Question: A few years ago you wrote about different kinds of rates of return on investments, such as time-weighted rate of return (TWR) and internal rate of return (IRR). Can you remind me of the differences and what they are used for?
Answer: Here is an updated version of my previous column.
The two rates of return you mention are used for different purposes. Investors use IRR to compare their portfolio’s return to their overall target return and to inform them of the growth of their investments. Investors use TWR to compare the growth of their portfolio to the market’s growth or to compare the performance of different portfolio managers.
As an individual investor with a financial plan, one of the assumptions you probably made was the target rate of return that is need to allow you to meet your goals for retirement, college funding, etc. You should compare that assumed target return to the IRR of your portfolio over time to see if you are on track to meet your goals.
The IRR is sometimes referred to as the “Money-weighted” or “dollar-weighted” rate of return. In reality, it is both time- and money-weighted. It is the rate of return that will make all the money flowing into your portfolio (inflows) equal to all the money that comes out (outflows). Inflows include the proceeds from any sale of an investment, dividends and interest that you receive, and money that you add. Outflows include the cost of each investment you purchase, reinvested dividends and interest, and withdrawals that you make.
The IRR is not the best way to measure how your advisor or your money manager is performing. For that purpose, you want to use the time-weighted rate of return (TWR). The TWR measures the performance of the investment without the influence of cash flows in and out of the account, whereas the money-weighted return factors in all cash flows, including contributions and withdrawals. Calculated over many periods, the money-weighted return will place more weight on the performance when the account size is highest.
For example, an investor opens an account with an advisor with $100,000. At the end of the year the account is worth $105,000. Both the IRR and the TWR for the first year are 5.00%.
Now assume that the investor adds $95,000 at the beginning of the second year. The advisor is now managing a $200,000 account. At the end of the second year, the account is worth $220,000. The account has increased by $20,000 and both the IRR and the TWR for the second year (only) equal 10%.
However, the annualized TWR and IRR returns over the two years will be different. The annualized TWR is 7.47% and the annualized IRR is 8.24%. The IRR is the return you would use to measure your performance against your investment target return, or goal. The TWR is the return you would use to measure how well the advisor or manager did, especially if you want to compare his/her performance to a benchmark.
The annualized IRR for the two-year period is higher than the TWR because the advisor had twice as much money to invest in year two when he made 10%, therefore the year two return is weighted twice as heavily.