Understanding XIRR: A key metric for mutual fund performance

Introduction

When selecting a mutual fund scheme, what comes to your mind? Is it returns?

Investing in mutual funds is a compelling avenue for long-term wealth creation, but assessing their performances can be complex. Two metrics are generally used to calculate mutual fund performance:

• XIRR or extended internal rate of return and
• CAGR or compound annual growth rate.

For calculating returns for lumpsum investments, CAGR is used. However, for SIPs (systematic investment plans), where timing and cash flows matter, XIRR is considered a better option.

So, what is XIRR? In this article, we will explore the concept of XIRR, its calculation and its importance.

What is XIRR in mutual funds?

When investing in mutual funds, you must understand the XIRR meaning in mutual fund returns. As many investors ask, “What is XIRR return?”.

XIRR essentially refers to a measure used to evaluate the performance of a mutual fund scheme. XIRR full form is an extended internal rate of return.

In simplest terms, XIRR means a financial metric that computes the annual returns on investment, considering both the invested amount and also mid-way cash flows and their timing.

The CAGR, for example, only looks at the beginning value and the final value of the investment, whereas XIRR includes all inflows and outflows over time and when they happened (even if cash flows are irregular).

Therefore, it is a better way to measure SIP’s performance because you can consider each SIP instalment, including the amount, dates, and withdrawals.

Also, since XIRR considers the compounding effect and time value of money when computing mutual funds’ returns, it becomes a more prudent financial metric.

Why is XIRR important for mutual funds?

Mutual funds need the XIRR as it provides a better understanding of your investment returns, particularly if you have irregular cash flows. Here is how it helps:

Precise assessment: CAGR assumes that investments are made at consistent intervals. But XIRR considers all the inflows and outflows in between, like dividends, redemptions and withdrawals, to provide a more accurate estimate. Further, it also considers the timing and magnitude of cash flows.

SIP friendly: SIPs are widely used by many investors to invest in mutual funds. To calculate returns for SIPs, consider using XIRR, since this method takes into account all the SIPs done during the investment period.

Redemption processing: When you redeem some of your units, it has an impact on your overall returns. By incorporating these withdrawals into its calculations, XIRR ensures that there is high precision regarding the performance of your investment.

Comparative instrument: XIRR can help you evaluate the performances of various mutual fund investments effectively, no matter if you invested in them at different times and with varying amounts. This helps assess which funds are performing better for you.

How to calculate XIRR?

Calculating XIRR for your mutual fund is simple; you can use Excel.

In Excel, the XIRR function can be used to calculate the returns.

The function is: XIRR = (values, dates, [guess])

Here,

Values: This represents the total amount you have invested, including any redemptions. All the cash outflows (SIP instalments) should be recorded as a negative value, and cash inflows (redemptions, withdrawals) should be positive.

Dates: These are the dates of your investments.

Guess: You can leave this part blank.

XIRR - Calculation using Excel

Let us take an example to understand how to calculate the XIRR using the Excel function.

Suppose you invest ₹5,000 in an equity mutual fund scheme through SIP for one year, starting from 1 Jan 2023. After a year (say 15 Dec 2023), the redemption amount is ₹65,000.

Let us find the XIRR.

Step 1: Enter the SIP investment amount in one column.

Step 2: Enter the corresponding date in another column.

Step 3: Input the redemption amount in the last row along with the date.

Step 4: Use the Excel formula - XIRR = (values, dates, [guess])

Source: XIRR Calculation - This is for illustration purpose only.

Here, 17.28% means that your investment has grown by an average of 17.28% in the year, considering when you deposited and withdrew money (cash flows and timings).

The XIRR takes into account the irregular cash flows invested during the year and gives a single percentage to represent how it has performed on the whole.

Final thoughts

XIRR is an essential metric for evaluating mutual fund investments, especially when regular contributions or withdrawals are made at different intervals, such as SIP.

Instead of looking only at the initial and final amounts invested in capital value terms, it tracks the timing and amount of each transaction, thereby making a reasonable estimate for returns. This aspect makes XIRR useful because it can be used to compare different mutual fund returns.

By understanding XIRR meaning, you can make informed decisions regarding your mutual fund portfolio and track progress towards long term financial goals.

Above article is authored by Quantum.

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