In order to make informed investment decisions, it is important to evaluate the performance of your investments. There are several metrics available to evaluate the performance of mutual funds. Among the many metrics available, XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate) are two of the most commonly used. They offer insights into how your investments have performed over time but are fundamentally different in their application and interpretation.
In this blog, we will explore what XIRR and CAGR are, how they differ from each other, when you should be using them, and why understanding these metrics is crucial for investors.
What Is XIRR?
XIRR (Extended Internal Rate of Return) is a financial metric used to calculate the annualised return on investments, particularly when cash flows (investments and withdrawals) happen at varying intervals. Thus this calculation is generally used to calculate returns of SIP (Systematic Investment Plan).
For example, you start an SIP for 12 months, skip 2 months, and then resume investing. On top of that, you also keep changing the investment amount at regular intervals. Hence, in these scenarios, XIRR will be used to calculate the returns of multiple transactions that were executed at different times.
How To Calculate XIRR?
The formula to calculate XIRR is:
XIRR = (NPV (Cash Flows, r) / Initial Investment) * 100
Where
NPV is Net Asset Value
r is the rate of return
Cash Flows are a series of investments and withdrawals over time.
Let’s say, you invest ₹10,000 in a mutual fund scheme every month. XIRR considers it whenever an amount is invested. The reason behind this is that the money put in earlier worked harder for you than the recent contributions. Therefore, a simple average return is not sufficient. An XIRR overcomes this by calculating an annualised return considering these differences in time.
Suppose you invest ₹10,000 every month for one year and your total grows to ₹1.2 lakhs. XIRR will consider the ₹10,000 invested in January and will work for 12 months, whereas the contribution in December will work for 1 month only. Thus it will give you a better idea of how your investment returned during the one year.
How To Calculate XIRR In Excel?
You can calculate XIRR using Microsoft Excel or any similar application, as it is tedious to calculate XIRR using pen and paper. All you need to know is your SIP amounts, maturity amount, and maturity date.
Here is a step-by-step guide on how to calculate XIRR in Excel:
- Open a blank workbook on MS Excel.
- In one column, write the header ‘Transaction Date’ and start entering the transaction date right below it.
- In the next column, write the header ‘Cash Flow’ and start adding the SIP amount against the respective dates.
- In the first column, write the date of redemption at the bottom i.e. in the cell just below the last transaction date.
- In any cell, type ‘=‘. This will invoke the formula function. Following this, type XIRR. Select the formula that appears by either pressing Tab on the keyboard or left-click on the mouse. When the formula asks you to enter values, select all values in the Cash Flow column from top to bottom. Now, type a comma and select all dates.
- Close the bracket and press Enter, keep the cell you entered when the formula is selected and click on the per cent (%) button in the Number section under the Home ribbon. This will convert the result into a percentage. This is the XIRR you are looking for. In our example, the fund returned 14.87% in the indicated period.
What Is CAGR?
CAGR or Compound Annual Growth Rate is the rate of return from a mutual fund during a specific period of time, assuming the profits are reinvested. CAGR shows the rate at which the investment grows each year to reach the investment’s final value.
The formula for CAGR = (Final Value / Initial Investment)^1/n – 1
Where:
The Final Value is the value of your investment at the end of the period.
Initial Investment is the amount you initially invested.
n is the number of years.
Let’s say, you invested ₹1 lakh and after three years, it grew to ₹1.3 lakhs.
The CAGR is calculated as:
CAGR = (1,30,000 / 1,00,000)^1/3 – 1 = 9.14%
This means that your investment grew at a compounded rate of approximately 9.14% annually over three years.
When To Use CAGR?
Long-Term Investments: CAGR is perfect for evaluating long-term mutual fund performance because it smooths out year-on-year volatility and gives you a clearer picture of the growth trajectory.
