Comparison of Time-Weighted & Dollar-Weighted Rate of Return Calculation Methods

In this analysis, we compare time-weighted and dollar-weighted investment performance calculation methods using actual price, unit balance and transaction data for two seperate account activity scenarios during the year 2001. We present this analysis so as to assist firms in choosing which method to use when deploying dailyVest performance reporting software. (Readers may refer to back-up calculations by clicking this link.)

INVESTOR SCENARIO #1

DESCRIPTION: Relative to this investor’s beginning balance of $8,000, investor makes regular, relatively small contributions of $83 approximately 12 times per year into a defined contribution retirement plan. Including employer contributions, overall yearly contributions were $1,380 with dividends reinvested. Also, the fund is somewhat volatile in terms of price fluctuation throughout the period. dailyVest software calculates the following returns for this investor scenario...

INVESTOR SCENARIO #2

DESCRIPTION: Relative to this investor’s beginning balance of $8,000, investor makes regular, relatively small contributions of $83 approximately 8 times per year. In addition, this investor also makes relatively large contributions of $2,500 each quarter. Including employer contributions, overall contributions were approximately $11,000 with dividends reinvested. dailyVest software calculates the following returns for this investor scenario...

ANALYSIS & CONCLUSION

BACKGROUND. In simple terms, personal rate of return or “investment performance” is the rate of growth of monies invested during a specified time period, expressed as a percent. dailyVest supports two basic and quite different performance calculation methods including Time-weighted rate of return (“TWRR”) and Dollar-weighted rate of return ( “DWRR” a.k.a. “IRR”). It must be understood that each method is designed to measure different things.

WHAT DOES THE TIME WEIGHTED RATE OF RETURN METHOD MEASURE? The TWRR calculation method was originally developed to measure the performance of a portfolio or fund manager and sprung from a need for industry consistency in reporting returns that are independent of a clients’ or individual investors’ actions. In this case, contributions and withdrawals by the client investor are not under the control of the fund manager. Thus the method, often said to be “manager-centric,” was designed to isolate the manager’s specific performance from investor timing and size of contributions / withdrawals to/from the fund. Furthermore TWRR depends only on the length of time a contribution or withdrawal has been in or out of the portfolio and not on the size of the investment – hence the term “time-weighted.” Using a TWRR to measure the performance of an individual investors’ portfolio or a retirement plan participant’s 401k will therefore take into account the amount of time an investor has been invested in a fund (or funds) and measures how well he or she performs at increasing the dollars invested over a specific period of time.

WHAT DOES THE DOLLAR WEIGHTED RATE OF RETURN METHOD MEASURE? In contrast with a time-weighted approach, the DWRR calculation method does measure the size and timing of cash flows, as well as the investment performance of the funds chosen by the investor. Thus, periods in which more monies are invested contribute more heavily to the overall return – hence the term “dollar-weighted.” In this case, investors are rewarded more for larger investments made during periods of greater price appreciation (of the fund). Dollar-weighted returns are said to be an “investor-centric” means of measuring performance because they do not isolate the fund’s underlying performance from an investor’s luck and timing.

CONCLUSION. In the two scenarios above (see details below) we see that the returns are relatively similar across calculation methods. This is due to the fact that the “timing” or price paid for the increased shares was not necessarily “optimal.” While DWRR is more sensitive to the size of a cash flow relative to the current balance, and the timing of that cash flow (…were the shares purchased at a “good” price or a “bad” price?), no one method is necessarily more suitable for certain types of investors than the other. So, the question a financial institution should ponder is not “What investment performance calculation method is right for my investors?” but rather, “What should be measured?”

It might be easy to conclude that the DWRR method is more appropriate for investors who might be either more highly compensated or who might make less frequent but larger contributions. It might have also been suggested that the TWRR method was better for investors with smaller balances and who make smaller but more frequent contributions. To be clear, no one performance calculation method is more suitable for different types of investors than another method. The desired method to use is simply a matter of deciding what should be measured. Financial institutions should use DWRR if they want to measure how well the participant did at the timing and amount of the inflow or outflow. They should use TWRR if they want to measure how well the investor did at growing the assets over time.