DIFFERENCE
BETWEEN CAGR, XIRR AND IRR
Returns have
always been the central standard while going for any investments. These
indicate how much the fund has lost or gained during the particular investment
period. You may come across returns expressed in the variety of nomenclatures.
Have you ever wondered what does each kind of return signify ? or why not use
single kind of return in all types of investments. What is the need to quote
CAGR in lumpsum investment while XIRR in SIP’s. It is the awareness of these
subtle yet significant differences that are going to take your investments to
new heights. The more you get to know the usefulness and application of these
returns, the more good you are going to
feel with your investment reports.
Absolute
Return
It helps you
to calculate the simple returns on your initial investment. What you need is
only the initial and the current or the ending Net Asset value (NAV) of the
scheme. In calculating the point to point or absolute return, the holding time
does not play a role. So if your initial NAV was, say, Rs. 20 and now after 3
years , it is Rs. 40, the point to point return comes to 100 percent.
Formula to
calculate absolute return
This formula is used to calculate returns when the holding period is less than 12 months.
Understanding
CAGR
CAGR stands
for Compounded Annual Growth Rate
The concept
of CAGR is relatively straightforward and requires only three primary inputs:
an investment’s beginning value, ending value and the time period. CAGR is
superior to average returns because it considers the assumption that the
investment is compounded over time.
Advantages
of CAGR
·
CAGR isthe
best formula for evaluating how different investments have performed over time.
·
Investors can
compare the CAGR in order to know how well one stock/mutual fund has performed
against other stocks in a peer group or against- market index.
·
The CAGR can
also be used to compare the historical returns of stocks to bonds or a savings
account.
Disadvantages
of CAGR
·
It ignores
volatility by assuming steady growth rate over the entire investment tenure,
only taking into account an initial and a final value
·
CAGR is also
subject to manipulation as the variable for the time period is input by the
reason calculating it and is not a part of calculation itself.
·
It shows past
performance of the fund as in you should
not expect your investments to grow as per CAGR in future.
·
It does not
consider the interim values and relies only on the ending value and the
beginning value which may again give a wrong picture if you ignore yearly
returns.
CAGR is a way
to smoothen out the returns, it determines an annual growth rate on an
investment whose value has fluctuated from one period to the next. In that
sense, CAGR isn’t the actual return in reality. This is similar to saying that
you went on a trip and averaged 60km/hr. The Whole time you did not actually
travel 60km/hr. Sometimes you were traveling slower, other times faster.
Let us
understand with an example
Suppose a
person invested Rs. 15000 in a mutual fund on 1 Jan 12 and redeem it on 1 Jan
18. The value of the investment at the time of redemption was 25000. So here
CAGR (Compounded annual growth return turns out to be)
Formula to
calculate CAGR
So,
Here we have
assumed that investment is done only at the beginning and also redeemed only
once. In between these six years, no investmentis made at nothing is redeemed.
So CAGR easily turns out to be 8.88%
But there are
sometimes when investment is not made at lumpsum but made periodically. So at
that time CAGR turns out to be an irrelevant method to calculate return.
Let us understand with an example
Suppose you started mutual fund investment on Jan 1 2012, with
details as follows
|
Date
(A)
|
SIP
Amount
(B)
|
NAV
(C)
|
Units bought
(D) (B/C)
|
NAV on redemption
(E)
|
Holding period (in years)
(F)
|
Value on redemption
(G) (D*E)
|
|
01/01/12
|
15000
|
44.54
|
336.72
|
50.078
|
6
|
16862.41
|
|
30/01/13
|
15000
|
40.44
|
370.87
|
50.078
|
4.92
|
18572.63
|
|
12/05/14
|
15000
|
37.19
|
403.30
|
50.078
|
3.63
|
20196.54
|
|
22/07/15
|
15000
|
41.02
|
365.64
|
50.078
|
2.47
|
18310.50
|
|
01/11/16
|
15000
|
42.98
|
348.98
|
50.078
|
1.16
|
17476.39
|
|
10/10/17
|
15000
|
44.89
|
334.13
|
50.078
|
0.22
|
16732.45
|
Let us first calculate CAGR we got
on our individual investment amount.
