When you hear that a fund has delivered an 11% return over the past five years, what does that actually mean? Does it imply that a single investment made five years ago would have grown by 11%, or is there more to the story? And would this return be the same for both a Systematic Investment Plan (SIP) and a lump-sum investment? If these questions confuse you, don’t worry—you’re not alone. Understanding mutual fund returns can indeed be complex, especially with terms like CAGR, absolute returns, and XIRR being thrown around. Let’s break these concepts down and explain how they differ.
Key Points to Remember:
- Mutual fund returns reflect historical performance, not future predictions.
- Different return measures (CAGR, XIRR, absolute returns) suit different types of investments and scenarios.
- Understanding these metrics is crucial for informed investment decisions.
What is CAGR?
The Compound Annual Growth Rate (CAGR) is one of the most commonly used metrics to describe mutual fund performance. It represents the annualized growth rate of your investment over a specific period, assuming the profits were reinvested.
Example:
- Karthik invested ₹1,00,000 in Axis Bluechip Fund on July 22, 2015.
- Over five years, his investment grew to ₹1,51,000 by July 22, 2020.
The CAGR for this investment can be calculated :
CAGR provides an average annual return, making it easy to compare different funds. However, it has some limitations:
- No Insight into Volatility: CAGR does not show yearly ups and downs in investment value.
- Not Suitable for SIPs: Since SIPs involve periodic investments, CAGR fails to account for varying cash flows.
What is XIRR?
The Extended Internal Rate of Return (XIRR) addresses the limitations of CAGR, particularly for investments involving multiple cash flows like SIPs. XIRR calculates a single annualized return figure, considering all cash inflows and outflows at different points in time.
Example:
- Karthik starts a SIP of ₹5,000 in Axis Bluechip Fund on July 22, 2015, for five years.
- Each monthly installment is invested at different NAVs and for different durations.
Using XIRR, the returns for each installment are calculated individually, and the overall return is derived. For karthik’s SIP:
- XIRR = 10.33%
This example highlights that SIP investments can yield higher returns compared to lump-sum investments due to the averaging of market volatility over time.
How to Calculate XIRR
You can use tools like Microsoft Excel to calculate XIRR easily. Enter all investment dates and amounts (as negative values) along with the redemption amount (as a positive value) and apply the XIRR formula.
What are Absolute Returns?
Absolute returns measure the total percentage increase or decrease in an investment’s value over a specific period, regardless of the time frame.
Example:
- Karthik’s investment in Axis Bluechip Fund grew from ₹1,43,600 in 2019 to ₹1,51,000 in 2020.
While absolute returns are easy to calculate and understand, they’re more relevant for short-term investments.
Comparing CAGR, XIRR, and Absolute Returns
- CAGR: Ideal for calculating returns on lump-sum investments over a fixed period. It provides an average annual growth rate but doesn’t account for volatility.
- XIRR: Best suited for SIPs or investments with multiple cash flows. It considers varying durations and compounding effects for each cash flow.
- Absolute Returns: Simple and useful for calculating short-term performance but not for long-term investments or periodic contributions.
Practical Applications
- For Lump-Sum Investments: Use CAGR to gauge the fund’s performance over a specific period.
- For SIPs: Use XIRR to account for varying cash flows and durations.
- For Short-Term Investments: Use absolute returns to measure the total gain or loss.
Final Thoughts
Understanding mutual fund return metrics like CAGR, XIRR, and absolute returns can empower you to make better investment decisions. Remember:
- Past returns are not indicative of future performance.
- Choose the right metric based on your investment type (SIP or lump sum).
- Evaluate funds over longer time frames (3, 5, or 10 years) for a clearer picture.
Happy investing!