TIME-WEIGHtED VS.

MONEY-WEIGHtED REtUrNS

Time-Weighted vs. Money-Weighted Returns

In this paper we discuss the process of evaluating investments in a portfolio, as well as tracking the income generated by those investments. Secondly, we discuss how you judge the performance of both your portfolio and your investment manager based on those calculations.

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TIME-WEIGHtED VS. MONEY-WEIGHtED REtUrNS

Whats the Difference, and What Do I Use to Judge My Portfolios Performance?

The major areas where an investment calculation is called for: Compounding of Interest (CDs, Savings, etc.) Consumer Lending Mortgages / Renancing Capital Budgeting / Project Analysis Real Estate, Mortgages, and Leasing Portfolio Management

When it comes to your investment portfolio, reports are only as good as your ability to interpret them. The ability to analyze true portfolio performance is muddled by the presence of gures generated by two dierent methods of calculating returns: Time-Weighted Return (TWR) and Money-Weighted Return (MWR). Compounding the confusion, in times of major market swings these two calculations can yield very dierent results! In reality, these methods of calculation have been developed for very dierent purposes. By understanding these purposes and the history behind TWR and MWR, you can make the best decisions for your portfolio.

The Road to a Standard Method of Calculating Returns First, it is worth discussing how these principles have evolved. Until recently there was no standardized approach to measuring the performance of an investment portfolio. In the early 1990s, however, the Association of Investment Management and Research (AIMR) established standards that were widely adhered to for about 10 years until AIMR was taken over by the CFA Institute. The CFA Institute has since renamed the standards and put tremendous eort into globalizing and modernizing them, eectively obtaining worldwide consensus. The CFA Institute created a separate organization the Global Investment Performance Standards (GIPS) Council which in practicality acts as a separate body with its own board of directors.

GIPS Global Standards

By understanding these purposes and history behind TWR and MWR, you can make the best judgments regarding your portfolio.

GIPS standards originally issued in 1999 are now becoming universally accepted within the investment industry. Organizations that provide investment counsel are realizing that they must be thoroughly familiar with these standards in order to gain the full meaning from the performance numbers they receive from investment managers. GIPS standards discuss two methods of calculating returns Money-Weighted Return (MWR) and Time-Weighted Return (TWR). Though the terminology can be confusing, with a little explanation, these calculations and their applications may be easily understood. Until recently, most students learned nance concepts using the MWR calculation method. For this reason, this article begins with MWR and then contrasts it with TWR. However, as you will see, the GIPS standards tend to favor TWR and do not consider MWR a recommended form of return calculation for investment portfolios. The GIPS preference for TWR holds true in most cases, with the exception of a handful of instances, which we discuss later in this paper.
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TIME-WEIGHtED VS. MONEY-WEIGHtED REtUrNS

Money-Weighted Return A Bottom Line-Oriented Calculation MWR measures internal rate of return, and is also referred to as the Internal Rate of Return (IRR), Dollar-Weighted Rate of Return (DWR), and Discounted Cash Flow (DCF) method. In the formula for MWR, each F represents a particular cash ow, or an instance in which cash is either being generated or acquired by an investment: , where: F0 is the value of the portfolio at the beginning of the period. Wi is the portion of the period that the external cash ow Fi was held in the portfolio because F0 is in for the whole period, W0 = 1. The objective is to identify when cash ows are entering or exiting an investment, and calculate the Internal Rate of Return (IRR) that would discount these cash ows back to the beginning value. It is helpful to think in terms of the implicit interest rate that would make these cash ows equivalent to a savings account or comparable investment. MWR Advantages This formulas key advantage is that it discloses the bottom-line economic value or gain of the investment, enabling you to discern how well it is performing according to your given cash ows. From a purely economic standpoint, this is the most relevant calculation. An additional key advantage of MWR is that it doesnt require interim valuations of the portfolio, because it is only concerned with the market value of the portfolio upon liquidation. MWR Disadvantages
In essence, this method does not tell you whether or not your investment manager is doing a good job

However, MWR has distinct limits, not the least of which is that reliance on it can lead to poor decisions concerning investment managers. This is due to the fact that MWR factors in the dollar amount of the investment in each period. In essence, this method does not tell you whether or not your investment manager is doing a good job because it is inuenced by the amount of money you are investing in each period. If you give the manager more money in one period and less in another, those changes should not inuence your managers calculated performance yet MWR is inuenced by the amount of money at work in each period. The calculation lends itself to looking at the portfolio from the investors standpoint rather than that of the investment manager. GIPS literature, therefore, does not recommend hiring or ring an investment manager based on MWR, as it penalizes or rewards a manager based on factors that are out of his or her control.
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TIME-WEIGHtED VS. MONEY-WEIGHtED REtUrNS

Its interesting to note that some literature surrounding MWR describes it as dicult to calculate. However, this really doesnt apply to the current era in which various computer software applications make this kind of calculation easy.

