XIRR vs absolute returns: the right way to track your SIPs
You have been running a SIP for three years. Your statement says absolute returns of 40%. A friend who invested a lump sum in the same fund the same month says 40% too. But your actual experience is very different, and absolute returns will not tell you that.
The problem with absolute returns on SIPs
Absolute returns work fine for lump sum investments. You put in Rs 1 lakh on day one. Three years later it is Rs 1.4 lakh. Return: 40%. Simple and accurate.
But a SIP is a series of investments at different times and different NAVs. Your first instalment invested three years ago has had different market exposure than the instalment you made last month. Absolute returns treat all the money as if it was invested at the same time and the same price. It is not. The result is a number that is almost always flattering and almost never meaningful.
What XIRR actually measures
XIRR stands for Extended Internal Rate of Return. It calculates the annualised rate of return for investments where cash flows happen at irregular intervals and different amounts. For a SIP, every monthly instalment is a cash outflow at a specific date. The current value is the cash inflow. XIRR finds the single annualised rate that makes those cash flows balance.
In simple terms: XIRR tells you what fixed interest rate on an FD would have given you exactly the same returns as your SIP, given when each rupee was actually invested. That is the comparison that matters.
A worked example
You invested Rs 5,000 per month for 36 months in a mid-cap fund. Total invested: Rs 1.8 lakh. Current value: Rs 2.52 lakh. Absolute return: 40%. Sounds great.
But your last instalment was invested only last month. It has had almost no time to grow. Your XIRR, which accounts for when each rupee was invested, comes out to around 12% annually. That is good, but it is very different from 40%. XIRR is the honest number.
Benchmarking your XIRR
A useful rule of thumb for Indian mutual funds: an equity fund XIRR of 12 to 15% per annum over a 5-year period is solid. Below 10% and you should question the fund choice. Below 7% and you would have been better off in a good FD. Compare your XIRR to the fund's own benchmark index to see if the fund manager is adding value above the market.
When XIRR can be misleading
XIRR becomes unstable for very short periods (under 1 year). A SIP running for 6 months might show an XIRR of 60% or -40% based on recent market moves. This is mathematically correct but not informative. Treat XIRR as meaningful only once your SIP is at least 18 to 24 months old.