Investments in mutual funds through systematic investment plans (SIPs) have become a favoured route for most investors. SIPs help in benefiting from market volatility: investors buy more units when market falls (volume gain) and fewer when market climbs (value gain).
But one question dogs every investor’s mind: How are SIP returns calculated? It is very easy to calculate a fund’s return when the investments are made through the non-SIP (lump sum) route. This is because the entry date and exit date are known. However, in case of an SIP, although the exit date and the exit value is known, there are series of dates on which the investments are made, implying multiple entry dates.
Moreover, there are possibilities of variations in the amount of investments made at different time intervals. For example, one may be investing Rs 2,500 every month that could be increased to Rs 4,500 per month or reduced to Rs 1,500 per month. How to estimate returns from such investments? The most widely used method is known as the internal rate of return or IRR method.
IRR is useful not only for SIP returns but also for estimating returns from money back insurance policies and bond yields. This calculation method equates the discounted value of the stream of investments (also known as cash outflows) to the discounted exit value of the investment (cash inflows). The discount rate that equates the present value of cash outflows and the present value of cash inflows is the rate of return earned by an SIP.
Let us understand this with an example: Assume you were investing Rs 2,500 per month in HDFC Equity fund (growth option) from October 2009 onwards. The investment was made on the 1st of every month and the tenure of the SIP was October 2009 to December 2010. This means a stream of 15 payments of Rs 2,500.
The last SIP was made on 1 December 2010 and all the units (accumulated over the tenure of the SIP) were redeemed on the same day. The exit value of the investment is Rs 46,004. Now, we need to look for a discount rate that will equate the present value of Rs 46,004 (cash inflow) and the present value of stream of SIPs, that is Rs 2,500 (cash outflows). Using IRR, we get the return as 2.85% per month or 34.25% annualised return.
Now let us check if 2.85% return equates the present value of cash inflow and cash outflows. If we discount the value of Rs 46,004 fifteen months back (at the beginning of first month) with 2.85% rate we get Rs 30,161. Similarly, we discount the stream of Rs 2,500 one by one to the beginning of first month. We sum the stream of discounted values and we get Rs 30,161.
Therefore, 2.85% per month equates the present value of cash inflows and cash outflows. These calculations have to be worked out using financial calculators or a spreadsheet. Working it out manually is very cumbersome and would require the mathematical genius of Einstein.
If that makes you feel challenged, the formula is: A 3-step guide to calculate your SIP returns Please send your feedback to [email protected] The ‘r’in the formula is the IRR or SIP return that you need to estimate. Clearly, the equation appears complicated. However, if you are MS Excel savvy, you can work out such calculation in seconds. MS Excel has a built in function for IRR.
The only requirement is that you need to input Rs 2500 in 15 consecutive cells with a negative sign (as these are cash outflows). In the 15th cell, just add the terminal value of `46,004 and use the function IRR. It will give you the value of 2.85% in no time. Apart from Excel, there are online IRR calculators available that works out the calculation for you.
Two such websites are engineeringtoolbox.com and datadynamica.com. Apart right” />from SIP returns, IRR can also be used for calculating returns from your money back insurance policies which also pay back money at regular intervals in addition to bonus paid out by some insurers.
Moreover, survivors get the full benefit of the amount insured irrespective of the money paybacks. As in case of an SIP, the insured pays premiums at regular intervals (say annually). Therefore, if at any point in time, one wants to estimate the returns, one can easily use the IRR by equating the present value of premium payments and the present value of payback amount plus bonus (if any).
Source: Economic Times
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December 28, 2010