XIRR Vs Absolute Returns
The returns that are accrued on mutual fund investments may be a bit confusing to calculate, especially if you are a newbie at investing. To the majority of investors, the computation of returns has a large role to play in investment and in trying to choose the products for investment. However calculations can be puzzling when stated. For instance, if a fund declares that it has yielded a 15% return within 5 years, what exactly does that mean for the investor?
The two well known and much-used ways to do this are XIRR and absolute returns. However, how do you know whether to opt for XIRR vs. absolute returns? Furthermore, you may be flummoxed as to what return applies to a SIP compared to a lump sum investment. However, once you grasp what both types of calculations entail, you can judge which to use.
Understanding Absolute Returns
A basic way to calculate returns in a mutual fund is to use absolute returns. This simple calculation refers to the difference between the initial investment made and any loss or gain at a given point. For instance, let's say you invested Rs. 10,000 five years back. Currently, your value is Rs. 15,000. That means that your absolute return is 50% in this period of time. However, this isn’t an accurate calculation.
When you compare XIRR vs. absolute returns, there is no accountability for time, volatility of markets, etc. with absolute returns. Hence, this method is typically used to compute returns within a year. If you wish to calculate returns of above a year, other measures may be used.
When to Use Absolute Returns
To illustrate when to use absolute returns and why you cannot use it under some instances, let us consider two options. One is to invest Rs. 10,000 in Fund X and get a return of Rs. 50,000. The other is to invest in Fund Y and get a return of Rs. 1 lakh. Clearly, Fund Y looks like the winner here. However, neither of these statements on returns have accounted for the time factor. Then your decision to go with the “winner” may be incorrect. When you want to compute returns for short periods, you can use absolute returns. Furthermore, when you wish to compute returns on a SIP, and the investment rises regularly, absolute returns don’t help.
An Illustrated Example of How to Calculate Absolute Returns
When to use absolute returns vs. XIRR may have become somewhat clear now, but an illustrated example with a formula may help you to grasp concepts further. The formula to calculate absolute returns is:
(Maturity Value - Investment Value)/Investment Value = Absolute Returns
Note, in the formula mentioned above, there is no factor of time involved. Only the values (amounts) are considered, and this is why the picture that absolute returns gives you is incomplete. Now if we use the examples of two funds above, according to the formula, Fund X would generate returns of 500%, and Fund Y would yield 1000% returns. However, what if Fund Y has taken a span of 10 years to generate the 1000% return, and Fund X has taken only 3 years to give you a 500% return? Then, won’t you think that Fund X is a better bet? This is how the factor of time has to be accounted for in any calculation of returns.
The acronym “XIRR” represents “Extended Internal Rate of Return”. This metric is effective to calculate returns in multiple investments, such as you find with a SIP. Hence, when opting for an exact calculation of returns, the choice between XIRR vs. absolute returns is easy. XIRR is that rate of return, as applied to each of your investments, that gives you the present value of your investment. The result that you get with an XIRR calculation takes into account several investments with periods. The results that this generates are exact with staggered investments over time.
When to Use XIRR
Now that you know why XIRR is used, you have probably come to the conclusion of when this can be used. Apart from calculating your returns on a SIP, XIRR can generate precise returns when you have made deposits of an irregular nature. XIRR is also a useful tool to give you exact returns of redemptions on a mutual fund.
An Illustrated Example of How to Calculate XIRR
In the options of absolute returns vs. XIRR, the extended internal rate of return tool is used more as it gives you results you can rely on. With different inflows and outflows of cash, as in the case of SIPs, the XIRR is used for returns in each fresh instalment in a SIP (that could be said to be a new investment within a SIP). For instance, if you have begun a SIP of Rs. 5,000 through a mutual fund, for a tenure of 5 years, your first instalment will be Rs. 5,000 for 60 months (12x5), the second instalment for 59 months, the third instalment for 58 months, and on and on like this.
The XIRR takes into account the way that every instalment gets compounded for a varying time span. Therefore, when XIRR is computed, the investment and the accumulated interest will be considered. If an investor invested Rs. 3 lakh in a five-year period, but the value of the said investment surged to Rs. 4 lakh in five years, then the XIRR would be 10.33%. How does this calculation take place? You need to do it on an Excel spreadsheet in the following steps:
- Open a sheet in Excel.
- In a column “A”, type in the dates of transactions (assume the 1st of each month for 5 years, that is, 60 months.
- In the next column, “B”, enter the SIP amount of 5,00, but do so as a negative figure as this is because it is an outflow of cash.
- In column A, against the date of redemption (after the 60 instalments), type in the total investment value in column B (4 lakh).
- In the box that appears below the one in which you have written 4 lakh, you must enter: “ = XIRR (B1:B61, A1:A61) * 100. Now hit “Enter”.
- The XIRR value as 10.33 will be shown as your result. This is your yearly SIP return.
When you look at XIRR vs. absolute returns, you may think that the XIRR calculation is more difficult to do. However, this is a more accurate way to calculate returns, and precision is a must in the computation of SIP returns. This way, you can decide how much of a further investment to make or whether you want to exit your mutual funds.
- What is the formula to compute absolute returns?
In order to compute absolute returns, the following formula is made use of:
(Value of Maturity - Value of Investment)/Value of Investment = Absolute Returns
- What is a suitable or good XIRR in mutual funds?
There is no such thing as a “good return” where mutual funds are concerned. However, typically, on equity mutual funds, a 12% XIRR (for a 10-year period) is considered suitable.
- What is a negative value in XIRR?
When the cash flows generated by the investment are less than the value of the initial investment, a negative XIRR occurs.
- Is there an online XIRR calculator?
A SIP online calculator can tell you the returns you will get on a particular SIP by entering inputs in the fields required for the calculation, such as amount invested, tenure, expected rate of return, etc.
- In mutual funds, what is meant by absolute returns?
In mutual funds, absolute returns refer to any returns that are generated by a particular fund over a period. Absolute returns are represented as a percentage and display the amount of growth or depreciation of an investment.