102 Session 9

Time Weighted rate of Return

Linked internal rate of return

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Faculty & Institute of Actuaries & are used
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Source: www.actuaries.org.uk
279
 What’s a rate of return?

This is a single number that tries to summarise a whole load of numbers.

e.g. in a year that had highs and lows and gains and losses, what single
measure describes a “good year”, or a “good manager”?

280
 What is a money weighted
rate of return?
This is the average “interest rate”
150
familiar from equations of value.
100

Ie it’s the average return on money, 50

where the average is weighted by
0
cashflows (hence the name) 0 0.5 1
-50

E.g. if 1/(1+i) = v, and our fund is valued -100

at 100 at the start of a year,
-150
and 198 at the end of the year, following
a cashflow of +49 mid-year,

Then v = 1/(1+MWRR) solves

281
100 = 49v0.5 + 198v
 Why is a money weighted rate of return no use
for benchmarking? (1)
1200
It’s distorted by cashflows.
1000
800
E.g. suppose a fund manager runs a unit trust

PRICE
(which pays no dividends). The unit price halves 600
over 6 months, and then doubles in another six 400
months (back where it started - see the red line) 200
0
Suppose a fund only invests in the unit trust. It
0 0.5 1
has a holding of 100 at the start of the year and
adds cash of 49 mid-year. 250
200
The 100 at the start of the year shrinks to a 150

CASHFLOWS
holding worth 50 mid-year. The new cash makes 100
a holding of 99. The 99 doubles in value to 198 by 50
the end of the year. (See the blue blocks). 0
-50 0 0.5 1
The average (money weighted return) is 40%, -100
because 100 * 1.40 + 49 * 1.400.5 = 198 282
-150
 Why is a money weighted rate of return no use
for benchmarking? (2)

Suppose an identical fund took out 49 mid-year, 1200

(ie it almost sold up completely so hardly saw any 1000
of the “rebound”). 800

PRICE
600
The 100 at the start of the year shrinks to a
holding worth 50 mid-year. The cash withdrawal 400
leaves a holding of just 1. The 1 doubles in value 200
to 2 by the end of the year 0
0 0.5 1
The average money weighted annual return
100
would be calculated as -72% because
50
100 * (1 – 72%) – 49 * (1 – 72%)0.5 = 2
CASHFLOWS
0
But both funds were invested in the same asset, 0 0.5 1
-50
managed by the same manager. The (different)
MWRRs haven’t measured the return on the -100
asset, and haven’t measured the manager’s 283
performance. -150
 What is a time-weighted rate
of return?
This is what the cumulative return on the
fund would have been had there been
1200
no cashflows. See
1000
http://www.investopedia.com/terms/t/tim
e-weightedror.asp 800

PRICE
600
In our example case it is nil. 400
200
The unit price fell and rose. 0
0 0.5 1
Ie the 1 + the total return =
=(1 – 50%) * (1 + 100%) = 1

Ie the total TWRR = nil.

284
 What is a linked internal rate
of return? +100%

250
200 -50%
Eliminating all the cashflows in the 150

CASHFLOWS
TWRR calculation requires a lot of data. 100
50
The LIRR gets round this by working out
0
a MWRR for various periods, then
-50 0 0.5 1
chaining the returns together. -100
-150
If we chose periods of a whole year for
100
our example, we’d just get the rather
useless MWRR. 50

CASHFLOWS
0
If we chose periods of half a year, the
LIRR would be nil, for both funds. 0 0.5 1
-50

-100
285
-150
Specimen Q12

286
Specimen Q12

2
1.8
1.6 Rough guess:
1.4
1.2
Cashflow
ignoring 0.2m
1
0.8 Value (cash in), grew
0.6
0.4
from …..to 1.8-0.2 =
0.2
0
1.6 => annual return
J F M A M J J A S O N D about …./1.2 ie 33%

Exact calc: the dates that matter are the start & the end.
Grew from 1.2 to …… in first period
Then grew from (1.4 + …..)= 1.6 to ….. in second period
Overall, grew by factor of 1.4 / 1.2 * 1.8 / ….. in a year
= growth factor of …….. pa ie …….% pa (close to guess?)

287
Specimen Q12

2
1.8
1.6 Rough guess:
1.4
1.2
Cashflow
ignoring 0.2m
1
0.8 Value (cash in), grew
0.6
0.4
from 1.2 to 1.8-0.2 =
0.2
0
1.6 => annual return
J F M A M J J A S O N D about 1.6/1.2 ie 33%

Exact calc: the dates that matter are the start & the end.
Just though investment management,
grew from 1.2 to 1.4 in first period
Then grew from (1.4 + 0.2)= 1.6 to 1.8 in second period
Overall, grew by factor of 1.4 / 1.2 * 1.8 / 1.6 in a year
= growth factor of 1.3125 pa ie 31.25% pa (close to guess)
288
Specimen Q12

