Return and risk: The two most important characteristics of any investment venture may it be mutual funds or real estate.

New mutual fund investors often grapple with different metrics used to calculate and state investment returns.

In this blog, we see how to interpret these metrics and which metric fits best where

This is the simplest of all the return metrics we are going to discuss here.

Absolute return measures theabsoluteincrease in your portfolio.

Lets say you invested Rs. 10,000 on 1stJune 2008. The value of your portfolio becomes Rs. 15,000 on 1stJune 2010. What do you think is the absolute return of your portfolio?

Now, lets say you invested Rs. 30,000 on 1stJan 2009 and the value of your portfolio becomes Rs. Rs. 40,000 on 1stFeb 2009. What do you think the absolute increase in your portfolio is?

When it comes to absolute return, the timeline doesnt matter. What matters are only two variables the investment amount and the current portfolio amount thats it!

Absolute return is rarely used as a formal return metric though you might see it on many mutual fund investment portals. But it doesnt tell you how well your investment is doing when compared to, lets say, an FD with an interest rate of 7% per annum!

What do you mean when your bankman says that the bank fixed deposit will earn you 7% interest per annum for 5 years? (We assume you do not choose the interest payout option)

If you invest Rs. 1,00,000 in an FD which has a 7% interest rate per annum the above is how your money grows year on year.

As you can see, the interest component increases every year! It is not Rs. 7000 every year which is 7% of the invested amount.

If you remember your high school mathematics, I just helped you understand the difference between simple interest and compound interest.

In simple interest, the interest is calculated on the initial investment and the interest is constant as long as the investment amount is constant.

In compound interest, on the other hand, the interest is calculated on the investment corpus and interests accrued already. This creates a snow-ball effect!

Question How much will be Rs. 10,00,000s value if it is invested for 10 years at 7% simple interest and 7% compound interest?

This is what is referred to as power of compounding!

The gap between the total interest earned will only widen with time.

CAGR is best suited to calculate the return of alumpsum investment in mutual funds. For calculating the returns of an SIP investment, IRR is used.

Lets see what IRR is and then XIRR is just an extension of it.

IRR stands for internal rate of return and gives us the annual growth rate given a bunch of regular cashflows and dates of the cashflows.

XIRR, on the other hand, stands for extended internal rate of return and give us the annual growth rate given a bunch of cashflows that may be irregular and dates of cashflows.

Lets see where you see XIRR as the return metric used an SIP in mutual funds.

Lets assume you invest Rs. 10,000 every month for 12 months on the 1stof every month. Now the value of your portfolio is Rs. 1,30,000 on the last day of the 12thmonth.

How will you calculate your returns? CAGR wont work because there are multiple investments made at different points in time. Heres how XIRR will help you

The timeline, cashflows and NAVs values are known.

We then calculate how many units we bought by investing Rs. 10,000 every month for 12 months at different NAVs prevalent on the purchase dates.

On 31stDec you are in possession of a number of units bought over the last 12 months. The value of these units is (Number of units bought * current NAV)

This gives us Rs. 1,30,000 as the value of the units we possess.

Next, use the XIRR formula in excel the inputs required are the dates (column 1) and cashflows (column 2). The XIRR of the above set of cashflows comes out to be 15.75%.

This will change every time the current NAV changes it is likely to be different on 1stJan 2020.

Absolute return gives you the absolute return your portfolio. It is not a very useful metric since it doesnt tell you the rate of growth since time is not of importance while calculating absolute return.

CAGR gives the annual rate of growth of a lumpsum investment.

XIRR helps you understand the annual growth rate of a bunch of cashflows which is what a mutual fund SIP is a cash outflow when you invest and a cash inflow when you redeem.

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You should have mentioned that bank FDs in India are usually quarterly compounding. Thus annual yield is more than the interest rate mentioned if we calculate based on annual compounding (cagr). For instance 7.4% annual interest rate with quarterly compounding translates to more than 7.6% cagr. Bank FDs, though have other disadvantages (liquidity and tax treatment) compared to mutual funds. But thats a completely different issue.

Point taken, Subhasish. The reason I have not delved into those details is because I didnt want to deviate from the topic ? Thanks for your comment.

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