Time-Weighted Return (TWR) GIPS Preferred Calculation Method The disadvantages of MWR are mathematically addressed by the Time-Weighted Return (TWR) calculation the preferred method of GIPS which measures the compound growth rate of one dollar initially invested in a portfolio over a stated period. TWR is not concerned with the total investment amount rather, it enables you to judge how well your manager is doing on a per-dollar basis. TWR is fairly simple, and can be calculated with a four-function calculator. Stated simply, start with the ending value of the portfolio, subtract the beginning value of the portfolio, and divide by the beginning value of the portfolio: , where: R = The TWR of the portfolio for the period in question EMV = Ending Market Value BMV = Beginning Market Value For example, lets say you start with $100 in a portfolio and your investment grows to $105 at the end of a period (the length of which is not important). TWR says you earned 5% over that time period:

It gets more complex, however, with each addition to the portfolio. If you have an external cash ow into or out of the portfolio, you must adjust the ending value for that amount, because the manager didnt earn it:

Where CF = Cash ows into the portfolio , A second complicating factor is that income earned in the form of interest or dividends that remains in the portfolio gets added to the ending balance. You must, therefore, be sure youre adding this to the ending balance of the portfolio. You indicate a minus cash ow if you added to the portfolio and a plus cash ow if you subtracted. TWR requires that you start with the beginning value and calculate the ending value
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TIME-WEIGHtED VS. MONEY-WEIGHtED REtUrNS

or return (R) for the period with each external cash ow. You start over with each cash ow, and calculate until you reach the end of the reporting period, accumulating R values for various periods of time. Geometric Compounding Length of Time Period is Irrelevant The length of the time periods is not critical because of Geometric Compounding, illustrated in the following example where 1 is added to the return (R) and then multiplied by the next return:

An example can best illustrate how you mathematically arrive at the calculation for Total Period TWR. Note that while we refer to each time period as a month, for these calculations, it could just as easily be a year, a week, or a day this part of the calculation is the same regardless of the time periods length. For our example, the rst month showed a 5% return (represented as .05), the second month showed a 2.2% return (.022), and the third showed a 1.5% return (.015). Each value for R is added to 1. We also need to calculate months that have losses. In this example the fourth month showed a 3.2% loss (-.032), while the fth month showed a 12% loss (-.12). The eect of the negative sign is to subtract the loss from 1. By multiplying these numbers together and subtracting 1, you calculate the geometrically-compounded return for the time period:

= -.072 or -7.2%
Annualized TWR Making Sense of the Numbers We said before that for basic calculations the length of the time period is irrelevant. And yet, to be meaningful, the results must be reported in terms of annualized rates of return. Otherwise, the reports dont make sense because you cannot compare one return to another if they cover dierent lengths of time. This is where time value comes back into play. To be meaningful, we need to calculate Annualized TWR percentages. In order to determine the Annualized TWR, you must calculate the root of the Total Period TWR (the root representing the number of years of data (n)):

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TIME-WEIGHtED VS. MONEY-WEIGHtED REtUrNS

This is both the process that GIPS recommends and the accepted method of reporting Time-Weighted Return for a marketable securities portfolio. TWR Advantages and Disadvantages The only true advantages of this method are: 1) It helps you judge your managers performance; and 2) It enables you to compare an investments performance to various indexes like the S&P and Dow Jones (which are also calculated as if you were experiencing the results of one dollar invested). There are two distinct disadvantages of TWR. One is that it doesnt tell you what amount of money you are actually taking to the bank. This is no small point for an investor. For this reason, people refer to MWR as the investors way of calculating return on investment, and TWR as the managers way of calculating it.
Its disadvantage is that it doesnt tell you what you are taking to the bank, which is no small point for an investor.

A second disadvantage is that TWR requires evaluation every time there is a cash ow a particular disadvantage if you have numerous cash ows. This requires that you carefully track external cash ows, adjusting the portfolio each time so that you dont give the manager credit for money they didnt earn. It also requires geometric compounding a fairly complex mathematical feat, without the use of software.

