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If you’re an active investor, you may find it tricky to assess exactly how well your investments are performing. You invest a bit today, withdraw a bit tomorrow, double down on a stock you see as promising the next week, and so on. A
t the end of the year it looks like you’re up big – but how much of that is simply a reflection of you injecting cash into your own portfolio?
To answer this, you need to understand the difference between time-weighted returns and money-weighted returns.
Once you do, you can dissect how well your investment strategy is actually doing, letting you cut out the noise of your cash flows. Below is a brief explanation and some examples to help you understand your investment performance like a pro.
Read more: Measuring Nominal vs Real Investment Returns
Let’s start with the more basic of the two terms: the time-weighted rate of return (TWR). This is a metric that doesn’t take into account the cash moving in and out of your portfolio.
Instead, using TWR is like asking, “What if I invested $1 in this particular asset over a certain period of time? What would the compound growth be at the end of the period?”
TWR is a really important way to assess things like the performance of a fund manager.
That’s because you can evaluate how well the assets that one manager chose performed compared to those selected by another manager,
regardless of whether a mountain of cash moved in or out of their respective portfolios during the investment period (something which the manager can’t control, and so shouldn’t be evaluated on).
Here’s a simple example of how you would calculate the TWR of a fund you’ve invested in over a three-year period. For the sake of simplicity, there’s no cash flowing in or out.
● In year one, the fund grows by 4%
● In year two, the fund grows by 6%
● In year three, the fund grows by 5%
Here’s how you would calculate the three-year TWR:
● Year one: 1.04
● Year two: 1.04 x 1.06 = 1.1024
● Year three: 1.1024 x 1.05 = 1.1575
Thus, your TWR is 15.75%, reflecting the compound growth achieved after three years.
As we mentioned, the above calculation assumes there was no cash flowing in or out. If there was, your calculation would have to break each yearly period into sub-periods, one for each time a new deposit or withdrawal was made, before multiplying them together like above.
The money-weighted rate of return (MWR), also known as the dollar-weighted rate of return, captures the effect of cash flows (both the size and timing of them) in and out of your portfolio.
In doing so, it captures the actual performance of your specific portfolio. It tells you your annualized rate of return (like the interest rate on your savings account) after taking into account all your deposits and withdrawals.
Here’s another way to think about it: if TWR is meant to isolate the portfolio’s underlying assets so you can assess how well the fund manager did picking them, the MWR is the other side of the coin:
it adds those cash flows back in, so you can also assess your performance as the investor moving cash in and out of the account. Most likely it’s you the investor who controls the money flows, so the MWR is a key way to see if you’re being shrewd about your money movements.
Of course, if no cash flows in or out of the portfolio during an investment period, the TWR and MWR will be the same.
Calculating the MWR is similar to calculating the internal rate of return (IRR). If you want to think about what the equation is doing, it’s finding the rate of return that will set the net present values of all cash flows equal to the initial investment.
The equation looks like this:
Need a crash course on how to calculate yields and rates of return?
Check out our post on Assessing Yield, Cash on Cash, And IRR
Doing this by hand (even with a calculator) can be very tedious, so most people either use Excel’s IRR function or an online calculator.
In any case, let’s draw out a simple example so you can get a feel for how it works. Consider an investment portfolio with just one inflow over a one-year period:
● January 1, 2023: You make an initial investment of $2000
● July 1, 2023: You make an additional investment of $1,000
● December 31, 2023: Your ending balance is $3,300
If we apply our MWR equation to the information above, it would look like this:
If you were to plug these values into a financial calculator or Excel, you will find that the rate of return that balances the equations is 19.6%. Happy investing.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
