ET Mutual Funds Explains: When to use CAGR, XIRR or IRR to calculate your mutual fund returns?

An investor before choosing a mutual fund scheme to invest always looks for the past performance of that scheme. Ever wondered why the returns are expressed in different nomenclatures? Why are they written as CAGR, IRR or XIRR? ETMutualFunds made it easy for the first time investors to understand what these nomenclatures mean and how one should calculate them.

Compounded Annual Growth Rate (CAGR)

CAGR calculates annual growth rate of an investment over a particular period of time. This measure is the most common tool used to measure/calculate returns generated by a mutual fund scheme. It shows the average annual return delivered by a fund over a specific period of time assuming that the returns are compounded every year.

For example, if you invest in a mutual fund scheme for five years, the CAGR would depict the average rate of return that the scheme has yielded every year for the past five years. With the help of a CAGR one will be able to find out the compounded annual growth or decline of the mutual fund investments.

This metric is particularly useful for long-term investments. It is mostly used to assess the lumpsum investments. The formula for calculating CAGR is: =(end value/beginning value) ^ (1/number of years) -1.

End value is the amount of money one will have after the period of investment

Beginning value is the amount of money one make investment withNumber of years is the total number of years that have passedSuppose an investor invested Rs 1.20 lakh in a mutual fund scheme. The investment grows to Rs 1.80 lakh after five years. CAGR will be = {(1,80,000 / 1,20,000) ^ (1 / 5)} -1 = 8.45%

The CAGR will be 8.45% which means a lumpsum investment of Rs 1.20 lakh needs to grow at a rate of 8.45% every year for a period of five years to grow to Rs 1.80 lakh in the end.

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Extended Internal Rate of Return (XIRR)

This measure calculates annualized returns for investments with cash flows at irregular intervals. It is a single rate of return which would give the current value of investment when applied to every instalment or redemption.

If you are investing through SIP mode, calculating XIRR will be the best way. This method is useful with different purchase prices and instalment periods. This method takes into account the timing of cash flows (inflows/outflows).

Here is how to calculate XIRR for your SIP portfolio/ investments.

Step 1: In first column add your date of investment

Step 2: In next column enter all your investment transactions

In this step, add all your investments transactions. Each transaction will be denoted with a minus sign (-) i.e. all outflows like investments and purchases will be marked negative. All inflows like withdrawals and redemptions will be marked positive.

Step 3: In this step mention the current value of your investment and the date of redemption.

Step 4: In this step use the XIRR function in excel. XIRR = (investment amount, date)

Also Read | How much will you earn if you increase your SIP investment every year?

Internal rate of Return

This metric is used to assess investment profitability.This method considers the changing value of money over time and acts as a special discount rate. In this method, cash flows are discounted at a certain rate based on when the cash flows happen to know the present value of investment.

An investor can use IRR to calculate returns of their SIP, SWP, lumpsum investments with multiple cash flows.

Suppose, you make an initial investment of Rs 1,000 and then every year make investments of different amount

Step 1: Enter dates in one column and investment amount is next column

One should make sure that your cash flow should have at least one negative and one positive value.

Step 2: Use IRR formula to calculate internal rate of return for a series of cash flows that occur at irregular intervals