Time weighted return

What Is Time Weighted Return?

Time weighted return (TWR) is a method of calculating investment performance that eliminates the distorting effects of external cash flows, such as deposits into or withdrawals from a portfolio. It is a key metric within the broader category of portfolio performance measurement and is particularly useful for evaluating the skill of a portfolio manager who does not control the timing or magnitude of these external money movements. Time weighted return focuses on the actual investment decisions and market performance, assuming a single investment at the beginning of a period and measuring its growth or loss in market value. This ensures that the calculated rate of return is independent of when an investor chooses to add or remove funds.

History and Origin

The concept of time weighted return gained prominence with the evolution of standardized investment performance reporting. Prior to its widespread adoption, varying methodologies could make comparing investment results difficult and potentially misleading. The need for a standardized approach led to the development of industry guidelines. Notably, the Global Investment Performance Standards (GIPS®), sponsored by the CFA Institute, have played a significant role in mandating the use of time weighted returns for most types of investment portfolios to ensure fair representation and full disclosure of performance. The GIPS standards, which evolved from the Association for Investment Management and Research (AIMR) Performance Presentation Standards, require time-weighted returns because they remove the effects of external cash flows, thereby reflecting a firm's ability to manage portfolios according to a specified mandate.¹⁵, ¹⁶, ¹⁷ This standardization effort, beginning in the late 20th century, aimed to foster greater transparency and comparability across investment management firms globally.

Key Takeaways

• Time weighted return measures the compounded growth of an investment over time, neutralizing the impact of client-initiated deposits and withdrawals.
• It is the preferred method for evaluating the performance of investment managers, as it isolates the manager's skill in asset selection and timing.
• The calculation involves breaking the overall investment horizon into sub-periods determined by significant cash flows, calculating returns for each sub-period, and then geometrically linking these returns.
• Regulatory bodies and industry standards, such as the Global Investment Performance Standards (GIPS), mandate or strongly recommend its use for public performance reporting.
• Unlike money-weighted return, time weighted return is less reflective of an individual investor's personal experience, especially if they actively manage their cash flows in response to market conditions.

Formula and Calculation

The time weighted return (TWR) is calculated by breaking the overall investment period into sub-periods. Each sub-period begins or ends with a significant external cash flow (deposit or withdrawal) or a scheduled valuation point. The return for each sub-period is calculated, and then these individual sub-period returns are linked geometrically to arrive at the total time weighted return.

The formula for calculating the time weighted return is:

Where:

• (R_n) = The simple return for each sub-period (n).
• The simple return for a sub-period is calculated as: $$R = \frac{(EMV - BMV - CF)}{BMV}$$ Where:
  • (EMV) = Ending Market Value for the sub-period
  • (BMV) = Beginning Market Value for the sub-period
  • (CF) = Net Cash Flow during the sub-period (positive for inflow, negative for outflow)

This method ensures that the timing of additions or withdrawals does not disproportionately influence the final return figure, making it suitable for comparing the true investment performance of different managers.

Interpreting the Time Weighted Return

Interpreting the time weighted return involves understanding that it represents the performance of a dollar (or other currency unit) that remained invested for the entire investment horizon, effectively removing the impact of any external contributions or distributions. A positive time weighted return indicates that the underlying assets grew in value over the period, independent of how much capital was actually in the portfolio at different times.

For instance, if a portfolio manager achieves a 10% time weighted return, it means that if a single dollar had been invested at the beginning and held throughout the period, it would have grown by 10%. This allows for a direct comparison of the manager's skill against a benchmark index or other investment vehicles, as the return calculation is unaffected by the ebb and flow of an investor's cash flows. It provides an unbiased view of the manager's ability to generate returns through their investment decisions, such as asset allocation, stock selection, and portfolio rebalancing.

Hypothetical Example

Consider an investor who starts with an initial investment of $10,000 on January 1.

• Period 1 (January 1 to June 30): The portfolio grows to $11,000.
• On June 30: The investor adds an additional $5,000 to the portfolio. The portfolio value immediately after the deposit is $11,000 + $5,000 = $16,000.
• Period 2 (June 30 to December 31): The portfolio (now $16,000) grows to $17,000 by year-end.

