What is XIRR in mutual funds and its importance in mutual fund investments?

Returns are always the most important metric when it comes to investment. There may be numerous other numbers you have to look at, but at the end of the day, what matters is how much profit you can get from the investment.

But even when it is obvious, many investors forget to properly calculate the returns their investment could give them. Both overestimation and underestimation come with a set of problems here. XIRR, which stands for Extended Internal Rate of Return, is an important metric that could be useful here. Let us learn more about XIRR and see how important it is for mutual fund investments.

The importance of XIRR

The basic purpose of every investment is to obtain returns. Profits may come from two sources: regular revenue and price appreciation. Mutual funds’ returns are often evaluated using either the compound annual growth rate (CAGR) or XIRR. CAGR, as the name implies, is the pace at which your investment increases annually during the investment term, assuming annual compounding. However, in the situation of many cash flows, CAGR or point-to-point returns are irrelevant or cannot be employed, although XIRR in mutual funds may. The purpose of using the XIRR formula in mutual fund management is to determine the overall rate of return on investments if there are several transactions at various periods.

IRR and its shortcoming

In financial analysis, the internal rate of return (IRR) is a metric used to assess the returns on possible investment options. In a discounted cash flow analysis, the discount rate is the percentage of the cash flow’s NPV (net present value) reduced to zero. There is interdependence between the NPV and IRR computations. Remember that the internal rate of return does not equal the worth of the project in cash. The return rate each year causes the net present value to cancel out. But IRR has some shortcomings. When comparing projects, IRR does not consider how big or small each one is. The cash flows are calculated by comparing the quantity of capital invested with the number of cash flows. Although IRR is useful for projecting future cash flows, it is based on the improbable premise that such cash flows can be reinvested at the same IRR rate. It simply isn’t a realistic option.

Why XIRR is important

Compounding annual growth rate (CAGR) is obligatory when deciding mutual fund investment, but the internal rate of return (XIRR) is much more relevant. Most assets do not have cash flows that are equally spaced in time, unlike mutual funds, which use XIRR for investments whose cash payments are evenly split in time. When calculating the return on a series of investments over time, XIRR is a more accurate metric since it considers cash withdrawals, rewards, switches, and other transactions. Mutual funds return calculations are greatly improved by using XIRR.

Converting IRR into XIRR

Fortunately,  XIRR may be used in excel sheets to account for irregular cash-flow periods. With the ability to specify dates for individual cash flows, XIRR provides a more precise computation of returns than its predecessor, IRR.

Conclusion

CAGR is a term that is well-known to many investors. The notion of compounding is at the heart of both CAGR and XIRR in mutual funds. The former may be considered a superset of the latter. If your mutual fund assets generate more than one kind of income, you must calculate your return using the XIRR method.