Internal Rate of Return or IRR and XIRR are two terms that you will often encounter while tracking your mutual fund folio performance. It is important to understand what the internal rate of return is.
Consider the above example. An SIP of 10000 rupees made into the ICICI Value Discovery Fund for 17 years, yielded a CAGR of 19.7%. Here, the CAGR has simply been calculate by taking into consideration the total investment you have made and the final amount that the fund has yielded. However, is this a correct method?
The answer is no. This is because, you were using an SIP to make investments into the plan. Here, your first investment of 10000 rupees stayed in the scheme for the entire duration of 17 years while the last investment must have barely stayed on for one month. Thus, compounded Annual Growth doesn’t paint a clear picture. This is where internal Rate of Return plays a very important role.
IRR helps you calculate a return factoring different time periods; it adjusts for the varying time frames.
When the inflows (that is investments) are in equal intervals IRR is used. When they vary XIRR is used.
Let us take an example of irregular inflows/investments. The below illustration shows inflows and redemptions over different periods.
On absolute terms an investment of Rs 3.1 lakh yielded a return of Rs 5.76 lakh. But it is the Internal Rate of Return of 19% that you have to compare with other asset classes to see how well your fund has fared.
For your mutual fund folio, the returns that a mutual fund company displays is not the absolute return but the XIRR, which takes into account all the investments, redemptions and the dates on which they were made.
Thus IRR is an extremely meaningful data point to help you compare returns when you invest across several time frames. IRR and XIRR can be calculated easily using the IRR and XIRR formula in Microsoft Excel.