Measuring Mutual Fund Returns : Understanding CAGR, XIRR, and Absolute Return

Understanding CAGR, XIRR, and Absolute Return

Introduction

In the world of investments, it is essential to gauge and evaluate the performance of your portfolio accurately. When it comes to measuring returns, three common metrics stand out: Compound Annual Growth Rate (CAGR), Extended Internal Rate of Return (XIRR), and Absolute Return.

In this blog, I’ll delve into these metrics, understand how they work, and explore their implications for investors.

#1: Compound Annual Growth Rate (CAGR)

What is CAGR?

Compound Annual Growth Rate (CAGR) is a metric used to measure the average annual growth rate of an investment over a specific period. It provides a standardized way to compare the returns of investments with different durations. CAGR takes into account the compounding effect, which means it considers the reinvestment of gains over time. This metric helps investors understand the consistent growth rate required to achieve the final investment value.

Calculating CAGR: Formula and Example

The formula to calculate CAGR is: 

CAGR = (Ending Value / Beginning Value) ^ (1 / Number of Years) - 1

To illustrate this, let's consider an example: You invested Rs 10,000 in a mutual fund five years ago, and today, the investment has grown to Rs 15,000. Using the CAGR formula:

CAGR = (15,000 / 10,000) ^ (1 / 5) - 1 CAGR = 1.5 ^ 0.2 - 1 CAGR = 1.095 - 1 CAGR = 0.095 or 9.5%

Therefore, the CAGR of your investment over the five-year period is 9.5%. This means that, on average, your investment has grown by 9.5% per year.

Understanding CAGR's Significance

CAGR is valuable because it smooths out the impact of market volatility and provides a more accurate representation of long-term investment growth. It helps investors compare different investments or strategies with varying time periods. Unlike simple average returns, CAGR accounts for compounding, giving a more realistic picture of the investment's performance over time.

Interpretation and Limitations of CAGR

Interpreting CAGR requires caution. It assumes that the investment grew at a steady rate year after year, which might not be the case in reality. CAGR does not consider fluctuations or volatility within the given period. Additionally, it assumes that all gains were reinvested, which might not always be possible. CAGR should be used alongside other metrics and factors to obtain a comprehensive understanding of an investment's performance.

Overall, CAGR is a powerful metric for evaluating the compounded growth rate of an investment over a specific time frame. It provides a standardized way to assess long-term returns, enabling investors to compare investments and set realistic expectations for future growth.

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#2: Extended Internal Rate of Return (XIRR)

What is XIRR ?

Extended Internal Rate of Return (XIRR) is a financial metric used to calculate the annualized return on an investment with irregular cash flows. Unlike CAGR, which assumes a fixed investment amount and regular intervals, XIRR considers varying cash flows at different points in time. It is especially useful when investments involve multiple transactions or when cash flows are not evenly distributed.

How to Calculate XIRR?:

Method and Example Calculating XIRR involves determining the discount rate that equates the present value of all cash inflows and outflows to zero. This rate represents the annualized return on the investment. While the calculation can be complex, spreadsheet software or financial calculators can automate the process.

Here's an example to illustrate the calculation:

Consider Investment B, which involved irregular cash flows. You initially invested Rs 20,000, and after one year, you received a dividend payment of Rs 2,000. Two years later, you received an additional dividend of Rs 1,500. To evaluate the annualized return using XIRR, you input the cash flow data into a financial tool or spreadsheet and calculate the XIRR value, which represents the annualized return: XIRR = 9.72%

The XIRR of Investment B is 9.72%, reflecting the annualized return considering the irregular cash flows and their timings.

The Power of XIRR in Complex Scenarios

XIRR is particularly valuable when investments involve multiple transactions, irregular cash flows, or different holding periods. It considers the timing and magnitude of each cash flow, providing a more accurate measure of investment performance. XIRR allows investors to assess the true rate of return, taking into account the timing and size of cash inflows and outflows.

Evaluating XIRR's Strengths and Weaknesses

XIRR offers several strengths as a performance metric. It accommodates irregular cash flows, provides a more accurate assessment of investment returns, and allows for comparison between investments with different cash flow patterns. However, it is important to note that XIRR assumes cash flows are reinvested at the same rate, which might not be practical in all cases. Additionally, XIRR relies on accurate input of cash flow data and can be sensitive to outliers or incorrect information.

