Time-Weighted Return: The Key to Smarter Funds
Have you explored how Time-Weighted Return can provide a clearer picture of your fund’s performance over time?
In situations where investors add or withdraw funds at different times, it becomes difficult to assess the portfolio manager’s true skill since the timing and amount of these cash flows can skew the results. For instance, you invested $100,000 in your portfolio and made a few large cash contributions over the year — $50,000 added in March and $30,000 withdrawn in September. Simply calculating the total return could be misleading without adjusting for these cash flows. The added funds might have boosted the portfolio’s value when the market was doing well, or the withdrawal could have occurred just before a market rally.
Using time-weighted return (TWR), we split the performance into three periods: January to March, March to September, and September to December. The return for each period is calculated separately and then compounded, neutralizing the impact of the cash flows. It gives a more accurate picture of the portfolio manager’s performance, unaffected by the investor’s deposit and withdrawal decisions. Read on to unlock the benefits of time-weighted return: the smarter ROI measure for fund managers.
Understanding Time-Weighted Return (TWR)
The Time-Weighted Return (TWR) is a critical financial metric that allows investors to accurately assess an investment’s true performance by removing the distortions caused by capital inflows and outflows. It is especially important for portfolios where investments or withdrawals are made over time, as it isolates the actual return generated by the investment manager, independent of how much or when money was added or removed.
At its core, TWR breaks down an investment’s total performance into separate periods, compounding the returns of each period while adjusting for the length of time between cash flows. This method ensures that each segment of the investment timeline is properly reflected in the overall return, giving a clearer picture of how the investment has performed over time.
By using the geometric mean of the returns, TWR provides a balanced view of a portfolio’s performance, especially when multiple cash flows are involved. This unique feature makes it a highly effective tool for comparing different investment managers or strategies. TWR levels the playing field by removing the impact of external factors like deposits or withdrawals, which can skew simpler return calculations.
When to Use TWR
Use time-weighted return when you want to focus on the pure investment performance, independent of cash flow timing. It is designed to eliminate the impact of cash flows and focus solely on investment performance, making it particularly useful in the following situations:
· Assessing Long-Term Portfolio Performance: TWR provides an accurate picture of how the portfolio itself has grown or shrunk based solely on investment gains or losses. It is ideal for tracking the performance of a portfolio over a long period where cash flows occur sporadically, such as with retirement accounts or endowments.
· Comparing with Benchmark Indexes: TWR is often used when a portfolio’s performance is compared against benchmarks or indices, which do not consider the investor’s cash flows.
· Comparing Fund Managers: TWR allows for a fair comparison between portfolio managers or funds. Since the investor controls cash inflows and outflows and not the manager, TWR isolates the effect of the manager’s investment decisions.
· Evaluating Investment Strategies: TWR is a reliable tool when the goal is to measure the performance of a strategy over time, irrespective of the timing or size of cash flows. This is especially useful in analyzing mutual funds, hedge funds, and pension plans, providing a sense of security in its accuracy.
Note: If you’re an individual investor looking to evaluate how much money you’ve made based on your own cash flow timing (deposits and withdrawals), money-weighted return (also known as internal rate of return or IRR) would be more appropriate.
Time-Weighted Return Formula
The time-weighted return formula is a crucial metric in investment performance analysis, as it effectively neutralizes the impact of cash flows — deposits or withdrawals — on the return calculation. By breaking an investment period into sub-periods, the TWR accounts for the underlying asset’s performance rather than the influence of investor actions, providing a clear view of how a portfolio or fund manager has performed. It makes TWR especially valuable when comparing the performance of different investments, as it offers a more accurate and standardized measure, independent of cash flow timing or size.
The TWR formula begins with calculating the time-weighted return for a single period of investment as follows:
Where:
· The investment’s final value is the total value at the end of the period, including returns or capital growth.
· The investment’s initial value is the amount of money at the beginning of the period.
· Cash flow refers to any contributions (deposits) or withdrawals (distributions) made during the investment period.
The formula subtracts the initial investment and cash flows from the final value to focus only on the gains or losses. Dividing this by the initial investment sum and cash flows normalizes the return, providing a percentage gain or loss relative to the invested capital.
