Source/Contribution by : NJ Publications
Returns Evaluation activity is done by investors quite often. We want to be aware of the clear position of our investments, what is our portfolio return, which investments are faring better than others, etc. There are various measures of return like Absolute Return, CAGR, Annualized Return, IRR, XIRR, etc. used to compute the performance of investment products. In this passage we will concentrate on the applicability of IRR and XIRR methods.
Performance stats of Mutual Fund schemes are generally expressed in terms of CAGR, i.e. compounded annual growth rate or Absolute Return if the period of investment is less than a year. Absolute Return is simply the difference between the beginning and the ending value of your investment, expressed in percentage terms. For Eg. You invested in a Mutual Fund Scheme on 1 Jan 2017, when the NAV was Rs 10, on 1st July 2017 it is Rs 12, so the absolute return is 20%. Here, the holding period is not taken into consideration. CAGR will give you the compounded annualized return number on your investment, so continuing the above example, if on 1st July 2019, the NAV grows to 20, then the CAGR is 41.42% from 01 Jan 2017.
However, these formulas have their limitations, they can be used in measuring point to point returns only. If there is a stream of inflows or outflows, like dividends from shares, or SIP investments, etc., then IRR and XIRR formulas should be used to get annualized return.
What is IRR?
IRR or Internal Rate of Return is a method for calculating returns from an investment, where the number of inflows or outflows are multiple. For Example, if you want to calculate the returns from your SIP investment of Rs 5,000 a month which you did for 3 years, it will be cumbersome to calculate the CAGR for each SIP installment, the first installment for 36 months, then 35 months, and so on until 1 month. IRR is a simple formula in excel which you can use to find out the cumulative return on your investment. Or, if you want to compare your SIP investment with any other periodic investment of yours like if you have also been investing in a Recurring Deposit over the same period, you can use the IRR formula to compare the returns from your investments. Your advisor can help you in applying the formula and analyze various returns. If you are an investor with NJ, you don't have to worry about using IRR either for your SIP investment, you can get the IRR number anytime on your investment from your Client Desk.
However, the IRR method can be used only when the inflows or outflows are regular, for irregular cashflows, there is an extension to the IRR formula, called the Extended Internal Rate of Return or XIRR. XIRR can be used in both scenarios, i.e. when the cash flows are regular or whether they are irregular. Now for instance, over these three years you have also invested in gold, lets say you bought Rs 20,000 worth of gold twice and Rs 30,000 worth of gold thrice, and all these investments were done at different time intervals. If you want to evaluate the overall return from your gold investment, then you can use the XIRR formula in excel to arrive at the same. You can also compare the performance of your SIP investment with the gold investment over the same time period, with the XIRR formula.
XIRR for analyzing Portfolio Returns. Investors generally invest in a number of investment products belonging to different asset classes over different time periods. If an investor has a portfolio of Mutual Funds, Bonds, Real Estate, Gold and PPF, and this investor wants to have a holistic picture of the Portfolio performance, so he must analyze his total Portfolio Return. The investor has to enter the purchase prices, the dates of purchase and the present value of all these investments in excel, with the help of the XIRR formula, the investor will have his Portfolio returns number. You can also compare the different investments in the Portfolio with the XIRR formula.
There are various return measures used to depict the performance of different investment products by the investment product providers. But for analyzing and comparing returns on a personal level, the IRR and XIRR formulas come in handy. You can seek help from your financial advisor for using these formulas and evaluating your investments individually, make comparisons or for getting a comprehensive view of your Portfolio.