What is XIRR in Mutual Funds and how does it work?

When you're thinking about investing in mutual funds, knowing how much money you're making is just as important as picking the right fund. Many people get mixed up between terms like CAGR, Absolute Returns, and XIRR. Out of these, XIRR is the most accurate way to calculate returns, especially when you invest at different times. In this blog, we'll explain what XIRR is, how it works with mutual funds, and why it matters for investors.

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What is XIRR?

XIRR stands for Extended Internal Rate of Return. It is a way to calculate the yearly growth rate of your investments when you make them at different times. Unlike other methods that treat all investments as happening at once, XIRR looks at each investment separately, including the date it was made. This makes it especially useful for regular investments like Systematic Investment Plans (SIPs) or when you make several lump sum investments in mutual funds.

In simple words, XIRR shows how much your money has increased each year, taking into account every time you invested or withdrew money. It gives a more accurate view of your returns compared to just using average returns or CAGR when you invest at different times.

Why XIRR is Important

Investors often wonder: Why can't I just use CAGR or simple returns? Here's why XIRR is better in many situations:

1. Handles Multiple Investments: Most investors put money into mutual funds little by little over time. CAGR is based on putting all the money in at once, but XIRR takes into account each time they invest.
   
   

2. Accounts for Withdrawals: If you take out part of your investment during the period, XIRR properly shows how it affects your overall returns.
   
   

3. Better Comparison Tool: It lets investors see how much money they can make from different funds or investment plans in a realistic way.
   
   

4. Realistic Reflection of Cash Flows: Because investments and withdrawals don't take place on the same day, XIRR gives an accurate picture of how well your investments are doing.
   

How XIRR Works in Mutual Funds

To understand XIRR better, let’s break it down step by step.

1. Understanding Cash Flows

XIRR is calculated using the cash flows. A cash flow happens when money is spent (like making an investment) or when money is received (such as getting back money through a redemption or receiving a dividend).

• Outflow (negative cash flow): When you put money into a mutual fund, it feels bad because you're spending your money.
  
  

• Inflow (positive cash flow): When you get dividends or use your rewards, it's good because money is coming back to you.

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2. Calculation Example

Let’s consider an example to make it simple:

Suppose you invested in a mutual fund as follows:

To calculate XIRR:

1. Take each cash flow and its date.
   
   

2. Apply the XIRR formula or use Excel/Google Sheets. In Excel, the formula is:
   
   

=XIRR(values, dates)

Here:

• Values: [-10000, -10000, -10000, 32000]
  
  

• Dates: [01-Jan-2023, 01-Apr-2023, 01-Jul-2023, 31-Dec-2023]
  
  

The result will show the annualized return, which takes into account when each investment was made and when the money was taken out.

Factors That Affect XIRR

Several factors influence your XIRR in mutual funds:

1. Timing of Investment: Earlier investments earn more over time, increasing XIRR.
   
   

2. Amount Invested: Larger investments at favorable market conditions can improve XIRR.
   
   

3. Market Returns: Mutual fund performance directly impacts inflows at redemption.
   
   

4. Frequency of Investments: Regular SIPs spread across market cycles usually give better XIRR.
   

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Advantages of Tracking XIRR

1. Accurate Measurement: Gives a realistic annualized return.
   
   

2. Portfolio Planning: Helps in understanding which fund or SIP is performing better.
   
   

3. Financial Goal Assessment: Allows you to check if your investments are on track to meet long-term goals.
   
   

4. Better Decision-Making: Helps decide whether to continue, stop, or switch funds.
   

Limitations of XIRR

While XIRR is extremely useful, it has a few limitations:

1. Assumes Reinvestment at Same Rate: XIRR assumes intermediate cash flows are reinvested at the same rate, which may not always happen.
   
   

2. Dependent on Cash Flow Accuracy: Any missing or incorrect transaction can lead to wrong XIRR.
   
   

3. Doesn’t Predict Future Returns: XIRR is historical; it doesn’t guarantee future performance.
   

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Conclusion

XIRR is a dependable way to check how well your mutual fund investments are doing, especially if you've made regular contributions or multiple transactions. It takes into account both the sizes and the times of your investments, giving you a clear idea of how much your money has grown over time.