If you happen to ask me, “what is my rate of return?” I’ll probably answer your question with another question, “which return and why?” This response usually results in a very cross look shot in my direction. But, actually there are different measures of return and many investors are unaware of their subtle, and some times not so subtle, differences. Understanding what each of these returns is designed to measure and how they differ will help you make better informed financial decisions.
In the financial industry today there are three measures of return that are frequently used; Simple Rate of Return (SRR), Internal Rate of Return (IRR) and Time Weighted Return (TWR). These measures of return may sound interchangeable but they are actually very different in how they calculate performance.
First, let’s look at a SRR. This is the easiest return to calculate and understand. It is simply the percentage change in market value. The SRR is most commonly used to calculate the performance of a benchmark or index where there are no cash flows that affect the underlying performance. A SRR, although easy to calculate for a benchmark, cannot accurately measure the return of an individual’s investment portfolio. This is where IRR and TWR come into the picture.
The IRR, also commonly referred to as the dollar weighted return, is the measurement of a portfolio’s actual performance between two dates, including the effects from all cash inflows and outflows. Because cash flows are factored into the calculation, greater weighting is given to those time periods when more money is invested in the portfolio. By this definition, the IRR of a portfolio can be significantly affected by both the size and timing of any cash contributions or withdrawals.
The IRR does provide a meaningful measurement of the absolute growth of a portfolio. And, it is a valuable tool for determining if a portfolio is growing enough to meet a future need or a specific investment goal. However, it is not an effective measurement tool for analyzing the long term performance of the portfolio’s underlying assets or comparing your investment manager to a different investment manager or market index. For periods longer than three months, the IRR can be greatly affected by factors beyond the control of your investment manager. This is where the TWR becomes a more meaningful measurement tool.
The TWR captures the true investment performance by eliminating all the effects of capital additions and withdrawals from the portfolio. Simply stated, the TWR is the return on the very first dollar invested into the portfolio. This makes the TWR a more meaningful measurement of performance when used to analyze the underlying performance of the portfolio’s assets or comparing your investment manager performance to alternative investments.
The method used to calculate the TWR is derived by dividing up the performance period into shorter sub-intervals, such as one month. Each sub-interval can be further divided into intervals based on the date of any cash inflows or outflows. Then, the IRR is calculated for each of these sub-intervals. Finally, the individual IRRs are then linked together with equal weighting (not dollar weighted) to derive at the portfolio’s overall TWR.
The TWR allows an investor the ability to accurately evaluate the true performance of the underlying assets and your investment manager, not just the return on the dollars you have invested in the portfolio. This may sound like a very subtle difference, yet, the IRR and TWR can be significantly different, even for the exact same period of time. It is important to understand the differences so you can make investment decisions with the best information available.