Time-weighted rate of return refers to the quantum of returns an investor can get from his investment for a particular period. It is different from Compounded Annual Growth Rate (CAGR) and is a popular metric for performance measurement in investments such as in mutual funds. When there are many withdrawals or deposits within the investment horizon, calculating the rate of returns may be difficult. This is where the time-weighted rate of return comes to the rescue. This article details this concept and helps you understand the importance of the time-weighted rate of return and how to calculate it.
This article covers:
- What is a time-weighted rate of return?
- What does the time-weighted rate of return tell you?
- What are the factors considered to calculate the time-weighted rate of return?
- How to calculate the time-weighted rate of return?
- Importance of time-weighted rate of return
- Time-weighted rate of return vs rate of return
What is a time-weighted rate of return?
The time-weighted rate of return is a technique for estimating an investment portfolio’s compound growth rate. When many transactions are happening in the investment during the tenure, it may not give the correct picture to average out the peaks and troughs and simply look at the rate of return. What we need is a measure that will consider these changes and derive the compounded growth rate.
The time-weighted rate of return divides a portfolio’s return into sub-periods or intervals depending on the investments and withdrawals made. It aggregates the returns of all the sub-periods to create the rate for the whole period.
The yearly rate of return, which is the proportion of profit or loss earned from an investment over a certain period is not the same as the time-weighted rate of return. One drawback of the rate of return is that it doesn’t account for changes in cash inflows and outflows. As a result, the approach eliminates the distorting effects of cash inflows and outflows on growth rates.
Thus, a time-weighted rate of return is more beneficial for public investment managers and fund managers dealing with public securities.
What does the time-weighted rate of return tell you?
The contributions and withdrawals made over time determine how much money will be generated on a portfolio.
The rate of return for each cash flow-changing sub-period or interval is calculated using the time-weighted return. By isolating the returns that have cash flow changes, the result is more accurate than simply taking the starting and ending balances of a fund. All cash dividends are assumed to be reinvested in the portfolio for calculating the time-weighted rate of return.
When there is external cash flow, such as a deposit or a withdrawal, which would indicate the start of a new sub-period, daily portfolio valuations are required. Sub-periods must also be the same for comparing the returns of different portfolios or investments, and then the calculations are completed by geometrically linking these periods.
As investment managers who deal in publicly traded securities do not typically have control over fund investors’ cash flows, the time-weighted rate of return is a well-known performance metric for these sorts of funds.
What are the factors considered to calculate the time-weighted rate of return?
When calculating the time-weighted rate of return, keep the following in mind:
- To compare various investment portfolios, sub-periods or intervals must be similar.
- Following a deposit or redemption, an investment valuation is necessary to indicate the start of a new sub-period.
- All returns must be considered to be reinvested in a portfolio.
How to calculate the time-weighted rate of return?
The basic formula for calculating the time-weighted rate of return:
TWR = (ending value – beginning value) / beginning value
For example, assume Mr A invested Rs. 10,000 in an ETF on a particular date. After 25 days his investment was valued at Rs. 11,000. Now, TWR would be calculated as:
TWR = (11,000 – 10,000)/10,000 = 0.1%
Now if multiple periods are involved, then it can be calculated as:
TWR = [(1+m1)*(1+m2)*…..*(1+mN)-1]
m1 = rate of return from 1st period
mN = rate of return from nth period
Importance of time-weighted rate of return
Calculating the rate of return for assets with numerous withdrawals and deposits can be difficult, which is where the time-weighted rate of return comes in handy.
A large number of investments and redemptions distorts the rate of return across the whole investment term. That being stated, one cannot simply subtract the amount at the beginning from the balance at the end because the latter does not account for cash flows. The rate of return for each period’s investment or withdrawal made is calculated using the time-weighted return.
Time-weighted rate of return vs rate of return
The rate of return is the net profit or loss on a venture over a certain period, which is expressed as a percentage of the original investment cost. The rate of return calculations ignores the cash flow variations in the portfolio.
On the other hand, TWRR takes all deposits and withdrawals into account when calculating the rate of return. For portfolios such as funds with smaller but more frequent contributions or withdrawals, the TWRR algorithm is more straightforward and does not allow for the distorting effects of the cash flow.
The time-weighted return (TWR) helps remove the impact of money inflows and outflows on growth rates. It is more compact than the rate of return to measure a fund’s value. It is always better to consult your financial planner to understand the nuances of various tools and technologies used to measure returns.