XIRR vs CAGR: Understanding the Key Investment Metrics
Tracking the performance of your mutual funds is a crucial aspect of making sound investing decisions. While checking on how your investments have performed, an investor comes across key metrics such as extended internal rate of return (XIRR) and compound annual growth rate (CAGR). In this article, we will explore XIRR vs CAGR, their features, and roles.
In order to understand the differences between XIRR and CAGR, it is necessary to look at each of these metrics individually.
Extended Internal Rate of Return (XIRR)
The extended internal rate of return, or XIRR, is a key metric used in assessing an investment. XIRR is especially useful in cases where investments or withdrawals have been irregular or made at different times. Investments made through a systematic investment plan (SIP) or real estate investments are examples where an investor could use XIRR.
XIRR is particularly helpful in the case of investments where inflows and outflows have been irregular, as it allows an investor to accurately gauge the performance of the investment.
Let’s say an investor makes a monthly SIP contribution of Rs 5,000 in a mutual fund scheme. After 3 years or 36 months, the total investment has grown to Rs 1.8 lakh. However, the return calculation will not be a straightforward exercise as the entire Rs 1.8 lakh was not invested in one go. The return for each SIP amount will be different from the others as they were all invested at different times. So how do you calculate the return of your portfolio as a whole after accounting for the returns of each invested amount?
This is where XIRR comes in. It takes into account the return on each investment in order to provide an accurate measure of the portfolio’s performance over a specific period.
XIRR is calculated using the following formula:
XIRR = (NPV (Cash Flows, r)/ Initial Investment)*100
Importance of XIRR
XIRR is a key metric used for evaluating the performance of your portfolio or investment. Here’s why XIRR is important
- XIRR is an accurate metric as it considers the timing of cash flows and the time value of money. As a result, it is a suitable way to track the performance of investments in which the investment is not made at one go and has been staggered over multiple time periods, such as investments made through a systematic investment plan, or SIP.
- Investors can gauge the return profile of their investment over a period with the help of XIRR, allowing them to effectively compare it with other mutual fund portfolios.
Compound Annual Growth Rate (CAGR)
Now let’s understand CAGR with the help of an example.
Which of the following investments fared better? Investment 1, which grew Rs 1 lakh to Rs 10 lakh over 15 years (absolute return of 900%), or Investment 2, which grew Rs 20,000 to Rs 1,20,000 over 10 years (or absolute return of 500%).
The answer is difficult to guess if the holding period of each return is different.
That’s where investors turn to the compound annual growth rate (CAGR). It helps an investor track the “annualised” return on investment. The CAGR is a single percentage number that gives the “smoothed” rate of return per year. It essentially shows how much an investment would have needed to grow each year to reach its final value, as if it grew at the same rate every year. Because of this exercise, CAGR allows the comparison of investments across different timeframes in a simple manner, as it standardises returns into a single annual rate.
In the example earlier, Investment 1 grew at 16.59% CAGR while Investment 2 grew at 19.62% CAGR, meaning even though Investment 1 was able to create more wealth because of the higher invested amount and longer timeframe, Investment 2 grew wealth faster.
While returns of an investment of up to one year can be easily understood using absolute returns, it is better to “annualise” the performance of any investment of more than a year using CAGR.
The formula to calculate CAGR is:
CAGR = (Final Value/Initial Value)^(1/n)-1, where n is the number of years.
By using the numbers in Investment 1 cited above, the CAGR can be calculated as follows:
= (10,00,000/1,00,000)^(1/15)-1
= (10)^(1/15)-1
=1.1659-1
=0.1659
CAGR= 16.59%
Importance of CAGR
- CAGR is the ideal metric to gauge an investment’s performance over any period of more than one year as it helps analyse the “annualised” growth rate.
- It also compares different mutual funds or investments as the time period for each investment becomes immaterial.
- CAGR is a straightforward metric that can help an investor easily track the investment’s performance over time.
Differences between XIRR and CAGR
Although both XIRR and CAGR are useful metrics, they have several distinct characteristics.
|
Points of Difference |
XIRR |
CAGR |
|
Timing of Investment |
XIRR considers the exact timing or date when an investment or withdrawal has been made. |
CAGR does not take into account the timing of the investment. |
|
Treatment of Cash Flows |
Multiple or irregular cash flows are handled. |
CAGR just considers the initial and final values of an investment. |
|
Usage |
It is suitable for investments that have multiple inflows or outflows. |
Suitable for long-term investments where there are no irregularities in cash flow. |
|
Calculation |
Calculation of XIRR is relatively more complicated. |
CAGR is a straightforward metric and is easy to calculate. |
|
Formula |
XIRR = (NPV (Cash Flows, r)/ Initial Investment)*100 |
CAGR = (Final Value/Initial Value) (1/n)-1 |
|
Accuracy |
XIRR can be used to accurately calculate the performance of a portfolio that has multiple cash flows. |
CAGR can accurately calculate the “annualised” returns of a portfolio. |
|
Suitability |
XIRR is suitable for investments like SIPs, real estate, etc. |
CAGR is used for long-term investments like stocks, mutual funds, or indices. |
|
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