CAGR vs XIRR in Mutual Funds: Understanding Key Metrics for Smarter Investing

Investing in mutual funds is one of the most popular ways to grow wealth over time. However, to evaluate the performance of mutual fund investments, it is essential to understand key financial metrics such as CAGR (Compound Annual Growth Rate) and XIRR (Extended Internal Rate of Return). Both these metrics help investors analyze returns effectively but are used in different contexts.

In this article, we will delve deep into the concepts of CAGR and XIRR in mutual funds, their differences, formulas, calculations, and how they help investors make informed investment decisions.

What is CAGR in Mutual Funds?

CAGR, or Compound Annual Growth Rate, is the average annual return of an investment over a specific period, assuming the profits are reinvested each year. It helps investors understand how their mutual fund investment has grown year-over-year in a smooth manner, even if the actual returns fluctuate.

Formula for CAGR

The formula to calculate CAGR is:

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

Example Calculation of CAGR

Let’s say you invested ₹1,00,000 in a mutual fund, and after 5 years, your investment grows to ₹1,80,000.

Using the formula:

CAGR = (1,80,000 / 1,00,000) ^ (1 / 5) - 1

CAGR = (1.8) ^ 0.2 - 1

CAGR = 0.1257 = 12.57%

So, the CAGR of this mutual fund investment is 12.57% per annum over 5 years.

When to Use CAGR in Mutual Funds?

CAGR is useful in the following situations:

• Lump Sum Investments – If you have made a one-time investment in a mutual fund, CAGR helps determine the annualized return.
• Comparing Mutual Funds – Investors can compare the historical performance of different mutual funds using their CAGR over the same period.
• Long-Term Investment Analysis – CAGR provides a smoothed return rate, making it ideal for evaluating long-term investments.

Limitations of CAGR

• Ignores Market Volatility – CAGR assumes constant returns every year, but in reality, market returns fluctuate.
• Does Not Work for SIP Investments – If you invest regularly through SIP (Systematic Investment Plan), CAGR does not accurately reflect returns.

What is XIRR in Mutual Funds?

XIRR, or Extended Internal Rate of Return, is a more advanced way of calculating returns, especially for SIP (Systematic Investment Plan) investments. Unlike CAGR, which assumes a lump sum investment, XIRR considers multiple cash flows at different times.

XIRR calculates the annualized return rate for multiple investments made at different intervals and is the best metric for SIP-based mutual fund investments.

Formula for XIRR

XIRR is calculated using an iterative approach (not a simple mathematical formula like CAGR). It finds the discount rate that satisfies the following equation:

NPV = Sum of (Cash Flow at Time t / (1 + r) ^ t) = 0

where NPV (Net Present Value) is 0, Cash Flow represents investments and withdrawals, t represents the corresponding time periods, and r is the XIRR (rate of return).

This equation is complex and requires software like Microsoft Excel, Google Sheets, or a financial calculator to solve.

Example Calculation of XIRR in SIP Investments

Let’s assume an investor makes the following SIP investments:

Now, to calculate XIRR in Excel:

List all the investment amounts as negative values (outflow) and the final amount as a positive value (inflow).

Use the XIRR formula:

= XIRR(values, dates)

The Excel formula will return an XIRR of approximately 14.5%.

This means the SIP investment generated an annualized return of 14.5% over 5 years.

When to Use XIRR in Mutual Funds?

XIRR is ideal for SIP investors and should be used in the following scenarios:

• SIP Investments – If you invest in mutual funds via SIP, XIRR accurately measures your annualized returns.
• Multiple Cash Inflows/Outflows – If you invest at different times or redeem partial amounts, XIRR provides a precise return rate.
• Comparing Different Investment Methods – XIRR helps compare SIP versus lump sum returns effectively.

Limitations of XIRR

• Complex Calculation – XIRR cannot be calculated manually and requires tools like Excel or Google Sheets.
• Sensitive to Timing of Investments – Returns fluctuate based on investment dates and cash flow patterns.

Difference Between CAGR and XIRR in Mutual Funds

Which is Better: CAGR or XIRR?

• If you invest a lump sum amount, use CAGR to measure your mutual fund performance.
• If you invest through SIP, use XIRR because it considers multiple investment dates and cash flows.
• For long-term investors, both CAGR and XIRR are useful, but XIRR provides a more realistic return percentage.

Both CAGR and XIRR are important metrics in mutual fund investing. While CAGR is great for lump sum investments, XIRR is the preferred choice for SIP investors or those with multiple cash flows.

Understanding these metrics can help investors make informed decisions, track their mutual fund performance, and plan their financial goals effectively. By using CAGR and XIRR, investors can better assess whether their investments are growing at an expected rate and make adjustments accordingly.

If you are investing in mutual funds, it is always recommended to check both CAGR and XIRR for a holistic view of your portfolio returns.