# 3: Absolute Return

What is Absolute Return ?

Absolute return is a measure of the total return generated by an investment over a specific period, expressed as a percentage or a monetary value. Unlike CAGR and XIRR, which focus on the average annual growth rate, absolute return provides a straightforward assessment of the overall gain or loss without considering the time factor. It reflects the actual profit or loss realized from an investment, irrespective of the duration or compounding effects.

Absolute Return Calculation:

The formula to calculate absolute return is:

Absolute Return = (Ending Value - Beginning Value) / Beginning Value * 100

Here's an example to illustrate the calculation:

Suppose you invested Rs 30,000 in Investment C, and after two years, the investment value increased to Rs 36,000. To calculate the absolute return:

Absolute Return = (36,000 - 30,000) / 30,000 * 100 

Absolute Return = 6,000 / 30,000 * 100 

Absolute Return = 0.20 * 100 Absolute Return = 20%

The absolute return of Investment C is 20%, indicating a profit of 20% over the two-year period.

To evaluate Investment C's performance against a benchmark, let's assume the benchmark achieved an absolute return of 15%. Comparing Investment C's absolute return of 20% with the benchmark's 15% shows that Investment C outperformed the benchmark by 5%.

Interpreting Absolute Return and its Application

Absolute return provides a clear indication of the actual gains or losses made from an investment, making it a useful metric for assessing performance. Positive absolute returns indicate profits, while negative absolute returns signify losses. It helps investors understand the success or failure of their investment decisions, regardless of the time taken to achieve those returns.

Absolute return is often used for comparing investment performance against a benchmark or a set target. For example, if the benchmark achieved an absolute return of 15%, and your investment achieved a return of 20%, it indicates that your investment outperformed the benchmark by 5%.

Comparing Absolute Return with Relative Performance

While absolute return is a valuable metric, it is important to consider it in conjunction with relative performance. Relative performance compares an investment's return to a benchmark, market index, or peer group, taking into account the overall market performance. It provides insight into whether an investment outperformed or underperformed the broader market conditions.

By combining absolute return and relative performance analysis, investors can gain a comprehensive understanding of their investment performance. Absolute return highlights the actual gains or losses, while relative performance provides context by comparing those returns to a broader market or benchmark.

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# 5: Which Metric to Use?

Understanding the Purpose of Each Metric

Let's explore when and how to use each metric effectively.

Choosing CAGR for Long-Term Growth Assessment

CAGR is an ideal metric when evaluating long-term investment growth. It considers the compounding effect and provides an average annual growth rate, smoothing out short-term fluctuations. Use CAGR when you want to assess the steady growth rate required to achieve a specific investment target or when comparing investments with consistent holding periods. It provides a standardized measure of growth, making it useful for long-term planning and setting realistic expectations.

Utilizing XIRR for Irregular Cash Flows and Multiple Transactions

XIRR is particularly valuable when dealing with investments involving irregular cash flows or multiple transactions. It accounts for the timing and magnitude of each cash flow, providing an accurate measure of the investment's performance. Use XIRR when analyzing investments with varying holding periods, intermittent cash flows, or complex investment structures. It helps assess the annualized return, considering the actual cash flow patterns and irregularities.

Applying Absolute Return for Overall Gain/Loss Assessment

Absolute return is a straightforward metric that measures the total gain or loss of an investment without considering the time factor. Use absolute return when you want a clear understanding of the actual profit or loss realized from an investment. It provides a simple assessment of performance and is useful for comparing investment returns against benchmarks or evaluating investments with different durations. Absolute return is effective in situations where the time factor is not a primary consideration.

Conclusion:

In summary, CAGR, XIRR, and absolute return are powerful metrics for analyzing investment performance. Each metric serves a unique purpose and offers valuable insights into different aspects of returns and growth. By understanding the strengths and applications of each metric, investors can choose the most appropriate one based on their specific requirements and gain a comprehensive understanding of their investment performance.

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