There are multiple methods for calculating a return on investment, including absolute returns, CAGR, and XIRR. While absolute returns are a good measure for computing returns on an investment held under a year, their accuracy reduces dramatically over longer horizons.
Thus, investors prefer calculating CAGR or XIRR returns to better judge a mutual fund scheme’s performance. Below, we explain both CAGR and XIRR and how they differ from each other.
What is CAGR in Mutual Funds?
CAGR, or Compounded Annual Growth Rate, measures an investment’s annualised rate of return over a specified period in percentage terms. In other words, CAGR is the hypothetical growth rate at which an investment is expected to grow steadily annually. Thus, CAGR ignores volatility in the returns generated.
CAGR is used for comparing investments on returns earned over different periods. However, it is not a suitable tool for evaluating an investment, which involves multiple inflows and outflows, as is the case with a Systematic Investment Plan (SIP).
How is CAGR Calculated?
A mutual fund investment’s CAGR can be calculated through the following formula:
CAGR = [{(Current Value / Initial Value) ^ (1/Number of Years)}-1] * 100
To illustrate, let’s assume a hypothetical situation, where an individual initially invests Rs. 1,00,000 in a mutual fund. Further assume, this investment grows to Rs. 1,79,000 after 5 years. The CAGR in this situation will be calculated as follows:
CAGR = [{(1,79,000 / 1,00,000) ^ (1/5)} – 1] * 100
CAGR = 12.35%
It means an Rs. 1,00,000 investment needs to grow steadily at 12.35% every year for 5 years to grow to Rs. 1,79,000.
Alternatively, when an investment worth Rs. 1,00,000 grows at a steady rate of 12.35% every year, it will be worth Rs. 1,79,000 after 5 years.
You can use Angel One’s CAGR calculator to compute your investment’s CAGR, as long as you know its initial value, maturity value, and tenure.
What is XIRR in Mutual Funds?
XIRR or the Extended Internal Rate of Return is the average annualised rate of return calculated for an investment with multiple inflows or outflows during a specified period. In short, it is an aggregate of all CAGRs earned on periodic cash flows made throughout the fund’s term.
To simplify, an XIRR will treat every cash flow as a separate investment, and then calculate the return earned on this particular cash flow. This process will be repeated for all cash flows during a specified investment period, and then be averaged out for the entire mutual fund investment.
Investors prefer computing XIRR on their mutual fund investments made via SIPs to make a better judgement about the returns generated. We understand why below.
How is XIRR Calculated?
The easiest method to calculate XIRR is through an excel spreadsheet or IRR calculator, as it includes multiple calculations for returns.
To illustrate, consider a scenario, where instead of a lump sum amount of Rs. 1,20,000, an investor decides to use a SIP to invest Rs. 10,000 per month for a year and makes no redemption during the investment tenure of 2 years (for the sake of simplicity).
As a result, the first instalment of Rs. 10,000 is invested for 24 months, followed by the next instalment of Rs. 10,000 invested for 23 months, the third Rs. 10,000 instalment remains invested for only 22 months, and so on. We tabulate it below.
| SIP (Rs.) | Date |
| 10,000 | 1 Jan 2020 |
| 10,000 | 1 Feb 2020 |
| 10,000 | 1 Mar 2020 |
| 10,000 | 1 Apr 2020 |
| 10,000 | 1 May 2020 |
| 10,000 | 1 Jun 2020 |
| 10,000 | 1 Jul 2020 |
| 10,000 | 1 Aug 2020 |
| 10,000 | 1 Sep 2020 |
| 10,000 | 1 Oct 2020 |
| 10,000 | 1 Nov 2020 |
| 10,000 | 1 Dec 2020 |
Further, if we assume after 2 years, this investment grows to Rs. 1,50,000, then XIRR will be 15.52%. The CAGR for this illustration would only be 11.80% [{(1,50,000 / 1,20,000) ^ (1/2)} – 1].
As you will have noticed, the CAGR return is lower than the XIRR return. Since CAGR does not treat these investments separately and ignores the time variation, it understates the mutual fund’s performance.
CAGR vs XIRR
The primary difference between CAGR and XIRR lies in their consideration of cash flows. A CAGR return assumes all investments have been made at the beginning of the year, while XIRR considers periodic instalments as separate investments. Resultantly, XIRR provides an accurate picture of the mutual fund’s performance.
We elaborate on the difference between CAGR and XIRR in the table below.
| Parameters | CAGR | XIRR |
| Definition | Measures the annualised compounded return on investment for a certain time period, assuming reinvestment of profits | Measures the average return earned by the investor after factoring in periodic cash flows separately during the stipulated period |
| Cash Flows | Doesn’t give an accurate picture of investment experiencing multiple cash flows | Considers all cash inflows and outflows during the investment’s tenure |
| Formula | [{(Current Value / Initial Value) ^ (1/Number of Years)}-1] * 100 | XIRR formula in excel sheet
Or ∑CAGR of all instalments |
| Suitability | Ideal for long-term lump-sum investments without any additional cash flows | Suitable for all kinds of investments. Particularly suited to investments with numerous cash flows during the investment period |
CAGR vs XIRR: Which Return Should You Choose?
As mentioned above, XIRR beats out the CAGR when investments are made in tranches during the stipulated tenure, as it considers all instalments as distinct investments. Hence, unless an investor is making a lump sum payment, XIRR should be preferred over CAGR.
Conclusion
To summarise, investors can use historical CAGRs to compare different mutual funds’ performances. However, before choosing to invest in a fund, an investor must determine whether they plan to go the lump sum route or a SIP. In the case of SIP investment, mutual fund investors must calculate XIRR values to get an authentic view of the AMC’s performance.
