One of the main reasons behind mutual fund investments is expecting inflation-beating returns, if not more. However, whenever people hear about a certain rate of return generated by mutual funds in India, they become doubtful of what to expect, like Saheb in the example given below:
Saheb wanted to invest in suitable mutual fund schemes and started checking the expected returns. On digging further, he found that some popular schemes offered a five-year return of 10%, a 3-year return of 8%, and so on. These numbers confused him and terms like CAGR and XIRR, written next to returns, added to the confusion.
Many individuals like Saheb find it challenging to understand such terms. Here, we will cover CAGR vs XIRR in detail to help you understand the differences between the two.
What is CAGR?
CAGR stands for Compounded Annual Growth Rate and is the most common tool to measure the returns generated by a mutual fund scheme. It shows the average annual return of a fund over a specific period assuming returns are compounded every year. It represents the compounded growth or decline of your mutual fund investments.
CAGR is calculated as:
CAGR = (Final Value of Investment /Initial Value of Investment) ^1/n – 1 (where n = investment period)
Example: Assuming you invested Rs 1,00,000 five years ago in one of the best mutual funds in India. If the current value of your investment is Rs. 1,51,000, then the CAGR will be 8.59% as per the formula given above. Your investment of Rs. 1,00,000 earned an average annual return of 8.59% to Rs. 1,51,000 after five years.
Limitations of CAGR
As detailed above, you might have thought of CAGR as a quick way to check returns for investments you plan in different schemes. However, it does not provide an accurate rate of return in the case of multiple investments within a specific tenure (SIP route). In the above example, the CAGR of 8.59% does not mean the actual return over your capital is 8.59% yearly. It might be higher in the first few years while lower in others or vice versa.
What is XIRR?
Also known as Extended Internal Rate of Return, XIRR is applicable when you invest in mutual funds via Systematic Investment Plans (also known as SIP) or multiple investments spread over a period. Here, the CAGR of each instalment is calculated to obtain an overall average rate of return.
The key thing to be considered here is that you invest money at a different price (also known as NAV) periodically, and each investment will be held for different durations. You can use the XIRR formula to calculate the returns and better understand the difference between XIRR and CAGR.
Differences between XIRR and CAGR
XIRR and CAGR represent returns from your mutual fund investments, but their applications differ. Here is a quick CAGR vs XIRR comparison table that highlights the differences:
Average compounded return for lumpsum investments
Aggregate CAGR of multiple mutual fund investments made within a period
Suitable for lumpsum investments
Suitable for SIP investments/multiple investments spread over time
What is a mutual fund?
A mutual fund is an investment instrument that pools money from different investors. The total pooled amount is then invested in different assets based on the fund’s objectives.
How can I invest in mutual funds?
Consider your current financial profile and goals, and then search for the right funds matching your goals. It is up to you to decide whether you want to invest via lump sum or SIP route.
Is my income from mutual funds exempt from income tax?
The taxation rules related to mutual funds in India depend on the type of funds you select and capital gains.
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Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully.