All returns are not created equal. There are 2 main types of returns you want to see on your performance report: Internal Rate of Return (IRR) and Time-Weighted Rate of Return (TWR).
What’s the difference?
- IRR measures the overall growth of the portfolio. If your goal is to reach a $1 million by age 65, IRR tells you whether your portfolio is growing fast enough to get there on time.
- TWR measures the growth of the average $1.00 in the portfolio. TWR tells you how well your portfolio is doing compared to the market or other managers.
Internal Rate of Return (IRR) is the single rate of return at which the beginning market value plus additions grows to equal the ending market value minus withdrawals.
IRR is computed through a process of trial and error (Base Estimation Method) where you “guess” what number makes everything you put into the investment equal everything you took out. Then you try that guess into the equation and, depending on the results, keep refining your guess until the equation works. In reality, returns may have bounced wildly up and down during the time period, but IRR is the slope of a hypothetical straight line between the beginning and ending value.
The timing and size of cash and securities moving in and out of the account greatly influence IRR. The larger the amount, the more it affects the return. The IRR should not be compared to a market index (which has no cash flows) or for measuring the performance of a manager, because IRR is affected by events over which the manager has no control, such as the client making large deposits or withdrawals.
Time-weighted Rate of Return (TWR) measures the investment philosophy.
TWR links together a series of returns on smaller sub-periods or “intervals” through a geometric formula. The intervals remove the impact of deposits and withdrawals and the number of total dollars. TWR measures the investment performance of the average dollar in the portfolio, and more accurately reflects the choices determined by the investment philosophy.
- TWR measures how well the manager did with the money invested.
- IRR measures how smart the client was to move money to/from the manager at the right time.
This post first appeared on Krisan’s Backoffice, Inc and is reprinted here with permission. Photo used here under Flickr Creative Commons.