Don’t make this mistake while computing mutual fund SIP returns!

We discuss how to avoid a common mistake made by investors while computing mutual fund SIP returns.

On 20th May 2021, the Sensex (price) index was 49,564.81. About 5 months later on 18th Oct 2021, it rose to 61,765.59. Many mutual fund AMC investment dashboards or investment portals would report the annualized return during this period as 70% (excluding dividends). But is this right?

An annualised return is a measure of growth over a year. If we take this 70% figure seriously, then Sensex should be more than 84,370 today (20th May 2022) relative to what it was a year ago. It is only about 53,860.

There are two types of annualised returns. The CAGR (for a single investment) and the XIRR (for multiple investments). See CAGR vs XIRR: Understanding Annualized Return.

Using either of them when our investment is less than a year old is like assuming Virat Kohli would hit a century because he drove his first ball for a four. Many investors make this common mistake.

SEBI has mandated that only the absolute return or percentage change in NAV/price should be used for computing returns less than a year old.

Take away: Use only the absolute return for investments less than a year old.

Can I use the XIRR for a SIP started one year ago? No. Not yet! Such a monthly SIP would have 12 instalments and only one of them would be one year old. So it does not make sense to annualise the return obtained.

To appreciate this, let us compute the weighted average duration. Consider a SIP started in May 2021. By April 2022 12 instalments would be over. Tabulated below are the dates and time elapsed in years with respect to the last NAV date at the time of writing (19th May 2022)

Only the first instalment is one year old. Let us compute the weighted average of the time elapsed.

If Rs. 5000 is the amount invested each month, then

First, we compute the sum-product
(1.04×5000)+(0.96×5000)+(0.87×5000)+ …. = 34931.51

Then divide this by the total investment (5000 x12)

34931.51/60000 = 0.58 years.

Does it make any sense to take the XIRR of a 1Y SIP whose average duration is only 0.58 years seriously?

Of course not. But then again, the XIRR in itself is only an approximation and should be used as a crude measure of growth. Remember there is no compounding involved with mutual funds!

A high XIRR tells you “all is well” at least temporarily and a low or negative value of XIRR often means “hang in there”.

After five years if your portfolio XIRR is 17%, do not assume your portfolio has grown 17% each year! Return measurements are always ‘point to point” and ignore the risks in the journey. For instance, see.

How annualized returns are computed!The average investment duration is important with respect to portfolio decisions. For example, you can safely ignore an XIRR of +120% or -34% when the avg duration is less than a year. But you should review the underlying fund or stock when the XIRR is -6% with an avg duration of 5.4 years.

Please also keep in mind that portfolio returns can swing wildly. What matters is accumulating enough cash for future expenses. See: My retirement equity MF portfolio return is 2.75% after 12 years! So do not take the XIRR too seriously. A high XIRR does not mean a high corpus!

Takeaway:  XIRR of a SIP investment or a mutual fund or stock portfolio become more and more representative of past growth as the avg duration becomes higher and higher.

We recommend taking XIRR of your individual SIPs and overall portfolio seriously only after two years of investing.

The freefincal mutual and stock portfolio trackers on Google sheets have now been updated with the average investment duration for each instrument and the overall portfolio to appreciate the portfolio and fund/stock XIRRs in the right context.