Calculating mutual fund returns: Difference between CAGR, XIRR, and absolute returns

The performance of a mutual fund is a key concern for investors. However, many may find it difficult to understand and assess their investment’s performance. There are several methods to assess a mutual fund scheme’s return. Three common ways are Compound Annual Growth Rate (CAGR), Extended Internal Rate of Return (XIRR) and absolute returns. Understanding these metrics can help investors better interpret their mutual fund returns and determine their progress towards their financial goals.

• Table of contents

1. Key metrics for evaluating mutual fund returns
2. What are absolute returns
3. What is compound annual growth rate (CAGR)
4. What is extended internal rate of return (XIRR)
5. What is the difference between XIRR and CAGR?
6. XIRR vs CAGR: What are their advantages and disadvantages?
7. CAGR vs XIRR for SIP: Which One is Better?

Key metrics for evaluating mutual fund returns

To evaluate mutual fund returns, you can use different metrics. Each method provides unique insights into your investment performance. The three main methods are:

Absolute returns Calculates the total percentage increase or decrease in your investment.

CAGR:Shows the annual growth rate of your investment over a specific period of more than a year, assuming that your gains are reinvested at the end of each year.

XIRR:Calculates the annualized return taking into account multiple cash flows at different times. This provides a more accurate return rate for investments that were made periodically at regular and irregular intervals. It accounts for any payouts in form of dividends, redemptions and also if there has been any additional investments.

By understanding these methods, you can get a clearer picture of how your mutual fund investments are performing.

What are absolute returns?

Absolute returns measure the total increase or decrease in the value of your investment without considering the time period. It is a straightforward way to see how much your investment has grown in absolute terms for two points in time. This is also commonly known as point to point returns

Example:

If you invested Rs. 10,000 in a mutual fund and its value increased to Rs. 12,000 after one year, the absolute return is calculated as follows:

Absolute return = (Ending value − Beginning value) / Beginning value × 100
In this case,
Ending value = Rs. 12,000
Beginning value = Rs. 10,000

Therefore, the absolute return is:

Absolute Return = (12000 − 10000) / 10000 × 100 = 20%

So, the absolute return is 20%, meaning your investment has grown by 20% over the period.

What is compound annual growth rate (CAGR)?

CAGR is a simple and widely used metric to calculate the average annual growth rate of investments generally held for more than a year. It smooths out the fluctuations in the returns over the investment horizon to arrive at one number. This gives a simpler view of the performance of your investment.

Example:
Suppose you invested Rs. 10,000 in a mutual fund three years ago, and now it has grown to Rs. 15,000. To calculate the CAGR, you can use a simple formula:

CAGR = (Ending Value / Beginning Value)1/n − 1

In this case,

Ending Value = Rs. 15,000
Beginning Value = Rs. 10,000
n = number of years (3 years)

So, the CAGR calculation would be:

CAGR = (15000 / 10000)⅓ − 1

This comes to approximately 14.47%. This means your investment grew at an average annual rate of 14.47%, even though the returns would have fluctuated year-on-year. The potential impact of compounding on your investments can also be estimated with the help of free online tools such as a daily compound interest calculator. The tool instantly calculates the potential size of your final corpus based on your invested amount, tenure and expected potential returns.

What is extended internal rate of return (XIRR)

XIRR is a more advanced method that accounts for cash flows. It is particularly useful when you make multiple investments of differing amounts and at intervals. XIRR provides a single rate of return for all these transactions.

Example:

Let’s say you invest Rs. 5,000 in January, another Rs. 3,000 in June, and Rs. 2,000 in December. After one year, your investment is worth Rs. 11,000. To calculate XIRR, you need to consider the dates of each investment. The Excel spreadsheet provides an easy way to calculate XIRR. Here are the steps to follow while calculating XIRR on MS Excel:

List all your cash flows in one column. Include both positive and negative values. Positive values represent cash inflows (like dividends), while negative values represent cash outflows (like SIPs).

List the corresponding dates of these cash flows in the adjacent column.

Use the following XIRR function in Excel: “=XIRR(values, dates)”

• values: The range of cells that contains the cash flows.
• dates: The range of cells that contains the corresponding dates.

What is the difference between XIRR and CAGR?

