XIRR or CAGR – Which is better to calculate the potential return of a mutual fund?

Mutual Funds

Investment means to invest timely to grow your wealth. Any investment’s earning potential is what assists you to decide whether you must invest or not. According to the risk-return correlation, if you want to earn higher returns then you must take more risks.

Investment in mutual funds requires you to have an in-depth understanding of the earning potential. Read on to understand the two major computations, i.e., CAGR (compounded annual growth rate) and XIRR (extended internal rate of return), to understand how both are different and which option you must select as per your investment.

What is CAGR?

When you compare distinct investment options or funds, you must ensure to compare CAGR to get an accurate earning potential. The CAGR formula is –

CAGR (per centage) = (Investment value/ maturity value) ^ (1/tenure in years) – 1

Suppose you have 2 investment options, in one of the options you earn Rs 200 on an investment of Rs 1,000 over an investment tenure of 20 months; and in other you earn Rs 100 on an investment of Rs 1,000 over an investment tenure of 10 months. Now, to determine which option is a prudent choice, you must compute the CAGR for both options.

In the case of the first option, CAGR will be 11.54 per cent. This will be computed as (1,200/1,000) ^ (1/1.67) – 1. Note that 20 months will be 1.67 years because 20 months/12 months = 1.67 years. In the same way, the CAGR for the second option will be 12.17 per cent.

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On comparing both options, you will view that the second option is generating better returns as compared to the first option. On the contrary, absolute returns in the case of the first option are higher as compared to the second one. Nonetheless, the potential to earn in the second option is higher because of a higher CAGR.

What is XIRR?

CAGR works accurately when you go for a one-time investment and the maturity amount continues getting re-invested. But what happens when you opt for an SIP (systematic investment plan) to invest in a mutual fund? The earning percentage of every investment tenure will be distinct and here is where CAGR may fail to compute accurate earning percentage for you over cumulative investment tenures. Instead, you must use XIRR for computing your multiple investments in mutual funds through the SIP route over the tenure.

Read the example below to understand how XIRR in an SIP investment is computed. Suppose you have invested Rs 1,500 per month in a mutual fund through an SIP over a tenure of 2 years and the maturity value is Rs 40,000. Here, you must use XIRR formula to get the return percentage. Note that you can compute your XIRR in mutual funds through an inbuilt function using Microsoft Excel. In Excel, the XIRR formula is “=XIRR (values, dates, guess)”.

Date SIP
1st January 2020 -1500
3rd February 2020 -1500
2nd March 2020 -1500
1st April 2020 -1500
1st May 2020 -1500
1st June 2020 -1500
1st July 2020 -1500
3rd August 2020 -1500
1st September 2020 -1500
1st October 2020 -1500
2nd November 2020 -1500
1st December 2020 -1500
1st January 2021 -1500
1st February 2021 -1500
1st March 2021 -1500
1st April 2021 -1500
3rd May 2021 -1500
1st June 2021 -1500
1st July 2021 -1500
2nd August 2021 -1500
1st September 2021 -1500
1st October 2021 -1500
1st November 2021 -1500
1st December 2021 -1500
3rd January 2022 40,000
XIRR 7.30 per cent
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If you use the CAGR formula for the above illustration, then the calculation would be around 5.41 per cent. This would be a thoroughly inaccurate calculation as the SIP mode contains multiple transactions occurring at distinct times and CAGR does not consider multiple transactions to provide the return percentage. This is why you must use the XIRR formula to compute returns in the case of SIP investment as it factors in cash flows of distinct periods.

CAGR or XIRR – Which option is prudent?

If you are looking to invest in lump sum, you must use CAGR to understand the earning potential. However, if you are looking to invest at distinct times, for instance, use the SIP mode, then you must use XIRR formula to make a proper investment decision.

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