A common question we often hear from our clients is “How should you calculate rate of return?” There are four primary methods to calculate investment performance that predominate across the financial industry:
- time-weighted return
- simple return
- internal return
- money-weighted return
Each of these methods was created to assess particular aspects of an investment’s return and has a different reason for being. One might think they are closely related since they all have the word return in them, but they yield very different results.
Time-Weighted Return (TWR)
Time-weighted return compounds the daily returns of your account from the time it was initially funded until present. It specifically does not consider when you deposit or withdraw cash from your account. We believe time-weighted return is the most appropriate way to evaluate an investment manager who does not have control over the timing of account inflows and outflows. It represents a true reflection of how your money has been managed, and not a reflection of how your contributions and withdrawals affected your performance. It should therefore come as little surprise to find your portfolio’s time-weighted return on your Wealthfront account dashboard each time you log in. As our CIO Burt Malkiel commented earlier this year: “I am afraid to say that emotion usually plays a more negative role than a positive role. Because the evidence is just so clear what people do wrong. They put money in at the wrong time. They take it out at the wrong time.” Evaluating an investment manager based on your decisions doesn’t seem like the right thing to do.
Simple Return (SR)
Simple return is your portfolio’s total net gain divided by net contributions. This is the most common “back-of-the-envelope” calculation that people employ when they scan their statements, largely because it’s so easy to calculate. X in, Y out. Unfortunately, this form of return is often the most misleading. Simple return weights all cash flows equally dating back to the beginning of your account’s life. As a result, a large, late addition of cash will massively reduce the return of an account, or mask the loss of an account. Ironically, a late withdrawal will massively swing the simple return the other way. As a result, simple return is almost never a good way to compare investment managers or your portfolio’s performance.
Internal Rate of Return (IRR)
IRR is the annual rate of return that will cause the net present value of your portfolio’s cash flows (deposits and withdrawals) and terminal value to equal the value of your initial investment. IRR can be an effective way to compare investment managers, but only over very long time periods. In the short term, volatility can magnify implicit IRR returns well beyond any reasonable expectation of long term return. IRR is most often used to evaluate private equity funds because they have many cash inflows and outflows and all cash flows are under the control of the fund manager.
Money-Weighted Return (MWR)
Money-weighted return is the IRR of your account for the specific period your portfolio has been managed. For example if your IRR is 8% and your account has only been managed for six months then the MWR would be 2.82%. MWR, like IRR, is only appropriate to evaluate an investment manager if she has control over the timing of all your cash deposits and withdrawals. For that reason it is often used by public equity managers who control their clients’ cash flows. Interestingly MWR and TWR converge over time if you make frequent deposits. While inappropriate for comparing investment managers (unless you have deposited and withdrawn the same amount of cash at the same time) MWR can play a useful role when considering how your portfolio has performed relative to your financial goals.
When Return Calculations Get Confusing
Most people are surprised to learn that one method of calculating return can lead to a positive outcome when an alternative approach results in a negative result and vice versa. The problem is usually caused by the impact of fluctuating markets on cash inflows and outflows. Here is an example: If you initially deposit $10,000 in your account and it doubles in one month and then you deposit $100,000 and the market drops 25% in the following month then your time-weighted return will be positive 50% and your money-weighted return will be negative 91% (and your IRR would be negative 17%). In this example your investment manager invested well, but unfortunately you timed the market poorly. Employing the money-weighted return would unfairly make the investment manager look as though she performed badly when the return was most influenced by the timing of your deposits.
Use the Right Return for the Right Job
So where does this leave us? Here’s your cheat sheet:
- Never use simple return
- Use time-weighted return to track the performance of an investment manager when you control contributions and withdrawals from the account
- Use IRR to track the performance of an investment manager when the investment manager controls contributions and withdrawals from the account
- Use money-weighted return to evaluate how your portfolio has performed relative to your long term financial goals
Return calculations are like any other tool. You need an entire toolkit and the knowledge of when to use each one to do an outstanding job.