25 Oct 2024
Understanding and evaluating the performance of any investment is necessary to make more informed financial decisions. XIRR and CAGR are two of the most popular metrics for evaluating the return on your mutual fund investments. While both offer valuable insights, they serve different purposes and are suited to different types of investments.
In this blog, we will cover the concept of XIRR and CAGR, the key differences between XIRR vs CAGR, their limitations, and more. We'll also explore how these financial metrics can aid in investment analysis and portfolio evaluation. Keep reading to enhance your understanding of these crucial investment calculation tools!
What Is CAGR?
CAGR (Compound Annual Growth Rate) is a metric used to measure the rate of return generated by an investment. If you're new to this concept, you might want to read more about CAGR meaning and how it helps evaluate investment performance over time. CAGR captures the annual growth rate by factoring in the initial investment value, time elapsed, and final value. It does not account for the fluctuation of capital inflow or outflow. Hence, this metric is ideal for comparing various long-term investments over the same period.
Mathematically, the CAGR formula can be expressed as:
CAGR = (Final Value of Investment / Initial Value of Investment) ^(1/n) - 1 (where n = investment period in years)
What Is XIRR?
XIRR (Extended Internal Rate of Return) is another metric used to measure the annualized return on investment generated from irregular cash flows with more accuracy. To understand XIRR meaning, it's important to note that XIRR full form stands for Extended Internal Rate of Return. This financial metric is primarily used to calculate returns from investments where funds are invested and withdrawn at various points in time.
XIRR is mainly used to evaluate returns from irregular investments along with partial withdrawals, such as real estate projects, multiple systematic investment plans (SIPs) in mutual funds, and other investments with varying cash flows. Understanding what XIRR is in mutual funds is crucial for investors looking to accurately assess their fund performance.
Rate calculations in MS Excel w.r.t. investments:
MS Excel does not have a CAGR function. The broad guidelines on which MS Excel function to use is as per the table given below.
| Type of Cash Inflow | Type of Cash Outflow | Amount in Cashflow | Frequency of Cash Flow | Scenario | MS Excel Function to Used (##) |
|---|---|---|---|---|---|
| Single | Single | Uniform | Uniform | Lumpsum Investment & Withdrawal on Maturity | Rate (PV is Lumpsum Investment, FV is Maturity amount, Nper is years) |
| Regular | Single | Uniform | Uniform | Sip investment & withdrawal on maturity | Rate (PMT is sip, FV is maturity amount, Nper is “years*12”) |
| Single & regular | Single | Uniform | Uniform | Sip & lumpsum investment in the same fund initially & withdrawal on maturity | Rate (PV is lumpsum investment, PMT is sip, FV is maturity amount, Nper is “years*12”) |
| Single | Regular | Uniform | Uniform | Lumpsum investment & swp till money is available | Rate (PV is lumpsum investment, PMT is swp, FV is 0, Nper is “years*12”) |
| Single | Regular & single | Uniform | Uniform | Lumpsum investment & swp during withdrawal phase plus lumpsum maturity amount | Rate (PV is lumpsum investment, PMT is swp, FV is maturity amount, Nper is “years*12”) |
| Regular | Single | Non-uniform | Uniform | Sip investment but sip pause or sip missed (date or amount) & withdrawal on maturity | XIRR |
| Regular or single | Single & regular | Non-uniform | Non-uniform | Sip or lumpsum investment or both but random partial withdrawal is done before maturity & withdrawal on maturity | XIRR |
| Multiple sips running parallel | Single | Uniform for each sip | Uniform for each sip | Multiple sips maturing on same or different date | XIRR |
| Multiple investments (dates of investments are available) | Multiple withdrawals (dates of withdrawals are available) | Non-uniform | Non-uniform | Assessing returns on investor portfolio held for a period of time | XIRR |
## Follow Time Value of Money Sign Conventions
CAGR vs XIRR: Key Differences
Here are some of the key differences between CAGR and XIRR presented in a tabular format:
| Point of Difference | CAGR | XIRR |
|---|---|---|
|
Cashflow |
It assumes a single initial investment value and a final value. | It calculates annualised returns from multiple, irregular cashflows. |
| Timing Sensitivity | CAGR ignores the timings of each instalment within the period of investment. | The XIRR accounts for the exact dates for cashflows. |
| Real-World Application | Stocks, lump sum mutual fund, and performance of market indices. | Multiple SIPs, SIPs where SIP Stop or SIP Pause has been exercised, real estate, and private equity investments. |
| Accuracy for Variable Investments | It is accurate for single cashflows. For uniform cashflows, Rate function in MS Excel needs to be used. | It’s more accurate. |
| Period Flexibility | It assumes a fixed time period. | It handles varying time periods. |
| Best Used For | Single investments held over a set period. | Portfolio returns where multiple investments & withdrawals happen. |
CAGR vs XIRR for SIP:
Assessing XIRR or CAGR for your investment evaluation entirely depends on the investment scenario and the type of investment you are trying to gauge. Both XIRR and CAGR come with their own pros and cons, and each is suitable for different investment strategies.
