Calculating returns is how an investor sees the performance of their investment. It can be tough to cipher when you factor in your regular contribution, market fluctuations, fees, and withdrawals.
How are my returns calculated?
There are three ways to calculate your rate of return: Time Weighted Return (TWR), Simple Rate of Return (SRR), and Internal Rate of Return (IRR).
The Time-Weighted Return captures the true investment performance by cutting out all the movements of investments and withdrawals from the portfolio. Simply put, the TWR is the return on the very first dollar invested into the portfolio. This makes the TWR a more meaningful measurement of performance and the best way of comparing your investment manager’s performance.
The TWR allows an investor to accurately evaluate the true performance of the assets and your investment manager, not just the return on the dollars you have invested in the portfolio. This might not sound like a big deal, but the IRR and TWR can be significantly different – even for the exact same period of time. It is important to understand the differences so you can make investment decisions with the best information available.
It’s also worth mentioning that this way of calculating returns is a requirement for investment advisors under the Global Investment Performance Standards.
Simple Rate of Return
Just like it sounds, the Simple Rate of Return is the easiest return to calculate and understand. It is simply the percentage change in market value. The SRR is most usually used to calculate the performance of an index where there is no cash coming in or out. An SRR, although easy to calculate for a benchmark, cannot really measure the return of an investment portfolio. This is where Internal Rate of Return and TWR come into the picture.
Internal Rate of Return
The Internal Rate of Return, sometimes called the dollar-weighted return, is the measurement of a portfolio’s actual performance between two dates – and that will include the effects from all deposits and withdrawals made during that time. Because cash flows are factored into the calculation, greater weighting is given to those time periods when more money is invested in the portfolio. By this definition, the IRR of a portfolio can be significantly affected by both the size and timing of any cash contributions or withdrawals. In other words, that large investment you made with a one-time windfall may shake up your overall returns and create an inaccurate picture of your portfolio. IRR is great for looking at absolute growth, but not ideal for analyzing the long-term performance. This is why the TWR becomes a more meaningful measurement tool.