XIRR in Mutual Funds: Understanding Its Meaning and Importance

Many investors prefer mutual funds for long-term wealth accumulation nowadays. When it comes to estimating returns from mutual fund investments, it's crucial to choose the right method for accuracy.

For instance, when investing a lump sum in a mutual fund, the Compound Annual Growth Rate (CAGR) is commonly used to calculate returns. This method works well since there's a single investment amount with no regular additions.

However, if you opt for a Systematic Investment Plan (SIP), a popular choice where you make regular investments on specific dates, CAGR isn't suitable. CAGR calculates returns based only on the initial and final investment values, ignoring the timing of contributions. 

In such scenarios, where the timing of investments matters, a better metric is the Extended Internal Rate of Return (XIRR). XIRR takes into account both the amounts and the timing of SIP investments to compute accurate returns. It considers the dates and amounts of all SIP transactions throughout the investment period.

Understanding how to calculate XIRR in mutual funds is important for SIP investors seeking precise insights into their investment returns. It's a valuable tool that aligns with the periodic nature of SIP investments, providing a more realistic reflection of performance over time.

What Is XIRR?

XIRR in Mutual Funds uses a formula that takes into account the timing and amounts of cash inflows and outflows in your investments. Specifically, it calculates the average annual return of each installment on an annual basis, adjusting these returns to provide an overall average annual rate of return for all your investments combined.

This method is particularly useful for estimating the return on Systematic Investment Plan (SIP) investments, where you make regular investments in a mutual fund scheme. By considering the timing and size of each contribution, XIRR offers a more accurate assessment of your SIP's performance over time.

Similarly, if you opt for a Systematic Withdrawal Plan (SWP), where you withdraw a fixed amount at regular intervals from your mutual fund investments, XIRR can also be applied. It helps in evaluating the overall return of your investments during the withdrawal phase, taking into account the timing and amount of each withdrawal.

How Does XIRR in Mutual Funds Works?

XIRR in Mutual Funds is a financial tool used to assess the profitability of investments that involve multiple cash inflows and outflows occurring at irregular intervals. It's particularly valuable for investors who engage in periodic investments or withdrawals from their portfolios.

It's crucial to grasp how XIRR operates within Mutual Funds and its benefits for investors.

Irregular intervals

One of the main advantages of XIRR in mutual funds is its capability to manage cash flows that occur at irregular intervals, which is typical in Mutual Funds. Investors often deposit money periodically or withdraw funds as required, and XIRR effectively accommodates these varying cash flows.

Cash Flows at different times

XIRR takes into account the timing of your cash flows, including the initial investment and any subsequent investments or redemptions made throughout your investment period.

Calculation considerations

When calculating XIRR in mutual funds, it factors in both the size and timing of cash flows. Essentially, it determines the discount rate that balances the present value of all cash flows—whether they are positive (like investments) or negative (like withdrawals)—to zero. This rate is then annualized to provide a percentage that represents the annual return rate of the investment.

Complete picture of performance

XIRR offers a clear picture of your investment performance by converting the return rate into an annualized percentage. This makes it straightforward to compare returns, even when cash flows happen irregularly and aren't strictly annual.

For instance, let's say you initially invested Rs 5,000 in a mutual fund. Six months later, you added Rs 2,000, and after one year, you redeemed Rs 1,000. XIRR would consider these cash flows occurring at different times and intervals. It would then calculate a single rate that reflects the annualized return on your investment, taking into account these irregular cash flows. This method ensures a comprehensive evaluation of your investment's profitability over time.

Why is XIRR Important? 

XIRR is a robust method that accurately computes returns, especially in scenarios with irregular investment plans over time. Unlike estimating returns based on compounding, XIRR provides precise figures. It's invaluable for assessing whether your investment portfolio is meeting expected returns.

For every SIP installment or liquidation, XIRR allows you to determine the exact value of your investment. By applying the XIRR formula, each cash flow (whether incoming or outgoing) is assigned specific dates, enabling precise calculation of returns. This approach ensures a more reliable evaluation of investment performance.

Why is XIRR particularly beneficial for mutual fund investments?

Suppose you invest in Systematic Investment Plans (SIPs) over a span of 5 years with varying monthly contributions: Rs 5,000 in the first year, Rs 8,000 in the second year, Rs 6,000 in the third year, Rs 7,000 in the fourth year, and Rs 10,000 in the fifth year. After completing this investment period, your total returns amount to Rs 1,20,000. Based on these contributions and the final return, your calculated return on investment stands at 15%. This illustrates how systematic and disciplined investing can yield a respectable return over time.

The outcome is referred to as the Internal Rate of Return (IRR). This concept helps determine the return on investments from equally spaced spending over time.

However, investments in mutual funds are typically not distributed as uniformly as shown above. When it comes to mutual funds, you usually invest and withdraw investments at sporadic moments.

It will result in the movement of cash in and out at various points in time. In this kind of situation, besides the money put in, the length of the investment is also important for generating a specific result.

You can apply the Extended Internal Rate of Return (XIRR) concept here.

XIRR is a useful tool for determining returns in cases where your cash flows (such as investments or redemptions) occur gradually over time.

For mutual funds, XIRR can handle various scenarios like SIP, lumpsum investments, and SWP withdrawals to calculate an overall return based on your investment and withdrawal timings.

Bottom Line

XIRR in Mutual Funds is essential in investment analysis as it provides a more thorough and precise evaluation of investment performance, especially in situations with irregular cash flows and dynamic investment options such as mutual fund SIPs. By making use of XIRR, investors can improve their decision-making and successfully navigate the intricacies of the financial markets.

FAQs

Q. What is a good XIRR for mutual funds?

A. Generally, an XIRR of 12% is considered good for equity mutual funds, while in the case of debt funds, it is 7.5%. Is XIRR better than CAGR? It depends on the investment type for which you are calculating the return. XIRR is better when there are irregular cash flows in the investment, such as SIPs in mutual funds.

Q. What does xirr of 10% mean?

A. 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.

Q. Is XIRR better than CAGR?

A. Neither is categorically better; XIRR is preferable for investments with irregular cash flows, while CAGR is suited for evaluating single, lump-sum investments over time.

Q. What is the difference between interest rate and XIRR?

A. IRR measures the profitability of a single investment and is used to compare different investments. XIRR, on the other hand, is similar to IRR but is used to measure the profitability of investments with irregular cash flows.