Definition and Examples of Time-Weighted Rate of Return (TWR)
How does the time-weighted rate of return work?
Time-Weighted Rate of Return vs. Rate of Return
What does TWR mean for individual investors?
Definition and Examples of Time-Weighted Rate of Return (TWR)
Investors and analysts can use multiple measures to calculate the rate of return on a specific investment or portfolio. Some measures can provide distorted results due to the effects of incoming and outgoing cash flows. The time-weighted rate of return (TWR) uses a unique formula that eliminates these misleading effects.
How does the time-weighted rate of return work?
The time-weighted rate of return calculates the rate of return for multiple sub-periods based on cash flow changes. It is essentially a calculation of the investment returns generated by the manager over specific time intervals that are geometrically or compounded related. The formula used to calculate the time-weighted rate of return is as follows:
TWR = [(1+HP1) x (1+HP2) x (1+HPn)] – 1
In this formula:
n = number of sub-periods
HP = (Ending value – (Beginning value + Cash flow)) / (Beginning value + Cash flow)
HPn = return for sub-period n
To calculate TWR, you need to find the return for each sub-period by subtracting the total of the beginning balance and cash flow from the ending balance. Then, divide the result by the total of the beginning balance and cash flow.
Each time there is a new cash flow into or out of the fund, a new sub-period starts. After adding the cash flow to each HP value, it gets multiplied by the other cash flows.
Let’s use this formula to take a look at a more realistic example. Suppose you want to use TWR to calculate the performance of an investment fund. You initially invest a contribution of $100,000, and by the end of the first month, your portfolio balance is $100,850. You will run the following calculation, which is part of the overall TWR formula:
HP1 = (100,850 – 100,000) / 100,000 = 0.8%
Now, let’s assume that during the second month, you added an additional contribution of $1,000. By the end of the period, your portfolio balance is $102,870. The formula would look like this:
HP2 = (102,870 – (100,850 + 1,000)) / (100,850 + 1,000) = 1%
Finally, in the third month, you make the same contribution of $1,000. By the end of the month, your portfolio balance is $109,100. The formula looks like this:
HP3 = (103,390 – (102,870 + 1,000)) / (102,870 + 1,000) = -0.4%
Once you finish the calculations for each individual sub-period, you can run the full TWR formula. Here’s what the result will look like using the above numbers:
TWR = [(1+.008) x (1+0.01) x (1+ -.004)] – 1 = 1.4%
In the example above, you can see that your time-weighted rate of return is 1.4% over three months.
Time-Weighted Rate of Return vs. Rate of Return
The rate of return (RoR) is another method to calculate profit or loss on an investment over a specified period of time. Unlike TWR, this calculation does not eliminate the effects of incoming and outgoing cash flows.
Time-Weighted Rate of Return vs. Rate of Return
Eliminates cash flow effects
Does not eliminate cash flow effects
Suitable for comparing the performance of multiple investments
Suitable for calculating the performance of a single investment
The rate of return, when expressed as a percentage, calculates the return on a specific investment using the initial investment and total profit or loss from the investment. The formula for calculating RoR is:
RoR = (Net profit or loss / Initial investment) × 100
Instead of considering incoming and outgoing cash flows, the total investment is treated as one large amount. When the rate of return is positive, it is considered a profit on the investment, and when the rate of return is negative, it reflects a loss. The rate of return can be a valuable figure for the individual investor to determine the return on a specific investment. However, it is not as useful for comparing the returns of multiple portfolios.
What does TWR mean for individual investors?
What TWR Means for Individual Investors
It is important for investors to understand the returns on the investments in their portfolios or the investments they are considering adding to their portfolios.
TWR is a useful tool for analysts to calculate and compare the performance of assets within a portfolio, but it requires a more complex formula than is ideal for most investors.
If you are only looking for the return on a specific investment, the rate of return may be a more useful calculation. You can find information about returns by visiting your online brokerage account or the brokerage’s website to track a specific asset.
Source: https://www.thebalancemoney.com/what-is-time-weighted-rate-of-return-twr-5181848
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