Money-weighted return

Definition

The money-weighted return is a measure of an investment's performance that accounts for the timing and size of cash flows into and out of the investment. Unlike time-weighted returns, which treat all periods equally, the money-weighted return emphasizes the impact of the actual capital invested at different times, making it particularly useful for understanding the returns generated for an investor based on their specific cash flow activity.

5 Must Know Facts For Your Next Test

1. Money-weighted return is also known as the dollar-weighted return because it reflects how much money was invested and when.
2. It is calculated by finding the IRR for a series of cash flows over time, making it sensitive to when cash is invested or withdrawn.
3. This measure can provide a more accurate picture of an investor's actual experience than time-weighted returns, especially in scenarios with significant cash inflows or outflows.
4. Investors should be cautious using money-weighted return when comparing performance across different funds or portfolios, as it reflects individual cash flow decisions.
5. In private equity and venture capital, money-weighted return is essential for assessing performance since funds often have irregular cash flows due to capital calls and distributions.

Review Questions

• How does the money-weighted return differ from time-weighted return in terms of measuring investment performance?
  • The money-weighted return differs from time-weighted return in that it takes into account the size and timing of cash flows associated with an investment. While time-weighted return treats each period equally regardless of when investments are made, money-weighted return gives more weight to periods where larger amounts were invested or withdrawn. This makes money-weighted return particularly relevant for understanding an investor's experience, especially in situations where cash flows are irregular.
• What role does money-weighted return play in evaluating private equity investments compared to traditional investments?
  • Money-weighted return plays a significant role in evaluating private equity investments because these investments typically involve complex cash flow patterns due to capital calls and distributions. Unlike traditional investments where cash flows may be more predictable, private equity can have varying investment timelines that affect overall returns. By using money-weighted return, investors can better assess how their specific cash flow decisions influenced the performance of their investments, providing a clearer picture of actual profitability.
• Critically assess how relying solely on money-weighted return could lead to misinterpretation of an investment’s success.
  • Relying solely on money-weighted return could lead to misinterpretation of an investment's success because it may not fully account for market conditions or other external factors influencing performance. For instance, if an investor timed their cash flows poorly but still achieved a high money-weighted return due to good market performance after their entry point, it could mislead them into thinking they made superior investment decisions. Additionally, comparing funds with different cash flow patterns based only on money-weighted returns might overlook inherent differences in risk profiles and management strategies, leading to flawed conclusions about overall investment effectiveness.

Related terms

Internal Rate of Return (IRR):

The Internal Rate of Return is the discount rate that makes the net present value of all cash flows from an investment equal to zero, serving as a critical metric for assessing profitability.

Multiple on Invested Capital (MOIC):

Multiple on Invested Capital is a performance metric that measures the total value generated by an investment relative to the capital invested, often expressed as a ratio.

cash flow:

Cash flow refers to the net amount of cash being transferred into and out of a business or investment, which can significantly impact overall returns.