Investing in mutual funds is a popular way for individuals to grow their wealth over time. As an investor, it’s important to understand the various metrics used to evaluate the performance of our investments. Three commonly used metrics are XIRR (Extended Internal Rate of Return), CAGR (Compound Annual Growth Rate), and Absolute Return. If you are looking for, “What is XIRR, CAGR and Absolute Return”, your search ends here. In this blog, we will explore and understand these methods. In addition to that, we’ll also explore the differences and applications of these metrics considering some real-life example in the context of mutual funds.
CAGR (Compound Annual Growth Rate)
CAGR is a widely used method for calculating the annualized return of an investment over a specific period. It is a straightforward way to assess the annual growth rate of your mutual fund investment. CAGR is most suitable for investments where contributions and withdrawals are infrequent and the growth rate is relatively stable.
Pros:
- Provides a simplified, consistent annual growth rate.
- Easy to calculate with basic math.
Cons:
- Ignores the timing of cash flows and is based on a constant growth assumption.
Formula:
The formula for CAGR is as follows:
CAGR = [(Ending Value / Beginning Value) ^ (1 / n) – 1] × 100
Where:
Ending Value is the current value of your investment.
Beginning Value is the initial investment amount.
n is the number of years.
Example:
Let’s say you invested Rs10,000 in a mutual fund, and after 5 years, your investment has grown to Rs15,000. To calculate the CAGR, we’ll use the formula:
CAGR = [(15,000 / 10,000) ^ (1 / 5) – 1] × 100
CAGR = (1.5 ^ 0.2 – 1) × 100
CAGR ≈ 8.11%
So, the CAGR of your investment is approximately 8.11% over the 5-year period.
XIRR (Extended Internal Rate of Return)
XIRR, which stands for Extended Internal Rate of Return, is a financial metric used to calculate the annualized rate of return for a series of cash flows that occur at irregular intervals. It’s a more advanced version of the traditional Internal Rate of Return (IRR) calculation, which assumes that all cash flows occur at regular intervals. XIRR takes into account the specific dates of each cash flow, making it suitable for investments or financial transactions with uneven or irregular cash flows.
XIRR is a more sophisticated method for calculating returns in mutual funds, especially when one has irregular cash flows, like reinvested dividends or multiple transactions. XIRR accounts for the timing of investments and redemptions and provides a more accurate picture of our returns. One can calculate XIRR using spreadsheet software like Microsoft Excel or Google Sheets.
Pros:
- Takes into account the timing of investments and withdrawals, providing a more accurate measure of returns.
- Useful for investments with irregular contributions or withdrawals. Such as mutual funds with multiple investment and redemption dates.
Cons:
- Requires financial software or spreadsheet tools to calculate accurately.
- Complex to calculate manually.
To calculate XIRR, one need the following inputs:
A series of cash flows: These represent the amounts of money one receives or invests, and they must occur at different points in time. These cash flows can be both positive (inflows, such as investments, dividends, or interest) and negative (outflows, such as withdrawals or expenses).
Corresponding dates for each cash flow: You need to know the dates when each cash flow occurs. This is important because XIRR considers the time value of money and gives more weight to cash flows that occur earlier.
An initial guess for the rate: XIRR calculations often require an initial guess rate, which helps the algorithm converge to the correct solution. A common initial guess is 10% or 0.10, but this can vary based on the nature of the cash flows.
The XIRR calculation is iterative and usually performed using financial software or spreadsheet software, such as Microsoft Excel, which provides a built-in function for XIRR. The formula finds the discount rate (rate of return) that makes the net present value (NPV) of all the cash flows equal to zero.
How to Calculate XIRR Using an Excel sheet?
Here is the step-by-step process of calculating XIRR in MS Excel.
Enter all your transactions in one column representing negative values. Where, there is an interest inflow, represent it as a positive digit.
In the respective column, add the date on which transaction is performed.
In the last row, enter the current value of your portfolio in mutual funds. Do input correct date.
Now in excel sheet you can use the XIRR function. XIRR usually contains values, dates, etc.
Example No 01:
Suppose you invested in a series of stocks and received the following cash flows on these dates:
You invested Rs10,000 on January 1, 2020.
You received a dividend of Rs500 on June 30, 2020.
You received another dividend of Rs600 on December 31, 2020.
You sold the stocks for Rs11,000 on February 28, 2022.
To calculate the XIRR for this investment, you would enter these cash flows and dates into an Excel spreadsheet. You would use the “XIRR” function, specifying the cash flows and corresponding dates as arguments. Excel will then find the rate of return that makes the NPV of these cash flows equal to zero.
In Excel, the XIRR formula would look something like this:
=XIRR(B2:B5, A2:A5)
Where:
B2:B5 represents the cash flows (-Rs10,000, Rs500, Rs600, Rs11,000).
