Time-weighted return

Definition

Time-weighted return is a method used to measure the performance of an investment portfolio by calculating the compound growth rate of the investment over a specified time period, eliminating the effects of cash inflows and outflows. This approach ensures that returns are evaluated based solely on the investment performance itself, providing a more accurate reflection of an investment manager's effectiveness in generating returns. By removing the impact of external cash flows, time-weighted return facilitates fair comparisons between different investments and benchmarks.

5 Must Know Facts For Your Next Test

1. Time-weighted return is particularly useful for comparing the performance of fund managers since it removes the impact of cash flows that they cannot control.
2. This method involves breaking down the measurement period into sub-periods, calculating returns for each sub-period, and then linking them together to get an overall return.
3. Unlike money-weighted return, which accounts for the timing and amount of cash flows, time-weighted return provides a clearer picture of an investment's pure performance.
4. The formula for calculating time-weighted return can be complex, as it typically involves geometric linking of periodic returns.
5. When calculating time-weighted returns, any periods with significant cash inflows or outflows can distort an investor's view if using other methods, making this approach invaluable for accurate performance assessment.

Review Questions

• How does time-weighted return differ from money-weighted return, and why is this distinction important for evaluating investment performance?
  • Time-weighted return focuses solely on the investment's performance by neutralizing the effects of cash inflows and outflows, while money-weighted return accounts for the timing and size of cash flows. This distinction is crucial because it allows investors to assess a fund manager's effectiveness without bias from external factors they cannot control. By using time-weighted return, investors can make more accurate comparisons between different investments and their respective benchmarks.
• Discuss the process of calculating time-weighted return and why breaking the measurement period into sub-periods enhances accuracy.
  • Calculating time-weighted return involves dividing the overall measurement period into smaller sub-periods based on when cash flows occur. Each sub-period's return is calculated separately, and then these returns are geometrically linked to obtain an overall performance figure. This method enhances accuracy because it reflects how each part of the investment performed without being skewed by cash flows that may have taken place during those periods.
• Evaluate how the use of time-weighted return can impact investor decision-making when comparing different investment managers or funds.
  • Using time-weighted return significantly influences investor decision-making by providing a fair comparison among different investment managers or funds. Since this method eliminates the effects of external cash flows, investors can see how well each manager has performed in generating returns based solely on their investment strategies. This clarity helps investors make informed choices about where to allocate capital, as they can identify top-performing managers without being misled by discrepancies caused by varying cash flow timings.

Related terms

cash flow: Cash flow refers to the total amount of money being transferred into and out of an investment over a specific period, which can affect overall investment returns.

benchmarking: Benchmarking involves comparing an investment's performance against a standard index or measure to evaluate its relative performance.

internal rate of return (IRR): Internal rate of return is the discount rate that makes the net present value of all cash flows from an investment equal to zero, often used for assessing the profitability of investments.