XIRR vs CAGR: Which is the best way to calculate mutual fund returns?

When investing in mutual funds, examining the past returns of the schemes you're interested in is a crucial step. There are several ways to calculate these returns, with XIRR and CAGR being two popular methods.

Choosing between XIRR and CAGR depends on the nature of your investment and the frequency of cash flows. XIRR is ideal for irregular investments, while CAGR works well for steady investments. Both methods help you gauge the performance of your mutual fund investments over time. Both have their own merits depending on the context of the investment. Here’s a brief overview of each method:

XIRR

XIRR, or Extended Internal Rate of Return, is a method used to calculate the annualised return on investment when cash flows occur at irregular intervals. It considers all cash inflows and outflows, along with their respective dates, to determine the annual rate of return. XIRR takes into account the timing and amount of each cash flow, making it a more precise method for investments with irregular cash flows.

For portfolio investors, XIRR is invaluable for assessing and distinguishing the performance of individual stocks within their portfolios. It helps identify which shares are causing losses or offsetting gains. When dealing with Systematic Investment Plans (SIP), calculating returns can be complex due to multiple investments with varying prices and time periods. Therefore, XIRR is commonly used to compute returns for SIP, simplifying the process for investors.

Advantages of XIRR

1. Accounts for uneven cash flows - XIRR considers the time value of money and the timing of cash flows, making it suitable for investments with irregular or uneven cash flows.

2. Provides accurate return calculation - XIRR offers a more precise calculation of the return on investment by considering both the magnitude and timing of cash flows.

Disadvantages of XIRR

1. May be difficult to calculate manually - XIRR manually can be challenging, especially for investments with numerous cash flows and changing rates of return.

2. May not provide a clear picture of long-term performance - XIRR calculates the annualised return over the entire investment period, which may not provide a clear picture of the long-term performance of the investment.

CAGR

CAGR, or Compound Annual Growth Rate, is a method 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 particularly useful for understanding the growth rate of an investment over time, especially for long-term investments like mutual funds.

Advantages of CAGR

1. Simple to calculate - CAGR is a straightforward formula that can be easily calculated using basic arithmetic.

2. Provides a clear picture of long-term performance - CAGR gives a clear picture of the average annual return of an investment over a specific period, making it useful for long-term investments.

Disadvantages of CAGR

1. Does not account for the timing of cash flows - CAGR assumes that cash flows are evenly spaced over the investment period, which may not be the case for investments with irregular or uneven cash flows.

2. Can be misleading for volatile investments - CAGR may not accurately reflect the performance of an investment with high volatility, as it assumes a steady rate of return over the entire investment period.

XIRR vs CAGR

XIRR and CAGR are both valuable tools for evaluating mutual fund investments, but they are used in different scenarios due to their distinct characteristics.

XIRR is typically used when evaluating funds with irregular cash flows, such as additional investments or withdrawals made at different points in time. It considers the timing and amount of each cash flow, providing a more accurate measure of the annualised return.

CAGR, on the other hand, is commonly used when evaluating 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 is suitable for calculating returns from lump sum investments, while XIRR is preferable for calculating returns from periodic investments like SIPs. While CAGR measures the annualised compounded return on investment, XIRR measures the average return earned by the investor after factoring in periodic cash flows separately.

In conclusion, when it comes to calculating mutual fund returns, the choice between XIRR and CAGR depends on the nature of the cash flows. If the cash flows are irregular or occur at different intervals, XIRR is the preferred method as it considers the timing and amount of each cash flow. This makes it more accurate for investments with irregular cash flows.

On the other hand, if the cash flows are regular and occur at consistent intervals, CAGR is more appropriate. CAGR provides a simplified measure of the average annual return over a specified time period, making it suitable for investments with regular cash flows.

In summary, choose XIRR for investments with irregular cash flows and CAGR for investments with regular cash flows. Understanding the nature of the cash flows will help you determine which method is best suited for calculating the returns on your mutual funds.

Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited