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What is the first thing that comes to your mind when you invest your hard-earned money in any investment? Returns, isn’t it?
All of us are naturally interested in the returns. All of us desire to have our money multiply over the years. However, the question is, how do you calculate your mutual fund returns?
The two methods of calculating your mutual fund returns are CAGR and XIRR.
So, what are these methods, how do XIRR vs CAGR differ and how to calculate CAGR and XIRR? Let’s find out.
What is CAGR?
The abbreviation for CAGR is the Compound Annual Growth Rate, and it informs you about the annual growth of your mutual fund investment. You can use this method when you invest a large amount of money at once (lump-sum) and get money back at regular times.
CAGR thinks that your investment grows at the same or constant rate all the time and finds out the average return you get in that time. CAGR helps you know how fast your investment grows over time, and that’s why it’s good for long-term investments like mutual funds
Calculation of CAGR
To compute CAGR, we need the beginning investment value, ending investment value and the period of investment.
The formula for calculating CAGR is:
CAGR (%) = (Ending investment value / Beginning investment value)^(1/investment tenure in years) – 1
For example, say you invested ₹2 lakh in a mutual fund in 2020, and it grew to ₹3 lakh in 2025. So, the CAGR will be:
CAGR = (3 lakh/2 lakh)^(1/5) – 1 = 8.45%
So, your investment has grown at an average annual rate of 8.45% over the five years.
Limitations of CAGR
Though CAGR is a simple method to calculate the mutual fund returns, it has some limitations;
- CAGR assumes that your mutual fund investment has grown or declined at a constant rate every year, which may not be true in reality. In other words, it ignores market movements.
- It does not consider the frequency and time of your cash flows, like investments, withdrawals, dividends, etc. Only initial and ending values are considered in it.
That’s where XIRR comes into play.
What is XIRR?
XIRR’s full form is an extended internal rate of return, and it is a method that computes the annual rate of return on investment when cash flows are not uniform.
It uses all the cash that flows in and out, as well as when these occurrences take place to determine the annual rate of return. XIRR considers both the magnitude and timing of each cash flow, making it a more suitable approach for investments with irregular flows such as SIP.
Calculation of XIRR
If you want to calculate XIRR, you must know the dates and amounts of all your cash flows, including the initial investment, the final value, and any intermediate transactions.
To compute XIRR, you can use an Excel formula. The formula is:
XIRR = (values, dates, [guess])
Here, dates signify a series of dates, values signify a series of cash flows, and guess is the random assumption for XIRR.
Limitations of XIRR
XIRR has some limitations, they are:
- To calculate XIRR, accurate data regarding cash flows is required, both date and time.
- XIRR turns out to be a sensitive measure, affected even by slight changes in cash flow information.
XIRR vs CAGR – Which is the right option?
CAGR and XIRR are essential indicators to measure the performance of your mutual fund portfolios. However, the difference between XIRR and CAGR is noticeable in terms of their implications and applications.
You can use the below tips to choose the right option:
- In case you have invested a one-time lump sum amount in a mutual fund and held it for the long term, then CAGR can be used to calculate your returns. It will provide you with an easy and convenient method to compare the returns of several funds or other investments over that period.
- If you have made more than one or infrequent investments and withdrawals in a mutual fund – through SIPs, STPs, SWPs, etc., then XIRR is the method to measure your returns. It will provide you with a more precise and true-to-life means of recording the frequency and timing in which your cash flows occur.
Annualised return CAGR and XIRR are useful methods to measure the returns of mutual funds, and each has its own purpose. Investors can make better decisions when they know how and when to use them.
So, understand about them beforehand and invest in the best mutual funds.
The CAGR is a way to calculate how much an investment has grown over a specific period (annually). For that, it only considers the initial and final values of the investment.
In contrast, IRR considers multiple cash flows and time periods to calculate returns, which makes it a more adaptable tool.
CAGRs are best for point-to-point returns or when you make a regular cash flow, i.e., lump sum mutual fund investment. But, if you want to calculate returns for SIP, SWP or STP, where irregular cash flows are involved, CAGR is not the right metric. Instead, XIRR is used.
No, XIRR is not equal to CAGR. XIRR is used when you have investments with irregular cash flows like SIPs. In contrast, a CAGR is the right metric to use when you have investments with regular cash flows, like lump sum investments.
The XIRR is akin to the Internal Rate of Return (IRR), but it’s specifically designed to evaluate the return on investments that have inconsistent cash flows.
Therefore, it provides a more precise profitability measurement for investments with cash flows that don’t occur at regular intervals.
The two major weaknesses of CAGR is that:
It assumes that your mutual fund investment has grown/declined at a constant rate every year, which may not be true in reality.
It does not consider the frequency and time of your cash flows, like investments, withdrawals, dividends, etc.