To calculate the time weighted return:

Step 1: Calculate the return for Period 1.
Beginning Market Value (BMV1) = $10,000
Ending Market Value (EMV1) = $11,000
Cash Flow (CF1) = $0
(R_1 = \frac{(11,000 - 10,000 - 0)}{10,000} = \frac{1,000}{10,000} = 0.10 \text{ or } 10%)

Step 2: Calculate the return for Period 2.
Beginning Market Value (BMV2) = $16,000 (portfolio value just after the deposit)
Ending Market Value (EMV2) = $17,000
Cash Flow (CF2) = $0 (the $5,000 was an external flow that redefined the start of Period 2)
(R_2 = \frac{(17,000 - 16,000 - 0)}{16,000} = \frac{1,000}{16,000} = 0.0625 \text{ or } 6.25%)

Step 3: Geometrically link the returns.
(TWR = [(1 + R_1) \times (1 + R_2)] - 1)
(TWR = [(1 + 0.10) \times (1 + 0.0625)] - 1)
(TWR = [1.10 \times 1.0625] - 1)
(TWR = 1.16875 - 1)
(TWR = 0.16875 \text{ or } 16.875%)

The time weighted return for the year is 16.875%. This figure represents the true growth of the investment itself, independent of the investor's decision to add more money mid-year. This approach is key to understanding the effects of compounding over multiple periods.

Practical Applications

Time weighted return is widely used in the financial industry, particularly by institutional investors and investment management firms, for several critical applications. It is the standard metric for reporting the historical performance of investment products like mutual funds and exchange-traded funds to the public.¹³, ¹⁴ This is because the fund manager has no control over when investors buy or sell shares, and TWR removes the impact of these external client cash flows, allowing for a clear assessment of the fund's underlying investment strategy.

Investment advisors use time weighted return to demonstrate their management abilities, providing clients with a consistent measure that can be compared against market indices and other investment professionals. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), require registered investment companies to include a "Management's Discussion of Fund Performance" in their reports, focusing on the fund's investment performance, a context in which time-weighted returns are indispensable for fair representation.¹¹, ¹² Financial data providers like Morningstar commonly display time-weighted returns to facilitate apples-to-apples comparisons of fund performance.⁹, ¹⁰ This consistent methodology helps investors make informed decisions when selecting funds based on historical returns.

Limitations and Criticisms

While time weighted return is an excellent measure of a manager's performance, it has limitations, especially from an individual investor's perspective. The primary criticism is that it does not reflect the actual dollar-weighted experience of an investor, particularly those who make significant cash flows into or out of their portfolio based on market timing or personal circumstances. For example, if an investor adds a large sum just before a significant market downturn, their actual dollar returns might be much lower than the reported time weighted return, which treats all capital equally across sub-periods.⁷, ⁸

Another drawback is the complexity of its calculation for portfolios with frequent transactions, as each external cash flow requires a new sub-period to be established for accurate valuation.⁶ For individual investors who manage their own portfolios and frequently contribute or withdraw funds, a money-weighted return (like the IRR) might be more relevant as it reflects the impact of their personal timing decisions on their overall wealth accumulation.⁵

Time Weighted Return vs. Money-weighted Return

Time weighted return and money-weighted return are two distinct methods for evaluating investment performance, each suited for different purposes. The key differentiator lies in how they account for external cash flows—deposits and withdrawals.

In essence, time weighted return answers the question, "How well did the investments perform?" whereas money-weighted return answers, "How well did my money perform?".

³, ⁴## FAQs

Why is time weighted return preferred for fund managers?

Time weighted return is preferred for portfolio manager evaluation because it removes the influence of client deposits and withdrawals. Since managers cannot control when investors add or remove money, TWR isolates the performance attributable solely to their investment decisions, allowing for a fair assessment of their skill.

²### Does time weighted return include dividends or capital gains?
Yes, time weighted return inherently includes both dividends (assuming reinvestment, or included in total return calculation) and capital gains or losses within the sub-period return calculations. It accounts for the total change in the portfolio's value, which encompasses all forms of investment income and appreciation or depreciation.

Can time weighted return be negative?

Yes, time weighted return can be negative if the underlying investments lose value over the measured period. A negative TWR indicates that the portfolio generated a loss, regardless of any cash flows an investor may have made.

Is time weighted return the same as annualized return?

No, time weighted return is a methodology for calculating return over a specific period, often multiple periods linked geometrically. An annualized return is a way of expressing a return that occurred over a period greater or less than one year on an annual basis. A time weighted return can be annualized if the period it covers is longer than one year, using a formula that adjusts it to an annual equivalent.

When are time weighted return and money-weighted return the same?

Time weighted return and money-weighted return will be identical only if there are no external cash flows (deposits or withdrawals) into or out of the portfolio throughout the entire investment horizon. I¹n such cases, the simple return calculation captures the full performance, which is effectively both time and money-weighted.