XIRR and IRR are the most important measures to calculate the rate of returns of the investment.
During the time of realizing profits or losses from an investment made years ago against the amount of initial investment, measures like ROI, IRR and XIRR come into place. They mathematically help us derive a more accurate understanding of the profit or loss made.
XIRR expands to an Extended Internal Rate of Return. It is a single rate of return on the investment made and fetches the current value of the investment. XIRR is a better function to calculate return when the cash flows are spread over the period of years. It allows for more accurate comparisons between different schemes. It takes into account both the timing and magnitude of cash flows, making it a more accurate measure than standard return metrics. XIRR in Mutual Fund is a more crucial metric than SIP because of the pattern of multiple cash flows happening at multiple different time intervals. In mutual funds, the investment made is not very evenly done at different points in time. IRR expands to an internal rate of return. It is a more accurate measure to understand where the cash flows and their time intervals are more uniform and regular in nature.
Despite this, XIRR is often overlooked by investors. This is likely due to the fact that it can be difficult to calculate, especially for those who are not very familiar with financial metrics. However, XIRR in Mutual Fund functions as a crucial metric for understanding the performance of that investment, and as such, it should not be ignored.
Investors often ask us about the importance of XIRR in mutual funds. To put it simply, XIRR is a metric that helps investors measure the performance of their investments. It is more accurate and is a real-time measure than other popular metrics like return on investment (ROI) and internal rate of return (IRR).
XIRR takes into account the timing of cash flows, which is very important because it provides a more accurate picture of how an investment has performed over time. For example, an investment that has gained 10% but has experienced several negative cash flows will have a lower IRR than an investment that has gained 10% but has had positive cash flows throughout the period. XIRR can be mathematically calculated using an inbuilt tool within Microsoft Excel.
To understand the significance of using XIRR in mutual funds for calculating returns, we shall consider an example. Suppose Adam invests Rs. 5,000 in a mutual fund via SIP. He wishes to continue to allocate his savings to this fund for a fixed period of 5 years. Now, let’s assume that after the completion of a time period of 5 years, the total value of his investment made was at Rs. 5,50,000.
In this example, the first installment of Rs. 5,000 was invested for the longest duration of 5 years. As a result of that, the annual return on the first installment amount will not be similar or equal to the returns earned on the subsequent investments made in the fund.
In easier terms, since the investment period for each installment was different, the corresponding compounded annual growth rate (CAGR) was also different. For investors, it is important to understand the performance of the scheme considering the CAGR of each of these monthly investments can be quite challenging.
Returns usually help investors benchmark their investment over a period of time and XIRR can give a better indication of loss or profit made from an investment. While XIRR in mutual funds is a more accurate measure of performance, it is important to remember that it is not the only metric that should be considered when making investment or redemption decisions.