What it means
Imagine two investors in the same fund. One adds a large sum just before a market fall, and the other adds nothing.
Their personal results will differ, but the fund manager did exactly the same job for both of them, and a fair measure of the manager should not be affected by when clients paid in. Time-weighted return solves this by breaking the measurement period into sub-periods, split at every date when money enters or leaves.
It calculates the return for each sub-period on its own, then links the results by multiplication. Because each segment is measured on the amount invested at the start of that segment, the cash flows have no influence.
The method is widely used because it lets you compare a manager against a benchmark or against competitors. Investment performance standards for professional managers generally require it, since managers do not control when clients invest.
Unit trusts and funds also use it when they publish performance figures. The main contrast is with the money-weighted rate of return, which is also called the internal rate of return.
The money-weighted figure reflects the investor's own timing, so it measures how the investor did, not how the manager did. When an investor adds money before a fall, the money-weighted return is worse than the time-weighted return.
The method has limits. It needs the portfolio value at every date a cash flow occurs, which can be hard to obtain for private assets that are valued rarely.
For those, a money-weighted measure is often used instead. It also helps to remember that returns are linked by multiplication, not addition.
A 10% gain followed by a 10% loss does not net to zero, because the loss applies to a larger base. That is why the time-weighted result for a year is not simply the average of the sub-period returns.
In practice
Real-world examples.
Example
A pension fund compares three equity managers over five years. Each manager received different contributions at different times, so the trustees use time-weighted returns to rank them on skill alone.
Example
A wealth adviser reports performance to a client who paid in a large inheritance halfway through the year. The adviser shows the time-weighted return to reflect the investment choices, then separately shows the money-weighted return to reflect the client's actual experience.
Example
A company managing a corporate cash portfolio receives monthly inflows from sales and makes regular withdrawals for payroll. The treasury team uses time-weighted returns so it can judge the portfolio's investment decisions without the noise of the cash movements.
Formula
Calculation
Time-weighted return = (1 + R1) x (1 + R2) x ... x (1 + Rn) - 1
Each sub-period return = (ending value - beginning value - cash added) / beginning value, where cash flows are measured at the sub-period boundary
An investor starts the year with $100,000. After six months the portfolio is worth $110,000, so the first sub-period return is (110,000 - 100,000) / 100,000 = 10%.
The investor then adds $50,000, taking the portfolio to $160,000. By the end of the year it is worth $144,000, so the second sub-period return is (144,000 - 160,000) / 160,000 = -10%.
Time-weighted return = 1.10 x 0.90 - 1 = 0.99 - 1 = -1%.
The investor actually lost $6,000, which is 144,000 - 150,000, a bigger loss in percentage terms than -1%, because most of the money was invested during the poor second half. The manager's own performance was only -1%.Case study
Seen in the real world.
Marlow & Finch Advisers is an illustrative, fictional firm that runs a growth fund. A client complained that the fund had returned only 2% over a year while a competitor's fund reported 8%.
The firm's analyst reviewed the client's account and found that the client had put in a large sum right before a sharp market dip in the second quarter. The fund's time-weighted return for the year was 7.6%, close to the competitor's, but the client's own money-weighted return was 2%.
The illustrative conclusion was that the manager had performed in line with the market, while the client's timing explained the shortfall. The firm sent a clear two-line comparison of both measures, which turned an argument about skill into a conversation about investing regularly.
Watch out
Common mistakes.
- Adding or averaging sub-period returns, when they must be linked by multiplication.
- Using time-weighted return to describe what an investor personally earned, when it ignores the timing of the investor's own cash flows.
- Failing to value the portfolio on every date when cash enters or leaves, which makes the calculation inaccurate.
Questions
People also ask.
What is the difference between time-weighted and money-weighted return?
Time-weighted return removes the effect of cash flows to judge the manager, while money-weighted return includes them to show what the investor actually earned.
Why do professional managers use time-weighted return?
Because they do not control when clients deposit or withdraw money, so the method gives a fair measure of their decisions.
Does time-weighted return need daily valuations?
Ideally it uses a valuation on each day a cash flow occurs, although many firms accept monthly valuations as a close approximation.
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