CAGR vs XIRR: Which is better for analysing mutual fund returns?

The Compound Annual Growth Rate (CAGR) is the average annual growth rate of a static investment amount over a specific period. However, the Extended Internal Rate of Return (XIRR) is used for investments involving multiple transactions and takes into account the timing and amount of each contribution or withdrawal.

Understanding the difference between these two return measures is important to accurately analyse mutual fund performance. Let's explore what CAGR and XIRR mean, their key differences, and when each metric should be used.

What is CAGR?

CAGR is a measure of the average annual growth rate of a mutual fund investment over a specific period. It shows the rate at which an investment would have grown each year if it had increased at a steady pace from its initial value to its final value.

This metric assumes that all gains generated during the investment period are reinvested, allowing the effect of compounding to be reflected in the final return. While actual returns may fluctuate from year to year, CAGR smooths out these variations and provides a standardised measure for comparing the performance of different mutual funds.

What is XIRR?

XIRR is a return calculation method used for investments that involve multiple cash flows occurring on different dates. It is particularly useful for mutual fund investors who make periodic investments through SIPs, SWPs, or additional lump-sum purchases.

Unlike CAGR, which assumes a single investment and redemption, XIRR takes into account both the amount invested and the exact timing of each transaction. Since SIP instalments are invested at different NAVs, each contribution may generate a different return. XIRR captures these variations and combines them into a single annualised return figure.

XIRR also considers the concept of time value of money, which means that money invested earlier has more time to grow than money invested later.

Difference between CAGR and XIRR

Here is a clear example of the difference between CAGR and XIRR.

Suppose you invest ₹60,000 as a lump sum in a mutual fund and its value grows to ₹85,000 after 5 years. Since there is only one investment and one redemption, CAGR is the appropriate metric to measure returns. In this case, the CAGR comes out at 7.21%.

Now consider a different scenario where you invest ₹1,000 every month through an SIP from 1 January 2020 to 1 January 2025. Over the five-year period, your total investment is still ₹60,000, and assume that the portfolio value at the end is again ₹85,000.

However, the return calculation is different because each SIP instalment is invested on a different date and remains invested for a different length of time. In this case, the appropriate measure is XIRR, which comes out to around 14%.

Hence, CAGR is best suited for lump-sum investments, while XIRR provides a more accurate picture of returns for SIPs involving multiple transactions.

You can easily calculate both CAGR and XIRR using the calculators available on mutual fund and financial websites.

Disclaimer: This is purely for educational/ informational purposes and should not be taken as any sort of investment advice. Always consult a SEBI-registered advisor before making any investment decisions.