Comparing Different Investments: CAGR is ideal when comparing different mutual funds or investments over varying time periods, as it gives a normalised rate of return
What Are The Differences Between XIRR And CAGR?
| Parameters | XIRR | CAGR |
| Meaning | Extended Internal Rate of Return, accounts for variable cash flows. | Compound Annual Growth Rate, measures steady growth over time. |
| Timing of Investment | XIRR considers the exact timing or date when an investment or withdrawal has been made. | CAGR does not take into account the timing of the investment. |
| Treatment of cashflows | Multiple or irregular cash flows are handled. | CAGR just considers the initial and final values of an investment. |
| Calculation | Uses specific dates and amounts of cash flows. | Calculates using beginning value, ending value, and time period. |
| Investment Type | XIRR is suitable for investments like SIPs, real estate, etc. | CAGR is used for long-term investments like stocks, mutual funds, or indices. |
| Rate of Return | Provides a rate that accurately reflects all cash flow timings. | Offers a simplified annual growth rate ignoring specific timings. |
| Complexity | More complex due to varying cash flows and their timings. | Simpler as it assumes uniform growth over periods. |
| Accuracy | Higher accuracy for irregular cash flows. | It may not accurately reflect performance for non-uniform investments. |
When To Use XIRR?
XIRR is ideal for situations where:
Investments involve multiple cash flows: If you invest periodically (eg., via SIPs or additional lump sums) or withdraw funds at different times, XIRR provides a more accurate return calculation.
Handling dividends and payouts: For investments where returns are partially reinvested or distributed (e.g., dividend-paying mutual funds), XIRR captures the full picture.
Real estate and private equity: These investments often involve irregular payments, making XIRR the preferred metric.
When To Use CAGR?
CAGR is best suited for scenarios where:
There is a single investment and redemption: If you make a one-time investment and withdraw after a few years, CAGR gives you a clear picture of the annualised growth.
Comparing the performance of different investments: Use CAGR to compare two investments with similar durations to identify which one performed better.
Assessing long-term trends: For historical data or projections, CAGR helps simplify the representation of growth.
What Are The Advantages Of XIRR?
The advantages of XIRR are as follows:
More accurate performance measurement – XIRR helps you measure the performance of your mutual fund investments more accurately. This is because it factors in the exact timing of cash flows. Also, since it considers withdrawals, it helps you measure the performance of your mutual funds in a more nuanced manner.
Accounts for uneven cash flows – XIRR considers the time value of money and the timing of cash flows, making it suitable for investments with irregular or uneven cash flows.
Factors in time value for money – XIRR factors in the time value of money by factoring in specific dates and cash flows. Thus, it helps you evaluate the actual return on your investment.
What Are The Limitations Of XIRR?
The limitations of XIRR include:
Warrants accurate cash flow data – XIRR requires you to input accurate and complete cash flow data. This includes the date and amount of each cash flow. If you give incomplete or inaccurate data, it can affect the calculation.
Sensitive to small changes in data – XIRR is a sensitive metric. Even minor alterations in cash flow data can make it challenging to compare different funds based solely on XIRR returns.
What Are The Advantages Of CAGR?
CAGR in mutual funds offers the following advantages:
Simple to calculate – CAGR is a straightforward formula that can be easily calculated using basic arithmetic.
Provides a clear picture of long-term performance – CAGR gives a clear picture of the average annual return of an investment over a specific period, making it useful for long-term investments.
Helpful in comparing funds – CAGR provides a standardised measure to compare the performance of different funds over a specified period of time.
What Are The Limitations Of CAGR?
CAGR also has certain limitations, the foremost of which are:
Constant growth assumption – CAGR assumes a constant growth rate throughout the analysis period. This may not align with real-life scenarios where market conditions and external factors could lead to fluctuations.
Can be misleading for volatile investments – CAGR may not accurately reflect the performance of an investment with high volatility, as it assumes a steady rate of return over the entire investment period.
XIRR vs CAGR – The Conclusion
Both CAGR and XIRR are invaluable tools for evaluating investment performance. While CAGR provides simplicity and a clear picture for single investments, XIRR captures the complexity of real-world cash flows. Choosing the right metric depends on the nature of your investments and the type of insights you are looking for.
If you are someone who is serious about investing, mastering these metrics is essential. By understanding their strengths, weaknesses, and use cases, you can better analyse your portfolio and make data-driven decisions to achieve your financial goals. sing up with Koshex
Frequently Asked Questions (FAQs)
Which metric is better for SIP investments?
XIRR is better for SIP investments because it considers the timing of each instalment and calculates the annualised return based on actual cash flows.
How does volatility affect CAGR and XIRR?
CAGR smooths out volatility, presenting a constant growth rate, while XIRR can reflect the actual impact of volatility on cash flows and returns.
Are there online tools to calculate XIRR and CAGR?
Yes, many financial platforms and investment calculators provide easy tools for calculating both XIRR and CAGR.
Leave a Comment