In our everyday course of life, we keep frequently applying some sort of performance and evaluation methods to things that we buy and use or even in the instance of investing our money. Performance evaluation and measurement helps us determine our course of action with our investment portfolio. When we buy a car, we ask the salesman about mileage, warranty, performance markers that help determine if it is worth buying or not. Such is the case with investments as well, and one of the few ways to calculate and determine its performance is the Time-weighted rate of return (TWRR) or TWR method.
What is Time Weighted Rate of Return?
It calculates the compound growth rate of an investment portfolio. It segregates the return on a portfolio into separate sub-periods or intervals based on the investments and redemptions made. This method eliminates the distorting effects of growth rates created by cash inflows and outflows.
Time Weighted Rate of Return Definition
TWRR is nothing but a geometric mean since it multiplies all the sub-periods return to generate the rate for the entire period. It is quite different from the annual rate of return where the percentage of loss or profit for an investment is calculated over a particular period of time. That being said, one of the limitations of TWRR is that it does not consider the differences caused by the inflow and outflow of cash. So you know what TWRR is, but what is it useful for and where do you use it? Here is all you need to know about TWRR.
Importance of Time Weighted Rate of Return
For investments with multiple withdrawal and deposits, calculating the rate of returns is quite a challenge and this is where TWRR comes into use. Too many investments and redemptions distort the ROR for the whole period of investment. With that being said, one cannot just subtract the balance at the start with the end since the latter does not take in account the cash flows. The time-weighted return gives the rate of return for each period when there was an investment or withdrawal.
Adding to this, the Global Investment Performance Standards requires the returns to be computed using TWRR. TWRR (time weighted rate of return) is an appropriate measure that is applied while evaluating the performance of fund managers and financial advisors who zero-control over the time or amount of cash flows, evaluating the asset allocations of funds and benchmarking them against market returns. TWR (or TWRR) is mostly used by public investment managers or fund managers who deal with public securities.
Factors for Time Weighted Return Calculation and The Time Weighted Return Formula
1. To calculate TWRR, the account history is divided into sub-periods, representing the interval between significant cash flow events or valuation dates. The TWRR (time weighted rate of return) is computed by geometrically linking the rate of return for each sub-period.
2. Each investment’s valuation is needed to mark the start of a new sub-period after a cash flow has happened.
3. It should be assumed that any and all returns are being reinvested in the portfolio.
The general time weighted rate of return formula on the portfolio is:
Portfolio Return = ( EV-BV ) – Cash flow / BV + Sum of (weight x cash flow)
EV: Ending Value
BV: Beginning valueIn simpler terms, to calculate the TWR ( TWRR) for each sub period is or a single period is:
TWR (TWRRn) = (EV-BV) / BV
Let’s assume that Mr. B has invested INR 70,000 in a mutual fund on 1st January 2017. On 31st December 2017, his invested amount was valued at Rs.71,000.
TWRR = (51,1000 – 50,000) / 50,000.
TWRR = 0.02%.
Now the time-weighted rate of return formula when multiple sub-periods is written as,
TWR = [(1 + R1) x (1 +R2) x .. x (1 + Rn)] – 1
Where R is the rate of return for each period.
So How Does It Work?
Mr. B over a period of 3 years,
|31 Dec 2017||51,000||1 Jan 2018||+20,000|
|31 Dec 2018||75,000||1 jan 2019||-10,000|
|31 Dec 2019||67,000|
The TWR for Jan 2017 – Dec 2017 is 2%
For Jan 2018 – Dec 2018,
TWR = [75,000 – (51,000 + 20,000)] / 51,000 + 20,000
TWR = 5.7%
For Jan 2019 – Dec 2019
TWR = (67,000 – 65,000) / 65,000
The Time weighted Rate of Return for the whole portfolio is
TWR = (1 + 2%) x (1 + 5.7%) x (1+ 3%) – 1
Therefore, the time-weighted rate of return = 12.7%
While this is the rate of return for the whole period (2017 to 2019) and an annualized rate of return. However, this can also be annualised.
While Time weighted Rate of return is one way to calculate the performance of an investment portfolio, there are other methods as well. Like the Money weighted rate of return. That being said, there are alternate methods to TWRR, like Simple Dietz method and Modified Dietz method.
The Difference Between Time weighted Rate of Return and Rate of Return
Rate of Return is simply the net gain or loss on an investment made over a specific period of time, said in percentage of the initial investment cost. While the gains on investment are defined as income received along with any capital gains realised on the sale of the investment.
However, the rate of return calculation does not account for the cash flow differences in the portfolio, whereas the TWRR accounts for all deposits and withdrawals in determining the rate of return. While the algorithm of TWRR(time weighted rate of return) is simpler than that of MWRR (Money-weighted rate of return) for portfolios (Funds) with smaller but more frequent contributions / withdrawals since it doesn’t take in account the impact or distorting effects of the cash flow. But then it does take in consideration the cash flow itself, which makes it quite challenging as it requires keeping track of all investments and redemptions. But that can be solved by using any software or online tools to do such calculations is, thus, more effective than other methods.
Keeping track of your investments is very important while calculating their performance is much needed, Time weighted rate of returns does help you achieve that while it also gives you a fair idea of what to do next – to cash in or cash out. TWRR just makes it simpler.