While deciding to invest in a mutual fund, we generally look at its past performances. So when a mutual fund says it has given a 15 percent return in 5 years, what does that mean? Does it mean that if I had invested ₹10,000, I would get a return of ₹1,500 after 5 years or something else? Also, does the return remain the same in the case of a SIP and lump sum?
Mutual fund returns can be a bit difficult to understand. Let’s understand what different terms mean.
Let's start with the most basic one, Absolute returns. It is the simplest of all, it just calculates the difference between your initial investment and your gain/loss at any point. Suppose you invested ₹10,000 5 years ago and your current value is ₹15,000. Then your absolute return for this time period will be 50 percent. But calculating precise returns is not that simple.
Absolute returns do not take into account any market volatility, time, etc and hence it is not the most accurate way of calculating your mutual fund returns. It is generally misleading and hence is used to look at returns of only 1 year. For returns of over a year, there are other metrics.
Suppose you have 2 options, invest 10,000 in fund A and get ₹50,000 return or invest in fund B and get a 1,00,000 return. You will obviously choose fund B.
To calculate absolute returns, we use = (Maturity Value – Investment Value)/Investment Value.
The absolute return of fund A is 500 percent and fund B is 1000 percent.
Simply looking at the absolute returns, your decision was correct, but this does not take time in account. What if the time period for fund A for the return is 3 years and fund B is 10 years. Then, will your decision be correct?
No. An investor could make more money investing in fund A for 10 years than fund B.
So, there are a number of factors that we have to take into account for calculating the exact returns of a mutual fund. Similarly, if we are using SIP, and the investment keeps rising, so does the return, absolute returns are not the way to go.
Let's take an example
Suppose you invest 5000 every month for 2 years and your total value is ₹1,50,000 after 2 years. you cannot calculate with ₹5,000 as the principal amount since you are adding to that every month. So after 2 years, your principal amount will be 1,20,000 and your interest will be ₹30,000, giving you a 25 percent return. However, this is not accurate, since SIPs are calculated by compound interest. So your principal amount will not just be 1,20,000. The interest would also have to be added to your investment amount and every month your investment amount will be your investment + the accumulated interest.
Hence, your return will not be as high as 25 percent if calculated through compound interest.
For such calculations, XIRR is used. Let's understand how that works
XIRR stands for Extended Internal Rate of Return and is used to calculate returns when there are multiple investments like in the case of a SIP. It is that rate of return, which when applied to your every investment will give you the current value of your investment. It takes into account your multiple investments as well as the time period of those investments. It gives you the exact return your staggered investments have made.
Along with SIPs, it is also a useful tool for calculating returns when you have made irregular deposits and redemptions in a mutual fund.
Let's understand with an example
Suppose you started a SIP of ₹5,000 in a mutual fund scheme for 5 years. So your first installment of ₹5,000 will be invested for 60 months, the second for 59 months, the third for 58 months, and so on.
It takes into account how each installment is compounded for a different time period. So when XIRR is calculated, each investment and its interest is taken into account. So overall, the investor invested ₹3 lakh in the 5 year period. But say the value of investment increased to ₹4 lakh after 5 years.
So the XIRR will be 10.33 percent. You can calculate your SIp investments here. It is not as simple to calculate as absolute returns.
In this case, the absolute return will come out to over 33 percent but that will not be accurate.
XIRR returns can be calculated on an excel sheet
Let's see how:
It is difficult to exactly understand and calculate mutual fund returns. but now that we know the basics, we know which return to look for while choosing a mutual fund.