We constantly invest a fixed amount in financial products such as mutual funds to secure our financial future. We may desire to redeem our assets after 5 years, 10 years, or 15 years. During that time, we usually divide the money we originally invested by the maturity amount we got to determine how much profit we made. But do you really think it is the best way to determine how much we gained? There has been no denying that returns have traditionally been the fundamental norms for investors when making a perfect investment decision.
Returns can be stated in a number of ways and nomenclatures and XIRR is one such term.
XIRR, also known as the Extended Internal Rate of Return, is a metric used to calculate the return on investment for mutual fund investments. It is a mathematical formula used to measure the annualised return on investments that involve investments made and returns received at multiple time intervals.
XIRR is a useful tool for investors to evaluate the performance of their mutual fund investments. It takes into consideration the multiple investments and withdrawals made by the investor at different time intervals. In simple terms, XIRR is a method that calculates the returns on investments that happen at different points in time.
What Is XIRR?
XIRR considers various cash inflows and outflows in its formula. It calculates the annual average return for each installment and adjusts them to provide an overall average annual rate of return for all your investments.
This calculation is especially useful for estimating the return on your systematic investment plan (SIP), where you regularly invest in a mutual fund scheme.
Additionally, if you opt for the Systematic Withdrawal Plan (SWP), you can utilise XIRR to gauge your overall return. SWP allows you to make regular withdrawals of a predetermined amount at fixed intervals. Using XIRR in this context helps in evaluating the effectiveness of your investment strategy and the returns generated over time.
Understand how XIRR is accurate with an example
Let us explore the accuracy of XIRR with an example. Imagine you initiated a monthly SIP of Rs. 8,000 in a mutual fund plan and maintained it for 4 years. Assume that after numerous fluctuations, your total investment swelled to Rs. 7.5 lakh at the end of the 4-year period.
In this scenario, your initial Rs. 8,000 contributions were invested for 4 years, totaling 48 months. The annual return for the first month's contribution will differ because it was invested for the longest duration. As each contribution remains invested for varying periods, their respective CAGR also fluctuates. Calculating the CAGR for each contribution of a mutual fund plan could be complex to analyse.
Hence, to simplify matters, all these CAGRs are amalgamated and adjusted to a common CAGR. This adjusted CAGR is depicted as the XIRR of a mutual fund plan.
How XIRR works in mutual funds?
XIRR calculates the annualised return on investments by considering the cash flows in and out of the mutual fund investment at different points in time. These cash flows can be investments made by the investor, the income earned from the mutual fund investment and the withdrawals made by the investor.
Why is XIRR or Extended Internal Rate of Return important?
XIRR is a useful tool for computing returns, especially when dealing with irregular investment patterns over time. It allows you to precisely determine the return amount rather than relying on estimated returns based on compounding. With XIRR, you can assess whether your investment portfolio is delivering satisfactory returns or not. By applying the XIRR formula to each SIP payment or liquidation, you can accurately evaluate the overall value of your investment. This formula assigns specific dates to each cash flow (inflow and outflow), ensuring precise return calculations.
What is a good XIRR in mutual funds?
The good XIRR for mutual fund investments depends on several factors, such as investment goals, risk tolerance, and time horizon. A good XIRR for a mutual fund investment should be at least higher than the inflation rate. It is essential to check the XIRR of a mutual fund against its benchmark index and the average returns of similar mutual funds.
How to calculate XIRR in mutual funds?
You must enter the transactions (additional purchases, SIP/SWP instalments, redemption) and the related dates in the designated area of an MS Excel sheet in order to compute XIRR for mutual funds. The statement of account that the AMC (Asset Management Company) will send you will include information about these transactions.
You can use the following formula in MS Excel to determine a mutual fund's XIRR:
"=XIRR (values, dates, guess)"
Here, you must enter cash inflows (dividends, SWP, redemptions) as positive values and cash outflows (lump-sum purchases and SIP payments) as negative values (i.e., place a minus sign before the amount).
The entry "Guess" is optional. It is by default taken to be 0.1.
If you have not yet redeemed your mutual fund units, you must enter the current investment value along with the NAV (Net Asset Value) of your mutual fund investment to compute XIRR.
Transactions like dividend reinvestment should be excluded because they don't result in actual cash flows. Moreover, switches should be considered a form of redemption when determining the XIRR at the level of schemes. But switches are irrelevant in the computation if you are computing XIRR at the portfolio level for mutual funds.
What is XIRR in NPS?
XIRR can also be used to calculate the return on investment for investments made in the National Pension Scheme (NPS). It calculates the annualised rate of return on investment and takes into consideration the contributions made and the returns earned at different time intervals.
As you can see from the examples above, XIRR is the best approach to calculating your real-world investment returns. CAGR is crucial to consider when choosing a mutual fund, but XIRR is critical when evaluating the returns on the investments you make. And IRR is employed for investments with equally spaced cash flows in time, but most investments are not as evenly spaced as you saw above in the case of mutual funds.
So, when a series of investments is made over time, involving transactions such as withdrawals, dividends, switching, and so on, XIRR is a superior approach to compute the return. XIRR is a far better tool for calculating mutual fund returns.
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