Evaluating and comparing mutual funds are vital steps of the investment process. By looking at the past performance of different mutual funds within the same category, you can choose a scheme that has a proven track record and consistently higher performance than its peers. This ensures your investment is on track with your financial goals.
CAGR and XIRR are two of the most commonly used financial metrics to gauge the performance of a mutual fund. To make an objective decision, you should understand what these terms mean as well as the differences between XIRR vs CAGR in our detailed guide.
CAGR Meaning in Mutual Funds
Compound Annual Growth Rate (CAGR) is a relatively simple metric used to measure the annualised growth of any investment, such as mutual funds or stocks. For a mutual fund, it shows the rate at which the investment has grown over a specific period. It provides a relatively clear picture of how the fund value has risen over time when cash flows happen at regular intervals.
The CAGR is a standardised metric used to compare the average performance of different mutual funds over a given time. It is useful in showcasing the rate of growth or decline of an investment over a certain period, such as 3 years or 10 years. Fund houses often show the 1-year, 3-year and 5-year CAGR of their mutual funds on their websites.
How to Calculate CAGR for a Mutual Fund?
As mentioned before, CAGR shows the average growth rate on average over a certain time. The formula to calculate this is as follows:
CAGR = [(FV / P) ^ (1/n)] – 1
Where FV is the final investment value, P is the principal investment amount, and n is the number of years of investment.
Suppose you invest ₹15,000 in a mutual fund, and your investment grows to ₹25,000 in 5 years. The CAGR at which the fund grows is:
CAGR = [(25,000 / 15,000) ^ (0.2) – 1] = 10.75%
This means that your mutual fund has grown annually by 10.75% on average for 5 years.
Pros and Cons of Using CAGR for Mutual Funds
To compare CAGR vs XIRR, we must first compare the benefits and limitations of CAGR in assessing mutual fund returns.
Pros
- CAGR is a very easy metric to calculate as it uses a simple formula that anyone can apply without requiring any tool.
- As it shows the average returns over a certain period without the use of any complex metrics, it gives a clear long-term perspective.
- You can use the CAGR metric to compare different investments. With CAGR, you can compare the performance of different types of mutual funds, multiple funds within the same category or against a particular benchmark.
Cons
- As a result of its simplicity, CAGR can be a misleading performance metric.
- It does not show accurate returns when you make multiple investments within a specific period. This makes it a poor metric for calculating SIP (systematic investment plan) returns.
- As it assumes a steady rate of return, looking at the CAGR does not tell you how volatile a mutual fund is.
XIRR Meaning in Mutual Funds
Extended Internal Rate of Returns (XIRR) is the average annualised returns of an investment calculated by taking into account its different cash inflows and outflows. Basically, it measures the internal rate of return after accounting for individual cash flows based on their specific dates.
Internal Rate of Return (IRR) is the annualised rate of return from a series of cash flows based on the discounted cash flow (DCF) method. Cash flows are discounted at a certain rate based on the present value of the investment; if cash flows happen earlier, they are discounted less and more if they happen later. This concept is called the time value of money, i.e., the value of money lowers over time.
XIRR is, thus, a more flexible version of IRR that accounts for irregular cash flows. As a result, it accounts for inflows via SIPs and lump sums as well as outflows via redemptions, dividends, systematic withdrawal plans (SWP), and more.
How to Calculate XIRR for a Mutual Fund?
When comparing CAGR vs XIRR, you should know that you can’t calculate XIRR using a simple formula. Instead, you must write down the series of cash flows, including investments and withdrawals, in one row/column and the dates of each instalment in the other row/column in an MS Excel spreadsheet. Then, you can use the following formula to calculate the XIRR:
=XIRR(values, dates, [guess])
Where ‘values’ is the total amount invested (minus sign for withdrawals), ‘dates’ is the corresponding date of each instalment in any recognised format and ‘guess’ is an optional number close to the XIRR result (can be left blank).
Let’s say you write down the instalment dates in Column C from Row 10 to 20 and cash flows in Column D next to each date in an Excel spreadsheet. The formula you should enter in the Formula Box will be “=XIRR(C10:C20, D10:20).
Pros and Cons of XIRR for Mutual Funds
Before we look into the differences between CAGR and XIRR, let’s check the benefits and limitations of XIRR.
Pros
- It’s a more versatile tool for measuring different types of investments as it accounts for both inflows and outflows in its calculation.
- The XIRR provides a useful reflection of an entire portfolio as it takes into account multiple transactions, including lumpsum and SIP investments, SWPs, dividends, partial redemptions, etc.
- It works well when the investment has varying rates of return or no fixed holding period.
Cons
- It’s complex to calculate and requires the use of a spreadsheet. You have to plot the accurate date and details of each transaction over your selected time frame, which is time-consuming.
- XIRR is a sensitive metric, and even minor alterations can change the final results.
- The Excel formula for XIRR assumes that subsequent cash flows have the same time interval. If this does not happen, the results could be inaccurate.
What are the Differences between XIRR and CAGR?
Here is a table highlighting the differences between XIRR vs CAGR to help you understand when to use each option:
| Aspect | CAGR | XIRR |
| Definition | Annualised rate of return over a certain period | Internal rate of return over a specific period based on individual cash flows |
| Timing of Investments | The total time of investment | The exact timing of each transaction |
| Types of Cash Flows Considered | Considers a single initial investment | Multiple, irregular cash flows |
| Accuracy | Lower for irregular investments | Higher for irregular cash flows |
| Better Suitable for | Single, long-term investment | Multiple investments and cash flows |
| Investment Type | Only lump sum investments | Lump sum, SIP, SWP, partial redemption, full withdrawal, etc. |
| Calculation | Uses a single formula | It requires the use of a spreadsheet |
| Complexity | Less complex | More complex |
XIRR vs CAGR – How do they Compare?
CAGR is a common tool for comparing the returns of different types of investments. It is typically used when comparing mutual funds with regular cash flows, as it assumes a constant rate of return. It’s also useful for long-term analysis as it provides a simplified measure of average returns. Anyone can calculate the CAGR of a mutual fund with a standard calculator.
XIRR measures the average returns after taking into account periodic cash flows. This can include both inflows from SIPs and lump sums and withdrawals, whether systematic or lump sum, at different points in time. This provides a more accurate picture of investment returns. However, the calculation process is more complex.
Final Words
In short, both XIRR and CAGR are useful tools in assessing mutual fund performance. However, when comparing the applicability and differences between XIRR vs CAGR, the former is better for investments with irregular cash flows, while the latter is better for regular investments. CAGR is also better for long-term investment analysis, while XIRR is better for analysing returns in the short term.
