your investment portfolio.