Model answer

289
Apr 2000 Q5

290
 Apr 2000 Q5

350
300 Rough guess: ignoring cash
250
in, grew
200
150
from 180 to
100 309 – (25+18+16)=…..
50
0 => 3 year return about
1/97 7/97 1/98 7/98 1/99 7/99 1/2000
……/180 ie 39%
Exact calc: Just though investment management,
grew from 180 to ….. in first six months. Over next year,
shrank from ……+25 = 237 to 230. Grew from …….+18 = 248 to 295 in next year.
Shrank from ……..+16= 311 to 309 in last six months.
Growth factor over period = 212/…… * 230/237 * 295/248 * 309/311
= 1.3509 (close to guess) => annual growth factor = 1.3509(……) = 1.105
=> TWRR = ……..% 291
 Apr 2000 Q5

350
300 Rough guess: ignoring cash
250
in, grew
200
150
from 180 to
100 309 – (25+18+16)=250
50
0 => 3 year return about
1/97 7/97 1/98 7/98 1/99 7/99 1/2000
250/180 ie 39%
Exact calc: Just though investment management,
grew from 180 to 212 in first six months. Over next year,
shrank from 212+25 = 237 to 230. Grew from 230+18 = 248 to 295 in next year.
Shrank from 295+16= 311 to 309 in last six months.
Growth factor over period = 212/180 * 230/237 * 295/248 * 309/311
= 1.3509 (close to guess) => annual growth factor = 1.3509(1/3) = 1.105
=> TWRR = 10.5% 292
Apr 2000 Q5

Model answer

293
Apr 2001 Q2

294
 Apr 2001 Q2

800
700 Rough guess: ignoring cash
600
500 in, 11% pa would increase
400 initial fund from 400 to 400 *
300
200
1.11^3 = …..
100
0 Add cashflows back in
1/98 7/98 1/99 7/99 1/2000 7/2000 1/2001
(without any return),
guess X= …..+ 50+ 40+ 60
Exact calc: Just though investment management,
Total growth factor is = 700
…… / 400 * ……/ (460 + 50) * …… / (500 + 40) * X / (650 + 60)
And total growth factor = 1.11^…. (11% pa TWRR)

=> X = £………m (close to guess?) 295

 Apr 2001 Q2

800
700 Rough guess: ignoring cash
600
500 in, 11% pa would increase
400 initial fund from 400 to 400 *
300
200
111^3 = 550.
100
0 Add cashflows back in
1/98 7/98 1/99 7/99 1/2000 7/2000 1/2001
(without any return),
guess X= 550+ 50+ 40+ 60
Exact calc: Just though investment management,
Total growth factor is = 700
460 / 400 * 500 / (460 + 50) * 650 / (500 + 40) * X / (650 + 60)
And total growth factor = 1.11^3 (11% pa TWRR)

=> X = £715.5m (a bit more than guess – OK allowing for additional return on cash in) 296
Apr 2001 Q2

Model answer

297
Apr 2003 Q8

298
 Apr 2003 Q8(i)a

60

50 Rough guess: ignoring cash

40 in, grew
30 from 40 to
20 53 – (4+2)= 47
10

0 => 2 year return is approx.

1/00 7/00 1/01 7/01 1/02
47/40 ie 18%

Exact calc: Just though investment management,

Growth factor over whole 2 years is
43 / 40 * 49 / (43 + 4) * 53 / ( 49 + 2 )
= 1.1647 (a bit below guess – OK as cashflow in got some return too)

=> Average annual growth factor (just due to management) = TWRR = 1.1647(1/2) – 1 = 7.92% 299
Apr 2003 Q8(i)a

Model answer

300
 Apr 2003 Q8(i)b

60

50
Rough guess: will be close to
TWRR. Will be more or less than
40
TWRR?
30

20
Will be slightly less. 2nd half of 2001
was worse (on TWRR measure)
10
than 1st half of 2001. MWRR for
0 2001 is average of frist & second
1/00 7/00 1/01 7/01 1/02
half of year. Average will be more
heavily weighted to (poor) second
Exact calc: half by the extra money that came
MWRR over first year is 43/40 = 1.075 in mid-2001.
MWRR over first year is i: if v = 1 / (1 + i)
Then (43 + 4)(1 + i) + 2(1 + i) (1/2) = 53 ie (1 + i) (1/2) (using quadratic formula) = 1.04085
and so 1 + i = 1.08337.
Hence 1 + LIRR pa = ( 1.075 * 1.08337 ) (1/2) = 1.07918 301
Ie LIRR is just less than TWRR (as guessed)
 Apr 2003 Q8(i)b

Abbreviated Model
answer

302
 Apr 2003 Q8(ii)

60

50
TWRR will be identical to LIRR
when calculations are identical.
40

30

20 Ie MWRR calcs (mid-period) must

10 be identical to TWRR calcs ie
0 simple end_value / start_value
1/00 7/00 1/01 7/01 1/02 ratios.
So, the intervals chosen for the
Intervals free of mid-interval-cashflow are: LIRR can’t include any mid-interval
cashflows.
1.1.00 to 1.1.01
(This is a bit unlikely as the point of
1.1.01 to 1.7.01 the LIRR sum is to get round the
1.7.01 to 31.12.01 heavy data requirements of the
TWRR calculation). 303
Apr 2003 Q8(ii)

Model answer

304
Sep 2003 Q2

305
Sep 2003 Q2

Model answer

306
 Key question
Get 100% on April 2003 Q8

It doesn’t matter how many times you see the

answers.

Your goal is to get someone else to understand

the solution.

307
Next session: par yields

END
308