If you’re an investor, chances are you’re looking for a reliable way to keep tabs on how your money is doing. And while various methods exist to measure the performance of an investment portfolio, calculating the time-weighted return (TWR) is the most common. The TWR measures the compound rate of growth in a portfolio while accounting for inflows and outflows of money. Read on for more about the time-weighted return and how to use it to evaluate the performance of your investments. You can also work with a financial advisor to determine the importance and results of the TWR on your portfolio.
The Time-Weighted Return, Explained
The time-weighted return (TWR) is considered a true representation of the performance of an investor’s portfolio. This is because it only reflects the impact of the market and your investment selections. In other words, the TWR is designed to compensate for however many deposits and withdrawals you make to your account. That stands in contrast to other portfolio metrics, such as calculating a personal rate of return (PRR), which can be skewed by the amount of money flowing in and out of the portfolio.
The TWR method looks at if and when a deposit or withdrawal occurred in your investments, then breaks down a portfolio’s overall return into corresponding sub-periods. This calculation is also known as the “geometric mean”, which is a fancy way of saying that the returns of each sub-period are multiplied by one another.
How to Calculate the Time-Weighted Return
First, you’ll want to calculate the rate of return for each of your sub-periods. You can do this by subtracting the beginning balance of the period from the ending balance of the period. Then divide the difference by the beginning balance of the period.
Next, create a new sub-period for each period in which cash moved in or out of the portfolio. This will yield multiple periods with a rate of return. Make sure to add “1” to each of the return amounts; this makes it easier for you to calculate negative return numbers.
Finally, multiply the rates of return for each sub-period, then subtract “1” to yield your TWR. The formula looks like this:
TWR = [(1 + HP^1) x (1 + HP^2) x … x ( 1 + HP^n )] – 1
TWR = Time-Weighted Return
n = Number of Periods
HP = (End Value – Initial Value + Cashflow)/(Initial Value + Cashflow)
HP^n = Return for Period “n”
An Example of the Time-Weighted Return
Let’s say you invest $500,000 in Portfolio A on December 31. By June 1 of the next year, your portfolio has grown to $526,709. You then make an additional $50,000 deposit to the account for a total value of $576,709. At the end of the year, your portfolio has decreased to $537,908. That gives you a first-period return of:
($526,709 – $500,000) / $500,000 = 5.34%
Your second sub-period would look like this:
[$537,908 – ($526,709 + $50,000)] / ($526,709 + $50,000) = -6.72%
Since you added a deposit, the rate of return was calculated to reflect the new deposit.
Finally, to calculate the TWR for your two periods you must multiply each sub-period’s rate of return together. The first period is the timeframe that led up to your deposit, and the second sub-period is the time frame after the deposit.
TWR = [(1 + 5.34%) x (1 + -6.72%)] – 1 = -1.73%
The Importance of the Time-Weighted Return
When money is flowing in and out of a portfolio, it can be challenging to determine the actual rate of return. Unfortunately, it’s not possible to just subtract the beginning balance from the ending balance of a portfolio, because you’ll also need to factor in any deposits to and withdrawals from the account. Otherwise, the cash flow will distort the return of the portfolio.
By using the TWR, you can break down the return into sub-periods determined by when money is added or withdrawn from the portfolio. This method then provides a return for each sub-period. By isolating the cash flow into sub-periods or intervals your calculation will be more accurate than subtracting the beginning from the ending balance. The TWR multiplies each sub-period together, which shows how the return will compound over time.
Since investment managers do not have control over the cash flow in their portfolios, TWR is a common performance measurement. This metric is often preferred over the internal rate of return (IRR), because the IRR is more sensitive to money movement.
Disadvantages of the Time-Weighted Return
Though considered the industry standard, using TWR is a very complex way to track and calculate cash flow. Money moving in and out of portfolios frequently can skew the calculation of your return. That said, some investors prefer to use the money-weighted rate of return instead. With this calculation, you set the present values of all cashflows equal to the value of your initial investment.
Time-Weighted Return vs. Rate of Return
The rate of return (ROR) measures the net gain or loss of an investment over a specific period of time. The ROR is expressed as a percentage of the initial cost of that investment. The gain includes both income received from the investment as well as capital gains realized. The time-weighted return does not factor in cash flow differences but instead calculates and accounts for deposits or withdrawals. Thus, the TWR helps in the calculation of the ROR but they aren’t comparable in what each is calculating.
The Bottom Line
TWR is just one of several ways you can measure the performance of your investments — but it is considered the gold standard in comparing the returns of different investment managers. That said, TWR isn’t infallible; since cash flows in and out of accounts daily it can be tough to calculate. But if you use the formula correctly, it’s a great way to get a thorough accounting of the growth of your investments.
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