November 15, 2016

What’s the Difference Between a Time-Weighted Rate of Return and a Money-Weighted Rate of Return?

Canadian securities regulators designed Phase 2 of the Client Relationship Model (CRM2) to ensure investors receive clear and complete disclosure of the performance of their investments and fees associated with their accounts. One of the new requirements associated with CRM2 is the disclosure of annual performance reporting using the Money-Weighted Rate of Return (MWRR) calculation methodology, which differs from the industry standard Time-Weighted Rate of Return (TWRR) methodology.[1] Going forward, Leith Wheeler will show both the TWRR and the MWRR in year-end portfolio performance reports. Below is an explanation of how these two measures differ.

Time-Weighted Rate of Return (TWRR)

TWRR represents the compounded daily return of your investment portfolio over a specific time period independent of any cash contributions and/or withdrawals. TWRR is believed to be the most appropriate way to evaluate an investment manager who does not have control over the timing of cash inflows and outflows from their clients’ investment accounts. This measure is used to compare the performance of investment managers relative to each other and to their appropriate benchmarks.

Money-Weighted Rate of Return (MWRR)

Another measure that can be used to evaluate investment performance is the Money-Weighted Rate of Return (MWRR). This measure represents the internal rate of return (IRR) of an investment over a specific time period including the impact of cash contributions and withdrawals. MWRR is believed to be an appropriate way to evaluate how your portfolio has performed relative to your financial goals because it represents your actual investment experience. MWRR is not appropriate for evaluating investment managers who do not have control over the size and timing of cash contributions/withdrawals from your portfolio.

Comparing TWRR and MWRR

Comparing the results of TWRR and MWRR calculations can be confusing. Sometimes one method results in a positive return, while the other method results in a negative return. This outcome is usually caused by the impact of fluctuating markets on cash contributions and withdrawals from the portfolio. The examples below help illustrate how these differences can occur.

Example One:

Let’s suppose you invest $200,000 in an Equity Fund. Over the first quarter the markets are negative and the Fund returns -4.0%. You do not let this short term performance discourage you and you decided to invest another $25,000. Over the second quarter the markets remain negative and the Fund returns -2.0%. As a true value investor you believe that these declines have created good buying opportunities in the markets, so you decide to invest another $25,000. The Fund’s performance picks up over the third quarter with a return of +1.0%. This return inspires you to invest another $100,000 in the Fund. During the fourth quarter performance really turns around and the Fund returns +4.0%.

Initial Contribution	$200,000
Q1 Return	-4.0%
Quarter End Market Value	$192,000
2nd Cash Flow	$25,000
Q2 Return	-2.0%
Quarter End Market Value	$212,660
3rd Cash Flow	$25,000
Q3 Return	1.0%
Quarter End Market Value	$240,037
4th Cash Flow	$100,000
Q4 Return	4.0%
Quarter End Market Value	$353,638
MWRR =	1.4%
TWRR  =	-1.2%

The Fund’s annual return is -1.2%, which is the TWRR. However, your annual return is +1.4%, the MWRR. You contributed a total of $350,000 of capital over the year and you ended with an investment value of $353,638 due to the timing and magnitude of your contributions.

Example 2:

Let’s consider the same example, however this time you withdraw funds in the second and third quarters.

Initial Contribution	$200,000
Q1 Return	-4.0%
Quarter End Market Value	$192,000
2nd Cash Flow	$25,000
Q2 Return	-2.0%
Quarter End Market Value	$212,660
3rd Cash Flow	($25,000)
Q3 Return	1.0%
Quarter End Market Value	$189,537
4th Cash Flow	($100,000)
Q4 Return	4.0%
Quarter End Market Value	$93,118
MWRR =	-3.8%
TWRR  =	-1.2%

The Fund’s annual return remains -1.2%. However, your personal return is -3.8% because of the timing and magnitude of your withdrawals. Thus we can see how investors can have different experiences with the exact same investment due to the timing and size of cash contributions and withdrawals.

TWRR and MWRR are generally the same for investors that do not have material cash flows over the investment period. When the TWRR is lower than the MWRR, it generally means that the timing of cash flows was beneficial to performance. When the TWRR is higher than the MWRR, it means that cash flows had a negative impact on performance.

Conclusion:

No one performance calculation is necessarily better than the other. It is simply a matter of deciding what needs to be measured. The MWRR calculation, also known as the IRR, is widely used in finance for evaluating the attractiveness and success of investments with cash flows. The TWRR calculation grew from a need for industry consistency when reporting returns that are independent of an investor’s actions. MWRR provides a better measure of an investor’s actual investment experience. TWRR provides a better measure of a manager’s performance against a peer group, index or other form of benchmark. Comparing TWRR and MWRR numbers for the same account over identical periods can determine if the timing and magnitude of cash contributions and withdrawals have had an overall beneficial or detrimental effect on the portfolio’s total return.

[1] TWRR is mandated by the CFA Institute and the Investment Funds Institute of Canada (IFIC) for use by their members when reporting composite or investment pool/fund performance.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service.  The info provided in this article is compiled from our own research and is based on assumptions that we believe to be reasonable, accurate at the time the report was written, but, is subject to change without notice.