CAGR is an appropriate metric if you are gauging the returns of lump sum investments, analyzing market trends, or drawing a comparison between various investment options. It is an easy-to-use tool and helps to draw conclusions from volatile and inconsistent data.
On the other hand, if you are dealing with investments with multiple cash flows at irregular intervals, XIRR is a better choice. Such types of investments include multiple mutual fund SIPs, investments in private equity, investments in real estate projects, and overall portfolio return evaluation.
When it comes to evaluating XIRR in SIP or multiple systematic investment plans running parallelly, XIRR is an ideal choice. This is because XIRR takes into account each investment (cash inflow) or withdrawal (cash outflow) made over time, providing a more accurate picture of your investment growth.
Limitations Associated with XIRR and CAGR
Both CAGR and XIRR are powerful metrics for evaluating your rate of return on investments. However, both of them come with various limitations, which are as follows:
Limitations of XIRR:
- Minor errors can have a large impact; even a small mistake in the dates can entirely change the results.
- XIRR is based on the assumption that cash flows can be reinvested at the same rate, which is not always the case.
- XIRR calculations are comparatively more complex and require financial calculators or software/applications or MS Excel. An XIRR calculator can be helpful for accurate calculations.
Limitations of CAGR:
- CAGR tends to ignore short-term volatility and smooths out year-to-year fluctuation, which can hide short-term fluctuations.
- It takes into account the investment value at the beginning and end, ignoring any kind of extra investments or withdrawals in between.
- Looking at CAGR values in isolation over certain periods (when investment value was very low or high) can lead to misleading results.
Conclusion
Both CAGR and XIRR are crucial metrics for calculating the return on investment in various investment avenues and scenarios. XIRR is more suitable when it comes to measuring returns on investments made at irregular intervals, especially for evaluating XIRR return in mutual funds. On the other hand, if you are willing to gauge the returns of a lump sum investment or the performance of a market index, CAGR can be a better choice.
By knowing when to apply each metric, you will be able to make more informed financial decisions and better assess the true performance of your investments. Whether you're dealing with long-term investments or short-term strategies, understanding these financial metrics is key to successful investment analysis and portfolio evaluation.
Frequently Asked Questions
1. What is the difference between XIRR vs CAGR?
The choice between XIRR or CAGR entirely depends on the investment scenario. XIRR can be a good option when it comes to measuring returns on investments made at irregular intervals. On the other hand, if you are willing to measure the returns of a lump sum investment or the performance of a market index, CAGR can be an appropriate choice.
2. Are annualized returns and CAGR the same?
CAGR is a type of annualized return assuming growth at a steady rate year over year, making it a more precise measure of compounded growth. There are other types of annualized returns, including absolute returns, rolling returns, and IRR (internal rate of returns).
3. Can we convert XIRR to CAGR?
No, XIRR and CAGR cannot be directly converted into one another because they measure different aspects of investment returns. XIRR accounts for cash flows occurring at irregular intervals, whereas CAGR assumes a single lump-sum investment and a steady growth rate.
4. Why is XIRR used to calculate returns from SIP and not CAGR?
XIRR is used to calculate returns from multiple mutual funds SIPs running parallelly as it accounts for multiple and irregular cash flows as a result of withdrawals, additional investments, etc. To calculate returns of SIP investment in a single fund, the RATE function in MS Excel needs to be used. CAGR, on the other hand, is more suitable for a single lump-sum investment made at the start of the period.
5. What is a good value of XIRR for a particular investor?
A good XIRR entirely depends on the context, including the risk level of the investment and the investor's expectations. A good XIRR in mutual funds can depend on several factors, such as individual risk tolerance and market conditions.
6. Which is better: CAGR or absolute return?
CAGR is preferable because it provides more clarity on investment performance over time, whereas absolute return simply ignores the time of these factors. Absolute Returns is used when the investment horizon is less than one year to avoid annualization. It is also used to calculate point-to-point returns of single investments like real estate.
Disclaimers
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