Exceptions to GIPS Recommendation of TWR Private Equity After making such a strong case for TWR, as GIPS was expanded to include real estate and private equity, it shifted its view of MWR. According to GIPS, in situations such as private equity in which the money manger is controlling cash ows, MWR is the best guide for measuring performance. This means MWR should be applied to highly liquid investments. Additionally, GIPS also refers to Since Inception-IRR (SI-IRR), where SI is designating the point at which the investment was initiated. This means performance should be calculated as MWR from the beginning of the investment. Therefore, for a private equity rm, rate of return must be reported in terms of this money-weighted calculation in order to comply with global investment reporting standards. Real Estate In the case of real estate, two methods are generally employed. The rst method involves formulas that calculate return in a manner very similar to TWR, referred to as Capital Employed. This method entails calculating your return based on its capital portion, which is typically either gauged in terms of its appreciation or the income generated through rental, etc. Additionally, GIPS recommends, but does not require, that real estate investment returns be reported in terms of SI-IRR.

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TIME-WEIGHtED VS. MONEY-WEIGHtED REtUrNS

Modified Dietz Dated, Yet Useful There is also a third method that is essentially a hybrid between MWR and TWR. This method, invented by Peter O. Dietz, is now called the Modied Dietz method of investment performance calculation. This was used quite extensively for a long time, and was only recently done away with by GIPS. While this is considered an out-of-date method, it can be useful as a method of approximation if you dont want to re-evaluate a portfolio every time you add a cash ow. In fact, at Financial Navigator, Inc. we use the Modied Dietz method on an intramonth basis, as were geared toward month-end valuation and dont necessarily perform valuations during the month. In such cases where you have a cash ow during the month Modied Dietz enables close conformity with GIPS standards while eliminating much calculation work (the value of which may be questionable).

TWR vs. MWR At this point the practical investor begins to ask, Which method do I use? In fact, the two calculations give you very similar results when there are few external cash ows and marketplace uctuations are mild. However, you see major dierences as the marketplace swings and weve seen some pretty dramatic swings over the past 12-18 months! In these situations, the two methods generate very dierent results that lend themselves to very dierent decisions. For example, consider a situation in which you give a large amount of money to your manager and, because the markets perform poorly, your investment also performs poorly. You then give that manager less money to invest, and over the next period of time, the markets perform well and you receive a higher rate of return. Under the TWR method, the manager makes the case that they handled the investment well. However, you likely note that you did poorly when you had a large investment, and well with a smaller one especially if you never recovered your investment. Therefore these two methods present a contradiction when both the dollar amount invested and the portfolios rates of return change.

Conclusion
The bottom line is, if youre looking at what you take to the bank, use MWR. However, if youre deciding whether or not to keep your current manager, use TWR.

At Financial Navigator, Inc., we use our software to perform both kinds of calculations, and work to educate our users about how they can make sense of the reports and apply the two dierent numbers they get for the same investment over the same period. The bottom line is, if youre looking at what you take to the bank, use MWR. However, if youre deciding whether or not to keep your current manager, use TWR.

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TIME-WEIGHtED VS. MONEY-WEIGHtED REtUrNS

Understanding the purposes and limitations of these two methods and the process by which they derive their results enables you to make sound judgments regarding your portfolio. By understanding both methods, you can take into account such factors as market performance, investment amount, and manager performance. Beyond the data, these calculations can help you better understand your portfolios true performance, and ensure your long-term investment success.

About the Author Edward Van Deman, CIPM, CPA/PFS CEO, President and Co-Founder, Financial Navigator, Inc. (FNI) Ed Van Deman leads FNIs corporate strategy and implementation and has devoted his entire career to nancial reporting systems. A pioneer in integrated general ledger accounting and portfolio management software for the high-net-worth marketplace, he is a licensed CPA in California and New York, and has earned the Personal Financial Specialist (PFS) credential awarded by the American Institute of Certied Public Accountants (AICPA). Ed holds an MBA (with Distinction) from New York University, a B.S. in Mathematics from Davidson College, and is one of only several hundred professionals worldwide to receive Certicate in Investment Performance Measurement (CIPM) designation from the CIPM Association, a division of the CFA Institute.

Edward Van Deman

CEO/President

About Financial Navigator Financial Navigator provides software and services to family oces serving highnet-worth clients. Its Navigator Suite of applications is an integrated general ledger accounting and portfolio management system that tracks, manages, and reports on investment and non-investment assets, allowing you to serve your clients with speed and accuracy.
Financial Navigator, Inc. 883 N Shoreline Blvd. Suite D-100 Mountain View, CA 94043 USA www.nnav.com fn@nnav.com 800 468-3636 650 962-0300

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