Before you start investing in the mutual funds, you should ideally examine the past returns of all the schemes that you want to invest into. And since there are a number of ways to calculate the past returns, you should opt for the one that suits you the most.
For instance, XIRR and CAGR are among the two most preferred parameters that are used to calculate the returns on various investment products including mutual fund returns.
Most investors get confused as to which parameter should one go for. Why should one measure the return on investment on their mutual fund investment in the first place? To find this out we have to explore XIRR and CAGR in detail to understand which method is the right way to calculate mutual fund returns.
What is XIRR?
XIRR stands for extended internal rate of return. It is a method that is used to calculate the annualised return on investment when cash flows happen at irregular intervals.
It takes into account all cash inflows and outflows, along with the dates on which they occur, to calculate the annual rate of return. XIRR considers the timing and amount of each cash flow, making it a more accurate method for investments with irregular cash flows.
What is CAGR?
CAGR stands for Compound Annual Growth Rate and is a method that is used to calculate the annualised return on investment when cash flows occur at regular intervals.
It assumes a constant rate of growth over a specific period and calculates the average rate of return during that period. CAGR is useful for understanding the growth rate of an investment over time and is commonly used for long-term investments like mutual funds.
XIRR vs CAGR
XIRR is commonly used when evaluating mutual funds with irregular cash flows. This could be the case when an investor makes additional investments or withdrawals at different points in time.
XIRR takes into account the timing and amount of each cash flow, providing a more accurate measure of the annualised return. It accounts for the compounding effect of investing or withdrawing funds at different periods, making it useful for comparing returns of funds with different investment patterns.
CAGR, on the other hand, is commonly used when evaluating mutual funds with regular cash flows. It assumes a constant rate of growth over a specific period, making it ideal for comparing funds that have a consistent investment pattern. CAGR provides a simplified measure of the average annual return over a specified time period, making it useful for long-term investment analysis.
Dev Ashish, a SEBI registered investment advisor, and Founder, StableInvestor, says, “While CAGR can be used to calculate returns from lumpsum investment in mutual funds, it is advisable to use XIRR for calculating returns from periodic (non lump sum) investments like SIP. Suppose you invest ₹1 lakh lump sum in 2017. After 5 years, the value of this becomes ₹2 lakh in 2022. In this case we use CAGR to calculate returns from lumpsum investments. This comes to 14.87% CAGR.”
Mukesh Vijayvergia, Founder of Nishkaera Financial Advisory and Wealth Management, echoes the same sentiments.
“While CAGR measures the annualised compounded return on investment for a certain period, assuming reinvestment of profits; XIRR measures the average return earned by the investor after factoring in periodic cash flows separately during the stipulated period,” Vijayvergia says.
Which one to choose?
When it comes to calculating mutual fund returns, it is important to choose the method that suits the investment pattern and cash flow behaviour of the fund. If the fund has irregular cash flows, such as additional investments or withdrawals at different points in time, XIRR is the preferred method. It provides a more accurate measure of the annualised return, accounting for the timing and amount of each cash flow.
On the other hand, if the fund has regular cash flows and a constant growth rate, CAGR is the preferred method. It gives a simplified measure of the average annual return over a specified time period, making it suitable for long-term investment analysis.
In conclusion, XIRR and CAGR are both important tools for calculating returns on mutual funds, but they serve different purposes. XIRR is useful for investments with irregular cash flows, while CAGR is suitable for investments with regular cash flows. By understanding the strengths and limitations of each method, investors can make better-informed decisions and accurately calculate returns on their mutual funds.
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Updated: 19 Oct 2023, 11:42 AM IST