Which two of the following statements are true regarding a time-weighted rate of return?

Time-weighted vs. Money Weighted Returns

As an investor it’s  important to know and monitor the performance of your investments and investment account. Step one is understanding performance measurements and what they tell you.

There are two standard ways of measuring performance: time-weighted returns (TWR) and money-weighted returns (MWR). TWR provides investors with a good measure to compare the performance of a fund against other funds and against key benchmarks. MWR provides investors with a good measure of their personal account performance.

What's the Difference?

Time-Weighted Returns (TWR)

Measures the rate of return on a fund over a period of time, excluding your investment decision-making and trading activity related to that fund (e.g., withdrawals, deposits, transfers)

Pros

• Can measure fund manager performance and compare it to fund benchmark
• Offers a rate that can be compared to other funds

Cons

• Impact of any changes you decided to make related to a fund during the period are not reflected in the rate

Best Use

• When comparing one fund or fund manager's performance to another

Money-Weighted Returns (MWR)

Measures the rate of return on an account over a period of time, including your investment decision-making and trading activity in the account (e.g., withdrawals, deposits, transfers)

Pros

• Shows your personal investment experience and account performance
• Helps clarify the impact your investment activity decisions are having on your account

Cons

• Not an effective measure of a portfolio manager's performance
• Can't be used to compare performance of other funds

Best Use

• When determining your account performance and the impact of your investment activity decisions

TWR and MWR in Action

To understand the difference between the two types of returns, consider the following hypothetical examples of three investors: Lori, Sheslie and Spencer. In each case, an initial investment is made on January 1, the markets declined by 4% between January 1 and June 30, and then rose by 7% between July 1 and December 31.

In the first scenario, Lori made no changes to her account over the year. In the second scenario, Sheslie was worried about the market decline and withdrew some of her investment on June 30. In the third scenario, Spencer saw the decline as an opportunity and made an additional investment on June 30.

TWR or MWR: Merits for Both

TWR and MWR rates both offer value to investors. TWR is best for comparing one fund or fund manager's performance to another, while MWR is best for measuring the performance of your personal account.

By considering both measures, you can have a clear picture of individual fund performance, as well as your account performance and the impact of your investment decisions on your portfolio.

To learn more, speak with your financial advisor.

This should not be construed to be legal or tax advice. Please consult your own legal and tax advisor.

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101 Concepts for the Level I Exam

Concept 3: Money-Weighted & Time Weighted Rate of Return

Money-weighted rate of return

• The money-weighted rate of return is simply the IRR of a portfolio taking into account all cash inflows and outflows.
• If a manager controls the cash inflows and outflows of a portfolio, then use money-weighted return to measure performance.

An investor buys a stock for $10 at time t=0. At the end of Year 1, he receives a dividend of $1 and purchases another stock for $12. At the end of Year 2, he receives a dividend of $0.5 per share and sells both shares for $13. Calculate the money-weighted return.

Solution:

Enter the following in a calculator: CF0 = -10; CF1 = -11; CF2 = 27; CPT IRR = 18.28%. The money weighted return is 18.28%.

Time-weighted rate of return

• Time-weighted rate of return is the compound growth rate at which $1 invested in a portfolio grows over a given measurement period.
• If a manager cannot control the cash inflows and outflows of a portfolio, then use time-weighted return to measure performance.

An investor buys a stock for $10 at time t=0. At the end of Year 1, he receives a dividend of $1 and purchases another stock for $12. At the end of Year 2, he receives a dividend of $0.5 per share and sells both shares for $13. Calculate the time-weighted rate of return.

Solution:

1. Break the measurement period into two sub-periods based on the timing of the cash flows.

1. Compute the HPY for each sub-period.

HPY1 = (12 – 10 +1)/10 = 30%

HPY2 = (26 – 24 + 1)/24 = 12.5%

1. Calculate the compounded annual rate by taking the geometric mean of the two sub-periods.

(1 + TWRR)2 = 1.30 x 1.125; TWRR = 20.93%

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