XIRR in Mutual Funds: Meaning and Calculation of XIRR

If you invest in mutual funds through SIPs or make multiple transactions, calculating your actual returns can be tricky. Simple return methods don't account for timing and irregular cash flows. XIRR solves this problem by giving you accurate, annualised returns that reflect your real investment performance. In this blog, we will understand the meaning of XIRR, the XIRR formula, how to calculate it, and its example.

What is XIRR In Mutual Funds?

In India's mutual fund market, most people don't invest everything at once. They invest in parts over months or years. This is where XIRR becomes very useful. XIRR stands for extended internal rate of return. This is a financial tool that helps you calculate the yearly return on your mutual fund investments. 

XIRR works with multiple cash flows that happen at different times. When you invest in mutual funds through SIPs or make various investments and withdrawals, XIRR gives you the most accurate picture of your returns.

When and why to Use XIRR?

You should use XIRR when your investment pattern involves multiple transactions at different times. If you invest through SIPs every month but sometimes skip installments, XIRR is your best choice. When you start with a lump sum and add more money later, XIRR gives you accurate results.

XIRR also works well if you use Systematic Withdrawal Plans. These plans let you take out money regularly from your investments. Any time your cash flows don't follow a single fixed pattern, XIRR helps you understand your real returns.

Regular return calculations like absolute returns don't consider timing. Even CAGR has limitations when you have irregular cash flows. XIRR solves this problem by looking at every transaction's date and amount. This gives you a true picture of how your investments have performed over time.

What is the XIRR Formula?

The XIRR formula works on a simple principle. It finds the rate where the net present value of all your cash flows equals zero. The formula balances all money going out (investments) with money coming in (withdrawals and current value). The mathematical expression looks like this:

In this formula, C represents your cash flows. Investments are negative numbers because money leaves your pocket. Withdrawals are positive because money comes back to you. The d values represent dates, and r is the XIRR rate you're trying to find.

You don't need to solve this formula by hand. Excel and Google Sheets have built-in functions that do complex calculations for you. The computer uses trial-and-error methods to find the exact rate that makes the equation work.

How To Calculate XIRR

Step 1: Open Excel or Google Sheets and create two columns. Label the first column as "Date" and the second column as "Cash Flow." This basic setup will hold all your transaction information in one organised place.

Step 2: In the first column, enter all the dates when you made investments or withdrawals. Start with your earliest transaction and work forward chronologically. Make sure you use a consistent date format that your spreadsheet software can recognise.

Step 3: In the second column, enter the money amounts for each transaction. Follow this important rule: investments are negative numbers and withdrawals are positive numbers. This convention works because investments take money out of your pocket while withdrawals bring money back to you.

Step 4: If you still hold some units and haven't withdrawn everything, add one more row. Enter today's date and the current market value of your remaining investment as a positive number. This step tells Excel what your investment is worth right now.

Step 5: Click on an empty cell where you want your result to appear. Type the XIRR formula using your data ranges. For example, if your cash flows are in column B and dates are in column A, type equals XIRR followed by your ranges in parentheses.

Step 6: Press Enter, and Excel will calculate your XIRR automatically. The result appears as a decimal number. Convert this number into a percent by multiplying it by 100. This percentage shows your annualised return rate considering all your transactions and their timing.

Real-World Use Cases Of XIRR

Let's look at a simple XIRR example to understand it better. Suppose you invest ₹10,000 on January 1st, 2024. Six months later, on July 1st, you add another ₹5,000. By January 1st, 2025, your total investment value grows to ₹18,000.

In your Excel sheet, you would enter three rows. The first row shows January 1st, 2024, with a minus ₹10,000. The second row shows July 1st, 2024, with a minus ₹5,000. The third row shows January 1st, 2025, with ₹18,000.

When you apply the XIRR formula to this data, it calculates your annualised return. This return considers that your first investment had a full year to grow, while your second investment had only six months. This timing difference is important and affects your overall return rate.

Limitations of XIRR

• Assumes Constant Reinvestment Rate: XIRR assumes you can reinvest all cash flows at the same rate. In reality, this might not always be possible due to changing market conditions.

• Limited Investment Opportunity Assumption: You might not find similar investment opportunities at the same return rate when you need to reinvest your money.

• Overkill for Simple Investments: For simple lump sum investments held for fixed periods, CAGR is easier to calculate and just as accurate. XIRR's complexity is only worthwhile when you have multiple or irregular cash flows.

• Not Always Practical: If your investment pattern is simple with single transactions, stick with simpler calculation methods that require less effort and provide similar insights.

Conclusion

XIRR is essential for mutual fund investors using SIPs or making multiple transactions. While it requires Excel for calculation, XIRR provides the most accurate annualised returns by considering the timing and amounts of all cash flows. Use XIRR for complex investments and CAGR for simple lump-sum investments.