This article, Time Weighted Returns Vs Money Weighted Returns was originally posted here. He is a veteran community member on InvestingNote, with username known as ThumbTack Investor.
TIME WEIGHTED RETURNS VS MONEY WEIGHTED RETURNS
I think probably 70% of the people here don’t really calculate their returns.
Certainly not the traders with multiple transactions, cos it is a mammoth task doing so.
The vast majority of the remaining 30% are probably calculating it wrongly (Wrongly, that is, if you are using your ROI and comparing it to active managers)
Basic management 101 tells us that whatever doesn’t get measured, doesn’t get done/improved upon.
Cos if you don’t have an accurate barometer of what you’re doing, you wouldn’t be able to tell what works and what doesnt. In fact, knowing human nature, you’re more likely to over emphasis your wins, and try to shut off the nagging voice reminding you of your losers. And those who don’t monitor, are very likely to have many losers to speak of. (cos no desire to know numbers to measure your performance, reeks of an unanalytical mind + laziness)
The novice who tries to measure return, would probably just take the difference between the portfolio value at the end of the period vs the start of the period, and divide that by the portfolio value at the start to get a raw return.
That’s a resonably good estimate…….. if you have ZERO infusions or withdrawals from the portfolio, and all dividends are automatically part of the cash portion of the portfolio. (highly unlikely to be the case for novices)
Things get complicated if there are multiple deposits and withdrawals.
Things get EVEN more complicated when the fund size varies, and the return varies (obviously) at various time points when you’re holding different fund sizes.
Hence the need to understand and differentiate between the Time Weighted Return vs Money Weighted Return.
I won’t, and probably can’t do as good a job elucidating this as @bgting who wrote about this somewhere if I rem.
Anyway, many websites talk about the difference.
Retail investors calculating an IRR (Internal Rate of Return) using Excel, would be getting the Money Weighted Return (MWR).
That’s realistically what’s the easiest for retail investors to do, with the least hassle.
Basically, you input every cash deposit and withdrawal into Excel, and the returns take into account your fund size.
Now, for a long while, I’ve been using this MWR and comparing it to the returns of well known hedge funds to get a gauge of where I stand.
Professional funds though, don’t use MWR, they use TWR.
So it’s not a like for like comparison, the calculation is completely different.
Still, I postulated that, well, how different can it be? Perhaps within a 1% difference?
Interactive brokers now automatically calculates both the MWR and TWR for my US portfolio, so suddenly, I am now acutely aware of how different it can be.
Attached images are the 2 returns taken errr 2 minutes ago.
They are real time.
As one can see, the 1 year MWR and TWRs for my US portfolio is very very different.
Certainly significantly different.
How about the returns automatically calculated by numerous websites that are popular? Like stock cafe?
TTI’s opinion is that…. well, if you’re comparing to YOURSELF over multiple years, so say, you just want to know the rate of improvement or de-provement over time, then it doesn’t matter what methodology you use, as long as it’s consistent over the years.
But what use is that?
Since any dumb joker can throw into a passive index, or a dumb joker with some deep pockets can throw it to some active fund manager, so logically, if one is going to actively manage your own funds, it makes sense to compare to these alternatives.
And other professional fund managers.
And to do that, we need to calculate the TWR to be accurate.
A 4%, 5% difference between IRR (MWR) and TWR is no joke.
Compound that over the years, and you’ve heaven and earth… no wait. Heaven and Hell, in terms of results.
So, unless these websites automatically calculating your returns require you to input CASH deposits and withdrawals, portfolio size daily, and all transactions when they occur, including fees incurred…
otherwise, the ROI number you get….
is just not accurate.
And sorry to pop your bubble, in all likelihood, as most people wouldn’t play by the same rules as professional hedgies, they wouldn’t treat cash as an actual asset class in your portfolio, that is, cash is not going to have a dilutive effect on your portfolio.
In reality though, the professional hedgie doesn’t have the luxury of asking for cash when, and ONLY WHEN, he needs it.
The cash sits there and from day 1, it’s dragging on portfolio returns, as long as you don’t deploy it. (May even drag more if you deploy it too!)
Of course, TTI here is just being very draconian.
Most of you will in all likelihood, don’t give a damn.
So much methodology, so much calculation.
(I don’t calculate TWR myself too, it’s too much work. I do MWR though.)
This post is just to highlight:
– the difference between TWR and MWR may actually be very significant
– if you got your ROI figures calculated by some automated sites, it’s very likely to be very much inflated. (assuming you play by the hedgie rules).
Once again, this article is a guest post and was originally posted on his profile on InvestingNote.
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