Basis	XIRR	CAGR
Definition	Calculates the rate of return by considering both investments and cash flows.	Calculates the rate of return based solely on the initial and final investment value.
Calculation	Computes returns for irregular cash flows.	Computes returns for constant investments.
Timing	Considers the timing of cash flows.	The method doesn't account for when cash flows occur.
Inclusion of cash flows	Requires all cash flows to be included.	It only requires the initial and final investment amounts.
Investment type	It can be suitable for investments with multiple inflows and outflows.	Applicable to investments with a fixed investment amount.
Complexity	Involves a more complex calculation method.	Involves a simpler calculation method.
Accuracy	It may provide more accurate results as it considers the timing and value of each cash flow.	May be less accurate as it does not factor in the timing and value of each cash flow.

XIRR vs CAGR: What are their advantages and disadvantages?

Advantages of XIRR

• Handles irregular cash flows: XIRR considers the timing of cash flows, making it well-suited for investments with uneven or irregular cash inflows and outflows.
• Accurate return calculation: XIRR provides a precise calculation by considering both the amount and timing of cash flows, providing a more detailed understanding of investment returns.

Disadvantages of XIRR

• Complex calculation: Calculating XIRR manually can be quite challenging, especially when dealing with investments involving multiple cash flows and varying rates of return.
• Limited long-term clarity: While XIRR does calculate annualized returns, it may not always provide a clear understanding of long-term investment performance.

Advantages of CAGR

• Easy to calculate: CAGR is a straightforward formula that can be computed using basic arithmetic, making it accessible to most users.
• Long-term performance insight: CAGR gives a clear view of the average annual return over a specific period, making it useful for understanding long-term investments.

Disadvantages of CAGR

• Ignores cash flow timing: CAGR assumes that cash flows occur evenly over time, which may not accurately reflect investments with irregular cash flows.
• Potentially misleading for volatile investments: CAGR assumes a constant rate of return, which may not accurately reflect the performance of highly volatile investments.

CAGR vs XIRR for SIP: Which one is better?

XIRR is generally considered better for SIP as it accounts for multiple cash flows at different intervals, providing a more accurate annualised return. CAGR assumes a single lump-sum investment, which doesn't reflect the periodic nature of SIPs, making it less precise for evaluating SIP performance.

Conclusion:

To make an informed investment decision, it is essential to understand the basics of mutual fund returns. By using methods like CAGR, XIRR, and Absolute Returns, you can get a broader view of how your investments are performing. Each method provides unique insights, helping you assess your mutual fund returns more accurately.Understanding how mutual fund returns are calculated is essential for evaluating performance. Once you've grasped the different return metrics, consider using mutual fund calculators to estimate the potential returns on your investment and accordingly make strategic investment decisions. For instance, if you opt for a step up SIP, where your SIP contributions are increased by a fixed percentage at regular intervals, you can use an SIP Step Up Calculator. This tool helps you visualise how steadily increasing your SIP contributions over time can potentially optimise your investment growth in the long term. While CAGR, absolute returns and XIRR can help assess the actual returns on an investment, investors can use a lumpsum mutual fund calculator to plan their future investments. The calculator helps you estimate your potential returns based on your tenure, lumpsum investment amount and expected returns. You can also compare your expected returns with the actual returns on investment for a more realistic estimate.

FAQs

What is CAGR, and why is it important for assessing mutual fund returns?

CAGR shows the average annual growth rate of an investment over a specific period, helping investors understand the rate of return on annualised basis.

How is CAGR different from other return metrics?

CAGR provides a smoothed annual growth rate based on the initial investment, the final value and the investment period. XIRR is suitable for investments made in instalments. Moreover, it takes into investments, dividends as well as redemptions.

What distinguishes XIRR from other return calculations?

XIRR considers multiple investments made at different times, providing a single rate of return that accounts for the timing of each cash flow.

How does XIRR handle irregular cash flows in mutual fund investments?

XIRR takes into account the dates and the amount of cash flows (investments as well as redemptions) over a period of time. This can provide a more holistic picture of how an investment grew over time.

How are absolute returns different from relative returns?

Absolute returns measure the total percentage increase or decrease in value without considering the time period, while relative returns compare performance against a benchmark or index.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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