What is time-weighted rate of return (TWR)?

The time-weighted rate of return (TWR) is a measure of the compounded growth rate of a portfolio. The TWR measure is often used to compare investment managers’ returns because it eliminates the distorting effects on growth rates created by inflows and outflows of money. Time-weighted return breaks down the return of an investment portfolio into separate ranges based on the addition or withdrawal of money from the fund.

The time-weighted return measure is also called geometric mean return, a complicated way of saying that the returns for each subperiod are multiplied by each other.

Formula for calculating TWR.

Use this formula to determine the compound growth rate of your portfolio. $TWR=[(1+HP_1)x(1+HP_2)x…x(1+HP_n)]-1$ where: TWR = Time-weighted return n = Number of subperiods $HP$ = (Initial value+Cash flow) $HP_n$ = Final value-(Initial value+Cash flow)

How to calculate TWR

Calculate the rate of return for each subperiod by subtracting the beginning balance of the period from the ending balance of the period and dividing the result by the beginning balance of the period. Create a new subperiod for each period in which there is a change in cash flow, whether it is a withdrawal or a deposit. You will get multiple periods, each with a rate of return. Add 1 to each rate of return to make it easier to calculate negative returns. Multiply the rate of return of each subperiod by each other. Subtract the result of 1 to get the TWR.

What does the TWR tell us?

It can be difficult to determine how much money has been earned from a portfolio when there are multiple deposits and withdrawals made over time. Investors cannot simply subtract the beginning balance, after the initial deposit, from the ending balance, since the latter reflects both the rate of return on investments and any deposits or withdrawals during the period of investment in the fund. In other words, deposits and withdrawals distort the value of the portfolio return.

The time-weighted return breaks down the return on an investment portfolio into separate ranges based on the addition or withdrawal of money from the fund. TWR provides the rate of return for each subperiod or interval in which changes in cash flow occurred. By isolating returns that have experienced changes in cash flow, the result is more accurate than simply the initial and final balance of time invested in a fund. The time-weighted rate of return multiplies the returns for each subperiod or holding period, linking them together and showing how the returns are compounded over time.

In calculating the time-weighted rate of return, it is assumed that all cash distributions are reinvested in the portfolio. Daily portfolio assessments are required whenever there is an external cash flow, such as a deposit or withdrawal, that denotes the start of a new subperiod. In addition, subperiods must be equal in order to compare the returns of different portfolios or investments. These periods are then linked geometrically to determine the time-weighted rate of return.

Because investment managers dealing in publicly traded securities typically do not have control over the cash flows of the fund’s investors, the time-weighted rate of return is a popular performance measure for these types of funds, as opposed to the internal rate of return (IRR), which is more sensitive to cash flow movements.

Limitations of TWR.

Because of the variations in cash inflows and outflows on a daily basis, TWR can be an extremely complicated method of calculating and tracking cash flows. It is preferable to use an online calculator or calculation software. Another rate of return calculation often used is the money-weighted rate of return.

KEY RESULTS.

• The time-weighted return (TWR) multiplies the returns for each subperiod or holding period, linking them together and showing how the returns are compounded over time.
• Time-weighted return (TWR) helps eliminate the distorting effects on growth rates created by inflows and outflows of money.

Source: www.investopedia.com