Investing in Mutual Funds Through SIP? 6 Things to Know About XIRR

Understanding XIRR: The Gold Standard for Accurately Measuring Your SIP Mutual Fund Returns

Systematic Investment Plans (SIPs) have revolutionized how retail investors approach mutual funds, making investing disciplined and accessible. While many investors track the returns of their SIP investments, there's often confusion about the most accurate method to calculate these returns. This is where XIRR (Extended Internal Rate of Return) comes for the rescue.

Unlike simple return calculations, XIRR provides a more realistic picture of your investment performance by accounting for the timing and amount of each cash flow. What follows are XIRR guidelines meant for the mutual fund holders.

1. What Exactly Is XIRR?

XIRR is a mathematical concept used in finance to ascertain the annualized rate of return on any investment with multiple and irregular time expected series of money cash flows. For instance, when dealing with the case of SIP investments where the investor contributes a fixed or variable amount at regular intervals, XIRR takes into consideration the following:

• The exact dates at which each investment was made by the investor
• What was the amount of the investment each time
• What is the current value of the investment
• And partial withdrawals made thereafter

XIRR, therefore, explains the compound annual return: Which is the respective annual return on the investment, factoring whether each unit of investment of every currency was invested or withdrawn at a particular point of time.

2. Why XIRR Is Superior to Simple Returns

Simple returns are just percentage changes from the original value of the investment to the present value. They are inappropriate in the case of SIPs. Here is why XIRR is more preferable:

• Considers the time-value of money
• Is aware that every investment is made at a given and specific time
• Provides a standard percentage for the year for making comparisons
• Takes into account different sums of investments

For example, if you put ₹5,000 a month for 36 months (summing to ₹1,80,000) and the current value is ₹2,20,000, the absolute gain would be 22.22%. This, however, does not take into account the fact that all of the investment was not operating for the period. XIRR may show 14.8%, which is the correct annual performance.

3. Why XIRR Is Different from CAGR

Both the formulas XIRR and Compound Annual Growth Rate (CAGR) give returns in terms of annualized percentages. The major difference, however, arises in the areas of application:

• In the case of CAGR, it combines the beginning and the ending values in a specific period when analyzing only one sum of money.
• Multiple cash flows, that take place in additions and include withdrawals within the whole time, are best calculated by XIRR which is best suited for SIP (Systematic Investment Plan) mode of investments.

XIRR and CAGR will be inevitably equal in the scenario of a single investment without any more withdrawals or contributions. Nonetheless, CAGR computations are inappropriate for SIP, since all periodic withdrawals are included in the calculation.

4. Calculating XIRR: The Process

Initially, understanding how XIRR is calculated is a very difficult task given the complexity of the mathematical calculation used in deriving it. Thanks to contemporary approaches calculations has become accessible through:

• Spreadsheet applications: Both Microsoft Excel and Google Sheets offer XIRR functions

• Financial calculators: Many online financial calculators offer XIRR calculation tools
• Mutual fund apps: Most investment platforms now display XIRR returns for your SIPs

To calculate XIRR in Excel or Google Sheets:

• List all investment dates in one column
• List corresponding investment amounts as negative values (cash outflows)
• Add the current portfolio value as a positive number (cash inflow) with today's date
• Apply the XIRR function to these ranges

5. Interpreting XIRR Results Correctly

Understanding what your XIRR percentage actually means is crucial:

• A positive XIRR indicates profitable investments
• XIRR of 12-15% is generally considered good for equity mutual funds over the long term
• Short-term XIRR figures may be problematic if excessively high
• Comparing your fund's XIRR with appropriate benchmarks provides context

Please remember that XIRR represents an annualized return percentage. Making it valuable not just for mutual fund SIPs but for evaluating and comparing performance across any investment with multiple cash flows – including fixed deposits, real estate, direct equity investments, bonds, alternative investments, and even business ventures.

6. Limitations of XIRR You Should Be Aware Of

While XIRR is the gold standard for evaluating SIP returns, it has limitations:

• XIRR presumes the reinvestment of each return at the same rate, which is not always feasible or protective of the returns
• It is devoid of the fact that there are risks in achieving the returns or venturing in the particular project
• The timing of deposits or withdrawals can be utilized to enhance the IRR
• In investment duration of less than one year, XIRR might produce exaggerated results

For comprehensive evaluation, consider XIRR alongside other metrics like Sharpe ratio, standard deviation, and maximum drawdown to understand both returns and risks.

Making XIRR Work for Your Investment Strategy

XIRR is not just a mere method of calculation for investments. It is a powerful decision-making tool that helps investors evaluate their portfolio's true performance. When you understand and regularly track the XIRR of your SIP investments, you can:

• Make fair analyses of various mutual funds performance abilities
• Journal your data-driven changes about continuing or stop contributing to a SIP
• Set realistic return expectations based on historical performance
• Evaluate the efficiency levels of a financial advisor

For serious mutual fund investors, regularly calculating XIRR should become a habit. It cuts through marketing promises and delivers the truth about your investment performance.