A2:A5 represents the corresponding dates (01/01/2020, 06/30/2020, 12/31/2020, 02/28/2022).
Excel will return the XIRR, which in this example might be approximately 10.71%, indicating the annualized rate of return for this investment with irregular cash flows.
Example No 02:
Suppose one has started a mutual fund SIP with the following contributions:
On January 1, 2021, invested Rs1,000.
On April 1, 2021, invested Rs1,000.
On July 1, 2021, invested Rs1,000.
On October 1, 2021, invested Rs1,000.
On January 1, 2022, invested Rs1,000.
And then, redeemed investments on April 1, 2023, and received Rs6,000.
Step 1: List the cash flows with their respective dates:
January 1, 2021: -Rs1,000
April 1, 2021: -Rs1,000
July 1, 2021: -Rs1,000
October 1, 2021: -Rs1,000
January 1, 2022: -Rs1,000
April 1, 2023: +Rs6,000
Step 2: Assign the appropriate signs to the cash flows, as mentioned above.
Step 3: Determine the time frame. In this case, it’s from January 1, 2021, to April 1, 2023, which is approximately 2 years and 3 months.
Step 4: Use a financial tool (like Excel) to calculate the XIRR. In Excel, you can use the formula =XIRR([cash flows], [dates]). Calculation will be like this, for this example:
=XIRR([-1000, -1000, -1000, -1000, -1000, 6000], [“2021-01-01”, “2021-04-01”, “2021-07-01”, “2021-10-01”, “2022-01-01”, “2023-04-01”])
After applying this formula, you’ll get an annualized return rate, which is the XIRR for your mutual fund SIP over the specified time frame.
How Much XIRR is considered Good?
Generally, an XIRR over 12% for equity mutual funds is considered good, and for debt mutual funds, anything above 7.5% is considered good.
ABSOLUTE RETURN
Absolute return is the actual return earned on an investment, expressed as a percentage of the initial investment. Absolute return is handy for a quick assessment of your investment’s performance, especially when you want to gauge how much your investment has grown or declined in percentage terms without considering the time factor. Absolute return is the simplest way to calculate your return on a mutual fund. It measures the actual profit or loss you’ve made on your investment, without considering the time period involved.
Pros:
- Simple to understand and calculate.
- Reflects the actual profit or loss in percentage terms.
Cons:
- Doesn’t consider the time value of money or the timing of cash flows.
- The formula for absolute return is:
Absolute Return = (Ending Value – Beginning Value) / Beginning Value × 100
Example:
If you invested Rs12,000 in a mutual fund, and after 3 years, your investment has grown to Rs13,500, you can calculate the absolute return as follows:
Absolute Return = (Rs13,500 – Rs12,000) / Rs12,000 × 100
Absolute Return = (Rs1,500 / Rs12,000) × 100
Absolute Return ≈ 12.5%
So, the absolute return on your investment is approximately 12.5% over the 3-year period
When to Use Each Metric
CAGR is a suitable metric when you want a straightforward, consistent annual growth rate, assuming steady returns over the investment period.
XIRR is the go-to metric when you have irregular contributions and withdrawals, and you want to accurately assess your investment’s performance, factoring in the timing of cash flows.
Absolute return is useful for a quick and simple assessment of your investment’s performance, mainly to see the actual percentage profit or loss.
In conclusion, understanding the differences between XIRR, CAGR, and Absolute Return is essential for evaluating your mutual fund investments effectively. Each metric has its own strengths and weaknesses, and the choice of which to use depends on your specific investment scenario and the level of detail you require for your analysis. It’s often a good practice to use multiple metrics to gain a comprehensive view of your investments.
Below attached a reference video for the ease of understanding and comparison between CAGR, XIRR and Absolute Returns:
Comparing the Methods
CAGR, XIRR, and Absolute Return each have their strengths and are useful in different scenarios. CAGR is excellent for assessing the average annual return over a fixed period, while XIRR is ideal for investments with irregular cash flows. Absolute return, on the other hand, gives you a simple measure of your profit or loss without considering the time aspect.
It’s essential to use the appropriate method based on your specific investment situation. Additionally, combining these methods can provide a comprehensive view of your mutual fund’s performance.
CONCLUSION
Mutual funds can be a valuable addition to your investment strategy, offering diversification, professional management, and accessibility. By understanding the basics of mutual funds and conducting thorough research, you can make informed decisions to help you achieve your financial goals. Remember that all investments carry some level of risk, so it’s essential to invest wisely and stay informed about your portfolio. Further, it is always beneficial to take some professional advice from a well-recognized/licensed financial analysts instead of believing on market tips.
Calculating returns in mutual funds is crucial for tracking your investment progress and making informed decisions about your portfolio. CAGR, XIRR, and Absolute Return are powerful tools to help you evaluate your investments accurately. By understanding these methods and using them in the right context, you can better manage your mutual fund investments and work towards your financial goals.
