All investors always look for nice and reliable ways to keep tabs on their money’s performance. There is no shortage of methods to calculate the performance of an investment portfolio, and finding the time-weighted return (TWR) is the most common method used. The time-weighted return measures a given portfolio’s compound rate of growth. It also accounts for inflows and outflows of money in the process. In this post, we will discuss more about time-weighted return (TWR) and how it can be utilized to evaluate your investments’ performances. Let’s get started:
Time-Weighted Return: Key Aspects
What is the Time-Weighted Return?
The time-weighted return (TWR) represents a portfolio’s true performance. We have used the term “true” because it is only a reflection of the impact of the market and your investment selections. In other words, the TWR compensates for the number of deposits and withdrawals you make to your account. This is distinctly different from various other popular portfolio metrics such as calculating a personal rate of return (PRR). At times, the amount of money flowing in and out of the portfolio can skew the results of the PRR method.
The TWR method observes every deposit or withdrawal and proceeds to break down a portfolio’s overall return into corresponding sub-periods. This method, in which the returns of every single sub-period are multiplied with each other, is also known as the “geometric mean”.
How to Calculate the Time-Weighted Return
In order to calculate the time-weighted return (TWR), you need to start by calculating the rate of return for all of your sub-periods. You can calculate that by subtracting the beginning balance of the period from the ending balance of the period. After that, you must divide the difference by the balance at the beginning of the period.
After that, you must create a new sub-period for each period in which cash moved in or out of the portfolio. This will result in multiple periods with a rate of return. Remember to add “1” to each of the return amounts. This is very important for simplifying the calculation of negative return numbers.
Once you have successfully done all that, 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”
Now, let’s try to understand the application of the formula with the help of an example.
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.
When you use TWR, you have the option to break down the return into sub-periods based on when money is added or withdrawn from the portfolio. After this, the return for each sub-period is also provided by this method. By isolating the cashflow into sub-periods or intervals your calculation will be more accurate than subtracting the beginning from the ending balance. The TWR shows how the return will compound over time by multiplying the sub periods together. The TWR is very popular among investment managers as a performance metric since they do not have control over the cash flow in their portfolios. The TWR is usually preferred to the money movement-sensitive internal rate of return (IRR).
Disadvantages of the Time-Weighted Return
Even though the TWR is an industry standard, it’s actually quite a complex way of tracking and calculating cash flow. The inflow and outflow of money from portfolios can heavily skew return calculations. To alleviate that problem, a lot of investors go with the money-weighted rate of return instead. In this method, you have to set the present values of all cash flows equal to your initial investment value.
TWR: Conclusion and Investor tips
When it comes to measuring the performance of your investments, TWR is one of the many different methods available. However, it is definitely considered to be the gold standard in comparing the returns of different investment managers. However, TWR isn’t a flawless performance metric by any stretch of the imagination. As cash flows in and out of accounts daily it can be tough to calculate. However, you can get around this problem by utilizing the formula correctly. It will give you a thorough accounting of your investments’ growth.
- While the TWR is a useful tool, it’s best for you if you go ahead and perform a few other calculations before you choose to go ahead with a particular investment.
- In case you feel like the TWR doesn’t provide you with the entire scope of an investment, you should definitely consult a financial advisor. Get an advisor that listens to your goals and requirements and advises accordingly.