Which method is appropriate for determining mutual fund returns—XIRR vs. CAGR?

 Which method is appropriate for determining mutual fund returns—XIRR vs. CAGR?

The ideal scenario would be for you to look at the historical performance of all the schemes you wish to participate in before you begin investing in mutual funds. You should choose the method that best fits you as there are several methods to compute prior returns. 

For example, the two most popular metrics used to compute the returns on different investment products, including mutual fund returns, are XIRR and CAGR. 

The majority of investors are perplexed about which metric to choose. Why, in the first place, should one evaluate their mutual fund investment's return on investment? To determine which approach is the most appropriate for calculating mutual fund returns, we must thoroughly examine XIRR and CAGR. 

Describe XIRR

Extended internal rate of return is abbreviated as XIRR. When cash flows occur at irregular periods, a technique is employed to determine the annualized return on investment. 

The yearly rate of return is computed by taking into account all cash inflows and withdrawals, as well as the dates on which they occur. XIRR is a more accurate strategy for investments with irregular cash flows since it takes into account the time and volume of each cash flow.

The CAGR is what?

The annualised return on investment is determined using the CAGR technique, which stands for compound annual growth rate, when cash flows occur at regular intervals. 

It determines the average rate of return over a certain time by assuming a constant rate of growth. CAGR is a popular measurement for long-term investments like mutual funds and is helpful for determining how quickly an investment grows over time.

CAGR vs. XIRR

When analyzing mutual funds with erratic cash flows, XIRR is often utilized. When an investor makes extra deposits or withdrawals at various times in time, this can be the situation. 

XIRR provides a more realistic representation of the annualised return by accounting for the time and magnitude of each cash flow. It is helpful for comparing returns of funds with various investment patterns since it takes into account the compounding impact of investing or withdrawing money at various times.

Contrarily, CAGR is often utilized when assessing mutual funds with predictable cash flows. It is perfect for comparing funds that have a regular investing pattern since it implies a constant rate of growth over a certain time period. CAGR is a valuable tool for long-term investment research since it offers a condensed measurement of the average yearly return over a certain time period.

While CAGR may be used to assess returns from lump-sum investments in mutual funds, it is advised to utilize XIRR for returns from periodic (non-lump-sum) contributions like SIP, according to Dev Ashish, founder of StableInvestor and a SEBI certified investment adviser. Consider investing a lump amount of Rs. 1 lakh in 2017. The value of this increases to 2 lakh in 2022 after 5 years. CAGR is used in this instance to determine the returns on lump-sum investments. This is a CAGR of 14.87%.

The founder of Nishkaera Financial Advisory and Wealth Management, Mukesh Vijayvergia, echoes these ideas. 

According to Vijayvergia, "XIRR reflects the average return obtained by the investor after factoring in periodic cash flows separately within the prescribed time, while CAGR measures the annualized compounded return on investment for a particular period, assuming reinvestment of profits.

Which should you pick?

It's crucial to choose a technique for computing mutual fund returns that works with the fund's investment strategy and cash flow behavior. The recommended strategy is XIRR if the fund has irregular cash flows, such as extra investments or withdrawals made at various times. By taking into account the time and magnitude of each cash flow, it gives a more precise measurement of the annualised return.

On the other hand, CAGR is the preferable strategy if the fund has consistent growth and regular cash flows. It is appropriate for long-term investment research since it provides a condensed assessment of the average yearly return over a certain time period.

In conclusion, while both XIRR and CAGR are crucial tools for estimating mutual fund returns, their functions are distinct. While CAGR is appropriate for assets with regular cash flows, XIRR is good for those with erratic cash flows. Investors may make smarter selections and assess the returns on their mutual funds by knowing the advantages and disadvantages of each technique.