Sample Calculation 1
Let’s go through a sample calculation of the time-weighted return formula for a single period of investment using the following assumptions:
· Investment’s Final Value = $15,000
· Investment’s Initial Value = $10,000
· Cash Flow = $2,000
Substituting the values:
In this example, the time-weighted return of the investment is 25%. It reflects the portfolio’s performance, removing the impact of the $2,000 cash flow during the investment period.
The time-weighted return formula does not end with calculating the TWR for a single investment period. Rather, it calculates the overall time-weighted return for multiple periods using geometric compounding. It combines the individual period returns (TWR1, TWR2, etc.) to provide a cumulative performance in various periods. Each TWRn represents the return on the investment over a specific period, and by multiplying them together, we incorporate the effect of compounding. To reflect the return of each period expressed in decimal form, we add the TWR to 1 (1+TWRn). The multiplication of all these terms provides the compounded return over the entire period. Then, subtracting 1 converts the compounded value to a percentage, giving the overall period’s overall return.
The time-weighted return formula for the compounded return over the entire period is as follows:
Sample Calculation 2
Here’s an example to demonstrate how the time-weighted return formula for the compounded return over the entire period works:
Assume the following period returns:
· TWR1 = 2% (or 0.02)
· TWR2 = -1% (or -0.01)
· TWR3 = 3% (or 0.03)
Substituting the values:
In this example, the overall time-weighted return of the investment for the three periods is 2.04%. This approach helps in isolating the effect of the actual investment performance across multiple periods, without the distortion caused by external cash flows during those periods.
Common typical TWR Benchmarks
A “good” TWR percentage depends on the investment type and market conditions, but generally, the higher the TWR, the better the investment has performed. It means the investment has grown consistently and outperformed a relevant benchmark or similar investments. Please note that a negative TWR can be good when it outperforms the overall market or relevant benchmarks during a downturn, indicating that the investment is losing less value than others.
Here’s a general summary of typical TWR benchmarks across various industries:
· Consumer goods tend to target moderate stability, ranging from 3–7% for staples, while discretionary funds could aim higher, typically between 6–12% in a strong consumer market.
· Energy sector investments, including oil, gas, and renewables, are highly volatile due to factors like global oil prices and political shifts. Benchmarks typically span from -5% to 15%.
· Financial sector funds, including banks and insurance companies, may align their TWRs with broader indices depending on market dynamics and regulations. Expected benchmarks range from 5% to 10%.
· Healthcare and biotech funds are potentially volatile to high risk and reward, with benchmarks varying widely from 8% to 15%.
· Real estate investment trusts (REITs) typically have benchmarks ranging from 4% to 9%. These benchmarks highlight the stable but lower-growth nature of real estate investments and provide investors with a sense of security.
· With its rapid growth potential, the tech sector often targets high TWRs. Benchmarks for this sector are usually aligned with indices like the NASDAQ-100, aiming for double-digit returns, frequently exceeding 10–15% annually in a growth market.
Utility funds, considered low-risk, generally aim for lower TWR benchmarks in the 3–6% range. This reflects the stable demand and regulatory framework in this sector, which is often aligned with indices like the Dow Jones Utility Average.
In summary, lower-risk industries tend to have lower TWR benchmarks, while higher-risk industries aim for higher TWR benchmarks due to their greater growth potential. This is because lower-risk industries prioritize stability and steady returns, whereas higher-risk industries offer the potential for greater rewards in exchange for increased volatility and uncertainty.
Unlock Smarter Investments with Time-Weighted Return
TWR eliminates the effects of cash flows, offering a more accurate comparison between different funds or assets. To provide a clear, unbiased measure of an investment’s performance over time, financial modeling is essential for calculating Time-Weighted Return (TWR). It gives a precise and systematic way to fairly compare different assets, make informed decisions, and gain insights into how well investment strategies work. This leads to better portfolio management and more reliable assessments of long-term investment performance.
Unlocking smarter investments with time-weighted return (TWR) through financial modeling involves accurately assessing an investment’s performance over time, free from the impact of cash inflows and outflows. Using TWR in financial models, investors can make apples-to-apples comparisons across different funds or assets, regardless of when capital is added or withdrawn. It helps investors optimize portfolios and align their strategies with long-term goals, ultimately driving smarter investment choices.
eFinancialModels.com provides financial model templates specifically designed for calculating and tracking Time-Weighted Return (TWR), enabling investors to measure performance accurately. These templates help streamline the analysis of investment returns, offering clear insights for smarter financial decision-making. Optimize Your Returns Now!
