Time-weighted return

Definition

Time-weighted return is a performance measurement technique used to evaluate the investment performance of a portfolio over time, which removes the impact of cash flows in and out of the portfolio. This method measures the compound growth rate of the investment, effectively standardizing returns to facilitate comparisons across different investments or managers. It is particularly important for assessing how well a portfolio manager is performing without the distortion from external cash flows.

5 Must Know Facts For Your Next Test

1. Time-weighted return is calculated by taking the geometric mean of periodic returns, ensuring that the effects of cash flows are neutralized.
2. This return method is particularly favored by institutional investors as it provides a clearer picture of a manager's ability to generate returns.
3. Using time-weighted return helps investors assess performance over multiple periods without being influenced by when cash flows occur.
4. The formula for calculating time-weighted return involves breaking down the investment period into sub-periods, calculating returns for each, and then compounding those returns.
5. Time-weighted return is especially useful for comparing funds or portfolios with different cash flow patterns, making it a key tool in performance evaluation.

Review Questions

• How does time-weighted return differ from money-weighted return in evaluating investment performance?
  • Time-weighted return focuses on the investment's performance independent of cash inflows and outflows, providing a standardized measure of how well an investment has performed over time. In contrast, money-weighted return considers the timing and size of cash flows, meaning it reflects the investor's actual experience based on when they invested their money. This difference is crucial for investors looking to evaluate a manager's skill versus their own decision-making regarding cash movements.
• In what scenarios would an investor prefer to use time-weighted return instead of money-weighted return for performance evaluation?
  • Investors should use time-weighted return when they want to assess the effectiveness of an investment manager without being influenced by external cash flow decisions. This is particularly relevant for institutional investors who may have significant inflows and outflows that do not reflect the manager's investment acumen. By using time-weighted return, they can accurately gauge how well the portfolio performed during their tenure without personal cash flow decisions skewing the results.
• Evaluate how utilizing time-weighted return can impact an investor's decision-making process regarding portfolio management.
  • Utilizing time-weighted return provides investors with a clearer understanding of a manager's ability to generate returns based on their investment strategies rather than personal cash flow activities. This can lead to more informed decision-making when selecting fund managers or assessing historical performance. By focusing on this unbiased measure, investors can avoid misleading conclusions drawn from money-weighted returns, which may overstate or understate actual performance based on timing and amounts invested, ultimately leading to better investment outcomes.

Related terms

money-weighted return: A performance metric that calculates the return of an investment based on the amount of money invested at different times, considering cash flows into and out of the investment.

benchmark: A standard or point of reference against which the performance of an investment or portfolio can be measured, often represented by a market index.

internal rate of return (IRR): The discount rate that makes the net present value of all cash flows from an investment equal to zero, used to evaluate the profitability of potential investments.