So, 
And so on for the other SIP’S
|
Date
(A)
|
SIP
Amount
(B)
|
NAV
(C)
|
Units
bought
(D) (B/C)
|
NAV
on redemption
(E)
|
Holding
period (in years)
(F)
|
Value
on redemption
(G) (D*E)
|
CAGR
on individual
Investment
|
|
01/01/12
|
15000
|
44.54
|
336.72
|
50.078
|
6
|
16862.41
|
1.97%
|
|
30/01/13
|
15000
|
40.44
|
370.87
|
50.078
|
4.92
|
18572.63
|
4.44%
|
|
12/05/14
|
15000
|
37.19
|
403.30
|
50.078
|
3.63
|
20196.54
|
8.54%
|
|
22/07/15
|
15000
|
41.02
|
365.64
|
50.078
|
2.47
|
18310.50
|
8.40%
|
|
01/11/16
|
15000
|
42.98
|
348.98
|
50.078
|
1.16
|
17476.39
|
14.07%
|
|
10/10/17
|
15000
|
44.89
|
334.13
|
50.078
|
0.22
|
16732.45
|
64.34%
|
|
|
|
|
|
|
|
108150.93
|
|
In this way, we can calculate CAGR for each of our investment.
But some people might be interested inthe total CAGR got on the
total investment made instead of CAGR on the individual investment.
|
Incorrect
Approach
|
Correct
Approach
|
|
Total investment made = 90,000
Redemption value = 108150.93
Time period = 6
Return :
{108150.93/90000)^(1/6)}-1
= 3.10%
|
Calculation of IRR (Internal
rate of return) in case of consistent cash flows
Calculation of XIRR (Extended
Internal rate of return) in case of inconsistent cash flows
|
Here, taking the same example we
can see Investment is made at irregular intervals. So the correct approach to
calculate return in this type of situation is XIRR .
Let us try to learn the concept of
XIRR in detail.
What is
the meaning of XIRR
XIRR stands
for Extended internal rate of return
XIRR is a
method used to calculate returns on investments where there are multiple
transactions happening at different times. It is a good function to calculate
returns when your cash flows(investments or redemption)are spread over a period
of time. In the case of Mutual funds,if you are investing through SIP or
lumpsum or redeeming through SWP or lumpsum , XIRR can take care of all those
scenarios and helps you calculate a consolidated return considering timings of
your investment and withdrawals.
You can think
of XIRR as nothing but an aggregation of multiple CAGR’s. If you make multiple
investments in a fund, you can use the XIRR formula to calculate your overall
CAGR for all those investments taken together.
XIRR Function
Errors
If you get an error from the Excel XIRR function this is likely to
be one of the following
|
Common
Errors
|
|
#NUM!
|
Occurs if Either
:
|
|
|
·
The
supplied values and dates arrays have different lengths
|
|
|
·
The supplied
values array does not contain atleast one negative and at least one positive
value
|
|
|
·
Any of the
supplied dates precedes the first supplied date
|
|
|
·
The
calculation fails to converge after 100 iterations
|
|
#VALUE!
|
Occurs if any of the supplied dates can’t be recognized as valid
excel dates
|
What is
IRR Approach
The IRR
approach is a guideline for evaluating whether to proceed with a project or
investment. The IRR rule states that if the internal rate of return (IRR) on a
project or an investment is greater than the minimum required rate of return, typically the cost
of capital, then the project or investment should be pursued. Conversely, if
the IRR on a project or investment is lower than the cost of capital, then the
best course of action may be to reject it.
Can CAGR
and IRR be Same
CAGR V/S IRR:
IRR and CAGR will be same when
1. You make a lumpsum investment (single
investment)and calculate returns for the same.
2. You make multiple investments but the annual
return is constant across years. These investments can be periodic like a SIP
or recurring fixed deposit. By the way, returns in a MF SIP are unlikely to be
constant.
CAGR V/S IRR:
IRR and CAGR will be different when
You make multiple investments and
the annual returns are variable. This will be the case with any volatile
investment such as equities.
You should not use CAGR when you
want to estimate returns for your mutual fund investments.
The Bottom Line
The CAGR
Helps frame an investment’s return over a certain period of time. It has its
benefits, but there are definite limitations that investors need to be aware
of. With multiple cash flows, the IRR or XIRR approach is usually considered to
be better than CAGR. Investors should understand how investment returns are
calculated and which return to consider for making investment decisions.
Awareness and knowledge about calculating the returns from investment is
important to be a smart investor.
Short Summary for the Difference between CAGR and XIRR
|
Particulars
|
CAGR
|
XIRR
|
|
Description
|
It is a measure of the compound
rate of growth
|
It is the average rate earned by
each and every cash flow invested during the period
|
|
Multiple
cash flows
|
It does not consider the
multiple cash flows
|
Yes, it is considered
|
|
Absolute /
Annualized measure
|
Absolute return
|
Only annualized
|
|
Timing of
cash flow
|
As cash flow are there, only
time matters is the time between the amount invested and amount redeemed. Longer
the period of holding the investment, better the CAGR.
|
It is very important. Timing
affects the returns. It gets influenced by the early cash flows. Returns
could be amplified or muted based on the timing of cash flows.
|
|
Measurement
|
Measures the performance of the
lumpsum amount invested
|
Measures of the performance of
the cash flow
|
....
