Key Takeaways
- Measures portfolio growth excluding cash flow impact.
- Calculates returns for sub-periods between cash flows.
- Preferred for fair fund performance comparison.
- Compounds sub-period returns geometrically.
What is Time-Weighted Rate of Return (TWR)?
The Time-Weighted Rate of Return (TWR) measures the compound growth rate of an investment portfolio by eliminating the impact of external cash flows like deposits or withdrawals. Unlike simple returns, TWR isolates the performance generated solely by the underlying investments, making it ideal for comparing fund managers and portfolio performance.
This method divides the evaluation period into sub-periods based on cash flow dates, calculates returns for each, and compounds them geometrically. Its precision makes TWR a preferred metric in financial analysis and investing discussions, such as those involving IVV and other index funds.
Key Characteristics
TWR has distinct features that differentiate it from other return calculations:
- Cash flow neutral: Separates the effect of investor deposits and withdrawals from investment performance.
- Geometric linking: Combines returns from multiple sub-periods using multiplication, not simple addition.
- Standard for managers: Widely used by investment managers to fairly compare returns across accounts and time frames.
- Annualization: Can be converted into a compound annual growth rate (CAGR) for multi-year periods.
- Insensitive to timing: Unlike money-weighted returns, it treats each sub-period equally regardless of invested amounts.
How It Works
To calculate TWR, you first identify all periods separated by external cash flows, such as investments or withdrawals. Each sub-period's holding period return (HPR) is calculated, including dividends or income, then linked by multiplying (1 + HPR) values together and subtracting 1.
This method removes distortions caused by investor behavior, providing a pure measure of investment performance. Platforms like M1 commonly employ daily TWR calculations to reflect frequent cash flow changes accurately.
Examples and Use Cases
Understanding TWR through real-world scenarios highlights its practical value:
- Airlines: Investors comparing Delta and American Airlines performance use TWR to isolate how each company's stock itself performed, unaffected by cash inflows or outflows.
- Bond funds: Evaluating a bond fund like BND with TWR helps separate market-driven returns from investor transactions.
- Index funds: Comparing returns of low-cost options such as best low-cost index funds benefits from TWR's cash flow neutrality, especially during volatile markets.
Important Considerations
While TWR is robust for assessing manager performance, it assumes cash flows occur at period boundaries and ignores intra-period timing, which can affect accuracy in rapidly changing markets. It is less suited for personal investment scenarios where timing and amount of cash flows matter, in which case money-weighted returns may provide better insight.
Using TWR alongside complementary metrics like R-squared and tactical asset allocation strategies (Tactical Asset Allocation) can provide a fuller picture of portfolio dynamics and risk-adjusted performance.
Final Words
Time-Weighted Rate of Return provides a clear view of your portfolio’s performance by removing the effects of cash flow timing. To apply this insight, calculate TWR for your investments or compare it across funds to make more informed decisions.
Frequently Asked Questions
Time-Weighted Rate of Return (TWR) measures a portfolio's compound growth by dividing the evaluation period into sub-periods at each cash flow, calculating returns for each, and linking them geometrically. This method removes the impact of deposits or withdrawals, isolating the investment’s performance.
Unlike simple rate of return, which can be skewed by the timing of cash flows, and money-weighted return, which weighs returns by invested amounts, TWR treats each sub-period equally. This makes TWR ideal for comparing investment performance independent of cash flow timing.
Investment managers prefer TWR because it accurately reflects the portfolio’s growth by excluding the impact of client cash flows. This provides a clearer picture of how the investments themselves performed over time.
First, split the total period into sub-periods at each cash flow event. Then, calculate the holding period return (HPR) for each sub-period and multiply (1 + HPR) values together. Finally, subtract 1 from the product to get the overall TWR.
Yes, to annualize TWR over multiple years, take the geometric mean by raising (1 + total TWR) to the power of 1 divided by the number of years, then subtract 1. This gives the average annual compound return.
Cash flows such as deposits or withdrawals mark the start and end of sub-periods in TWR calculation. By segmenting returns around these flows, TWR eliminates their distorting effect on the portfolio’s overall performance.
While primarily used by investment managers for performance comparison, individual investors can also benefit from TWR because it shows true investment growth regardless of when money was added or withdrawn.
Sure! If you start with $100, it grows to $102, then you add $5, and it grows to $115, TWR calculates returns for each phase separately and compounds them. Here, the TWR would be about 9.5%, showing real investment growth excluding the timing of the $5 deposit.
