Mutual Funds: Why does XIRR give a better picture of SIP returns?

When you invest in a mutual fund scheme via a systematic investment plan (SIP), computing returns is not as simple as it appears. Reason: Each SIP is a separate investment, and its individual returns are supposed to be computed separately. This can be done using the extended internal rate of return (XIRR) method, not absolute return or CAGR.

What is XIRR?

It is a metric for calculating the annualised return on investments made via multiple transactions at irregular intervals, e.g., monthly SIPs in a mutual fund. Suppose you invest ₹5,000 via SIPs in a mutual fund scheme over 1 year. In total, you make 12 individual investments, each with its own specific tenor.

XIRR over annualised return

Compound annual growth rate (CAGR) is the average return of an investment over a period longer than one year. Suppose a sum of ₹60,000 is invested for 3 years. Then the CAGR of 12% means the investment grew at 12% per year on a compounded basis, even if the actual returns were slightly different.

Conversely, XIRR is a better metric to show returns on irregular investments. For example, if you invest ₹5,000 at the start of each month for the next 24 months, the CAGR would not reflect the actual return on this investment. Here, each investment of ₹5,000 is treated separately, and its growth is computed accordingly.

Preeti Zende, a Sebi-registered investment advisor and founder of Apna Dhan Financial Services, explains the reason. "XIRR takes into account each of your individual contributions, the exact dates you made those investments, and how long each amount stays invested. This makes XIRR a much better reflection of the actual returns you earn, especially when dealing with periodic or irregular cash flows, like with SIPs. It’s a more accurate way to see how your investments are really doing," she says.

Key differences

1. CAGR method assumes that you have invested the entire sum in one transaction.

2. CAGR method also assumes that the money remained invested for the entire duration.

3. On the other hand, it is far from true because your first SIP could remain invested for 3 years, whereas your last instalment could be invested for just one month.

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