Just started investing in mutual funds? Are you having difficulty understanding these new terms? Are you wondering what is the difference between CAGR and XIRR. Do not worry we have got you covered.
When I started investing in mutual funds. I saw that each fund had a CAGR number eg: xyz fund with 12% CAGR. I always wondered what that meant when I started. As a beginner you often tumble on these kinds of questions.
What is CAGR?
CAGR is Compounded Annual Growth Rate, It is the most common term used to know the returns of a fund. It is the average growth rate of a fund for a longer duration than 3 years. CAGR shows the average growth rate at which your investment has grown.
How to calculate CAGR?
It is calculated as:
(final investment value/initial investment value) ^1/n – 1
Where n is the number of years.
Let us understand it with an eg:
Mr. A invested in xyz fund with initial investment of Rs 10,00,000/- . After 5 years, Mr. A got a return of Rs 15,10,000/- . To calculate Mr. A’s CAGR we have to use the formula.
(15,10,000÷10,00,000)^⅕ – 1
= 8.5% CAGR
So, Mr. A’s CAGR on the investment of Rs 1,00,000 in the xyz fund gave him 8.5% CAGR.
Limitations of CAGR
There are some limitations of using just CAGR. Let’s see the example above, it looks like the investment has increased in a linear manner. Which is never the case; each fund has a different value each year and at each point of time of the year. To say that it increases at a stable rate is completely not true.
In Mr. A’s case we saw he earned a return of 5,10,000/- on an investment of 10,00,000 over 5 years. As per CAGR the investment grew at 1,02,000/- per year.
The Actual growth of the investment was:
2016 – (-0.35%) = 9,98,500/-
2017 – 15.82% = 11,56,490/-
2018 – 21.66% = 14,06,990/-
2019 – 2.6% = 14,36,010/-
2020 – 5.19% = 15,10,010/-
When we look at CAGR we do not get the actual ups and downs of the fund each year. CAGR can be different depending upon the duration of investment.
CAGR is usually used to depict annual mutual funds growth rate. Yet it has some limitations, it can only show the return on investment on a lump sum amount and not on SIP investments.
This is because CAGR calculates point to point investments and it will not be able to show the investment made for different time periods.
SIP for 5 years means amount invested on different time periods and for different time duration.
The first installment will be invested for 5 years.
The second installment will be invested for one month less than the first. And the third will be invested one month less than the second and so on.
SIP investments are calculated by a method we call XIRR.
What is XIRR?
XIRR stands for Extended internal rate of returns. We calculate it by taking the CAGR of all the investments made during the time period and add them up.
We can understand it by eg :
Mr. A decides on making a SIP of rs 50,000/month. So each installment is a new investment. We calculate the CAGR of all the investments and then add them up which gives us an annual return of 10.33% of annual growth returns.
Assumption: there was no withdrawal.
Each withdrawal can impact the XIRR and even if he invested a lump sum amount in between would also have made an impact on the XIRR. This is because XIRR takes account of all cash inflows and outflows. This means if you invest money or make a redemption, This can impact the XIRR of your investment.
CAGR VS XIRR
CAGR and XIRR are both used to calculate the growth rate.
CAGR is ideal for calculating the lump sum investment which is invested at one point of time and withdrawn at another point of time.
XIRR on the other hand is more suited to calculate the growth returns when the amount is invested at different points of time. It takes account of all cash inflow and outflows. Each investment and each withdrawal can impact the XIRR growth rate.
What did we learn?
