Return and risk: The two most important characteristics of any Investment venture may it be mutual funds or real estate.

New mutual fund investors often grapple with different metrics used to calculate and state investment returns.

In this blog, we see how to interpret these metrics and which metric fits best where…

Absolute Return

This is the simplest of all the return metrics we are going to discuss here.

Absolute return measures the absolute increase in your portfolio.

Let’s say you invested Rs. 10,000 on 1^st June 2008. The value of your portfolio becomes Rs. 15,000 on 1^st June 2010. What do you think is the absolute return of your portfolio?

It is 50% calculated as follows –

Now, let’s say you invested Rs. 30,000 on 1^st Jan 2009 and the value of your portfolio becomes Rs. Rs. 40,000 on 1^st Feb 2009. What do you think the absolute increase in your portfolio is?

It’s about 33%!

When it comes to absolute return, the timeline doesn’t matter. What matters are only two variables – the investment amount and the current portfolio amount – that’s it!

Absolute return is rarely used as a formal return metric though you might see it on many Mutual Fund Investment portals. But it doesn’t tell you how well your investment is doing when compared to, let’s say, an FD with an interest rate of 7% per annum!

Compounded Annual Growth Rate (CAGR)

CAGR is where time is of importance.

What do you mean when your bankman says that the bank fixed deposit will earn you 7% interest per annum for 5 years? (We assume you do not choose the interest payout option)

Here’s what exactly he means –

If you invest Rs. 1,00,000 in an FD which has a 7% interest rate per annum the above is how your money grows year on year.

As you can see, the interest component increases every year! It is not Rs. 7000 every year which is 7% of the invested amount.

If you remember your high school mathematics, I just helped you understand the difference between simple interest and compound interest.

In simple interest, the interest is calculated on the initial investment and the interest is constant as long as the investment amount is constant.

In compound interest, on the other hand, the interest is calculated on the investment corpus and interests accrued already. This creates a snow-ball effect!

Question – How much will be Rs. 1,00,000’s value if it is invested for 10 years at 10% simple interest and 10% compound interest?

Answer –

This is what is referred to as ‘power of compounding!’

The gap between the total interest earned will only widen with time.

CAGR is best suited to calculate the return of a lumpsum investment in mutual funds. For calculating the returns of an SIP investment, IRR is used.

XIRR (Extended Internal Rate of Return)

I know this is the one you were looking for!

Let’s see what IRR is and then XIRR is just an extension of it.

IRR stands for internal rate of return and gives us the annual growth rate given a bunch of regular cashflows and dates of the cashflows.

XIRR, on the other hand, stands for extended internal rate of return and give us the annual growth rate given a bunch of cashflows that may be irregular and dates of cashflows.

Let’s see where you see XIRR as the return metric used – an SIP in mutual funds.

Let’s assume you invest Rs. 10,000 every month for 12 months on the 1^st of every month. Now the value of your portfolio is Rs. 1,30,000 on the last day of the 12^th month.

How will you calculate your returns? CAGR won’t work because there are multiple investments made at different points in time. Here’s how XIRR will help you…

Here’s how I calculated the XIRR above –

The timeline, cashflows and NAVs values are known.

We then calculate how many units we bought by investing Rs. 10,000 every month for 12 months at different NAVs prevalent on the purchase dates.

On 31^st Dec you are in possession of a number of units bought over the last 12 months. The value of these units is (Number of units bought * current NAV)

This gives us Rs. 1,30,000 as the value of the units we possess.

Next, use the XIRR formula in excel – the inputs required are the dates (column 1) and cashflows (column 2). The XIRR of the above set of cashflows comes out to be 15.75%.

This will change every time the current NAV changes – it is likely to be different on 1^st Jan 2020.

In conclusion

Absolute return gives you the absolute return your portfolio. It is not a very useful metric since it doesn’t tell you the rate of growth since time is not of importance while calculating absolute return.

CAGR gives the annual rate of growth of a lumpsum investment.

XIRR helps you understand the annual growth rate of a bunch of cashflows which is what a mutual fund SIP is – a cash outflow when you invest and a cash inflow when you redeem.

The post XIRR, CAGR, Absolute Return: Measures of Mutual Fund Investment Returns Explained appeared first on Finpeg Blog.