How should I Measure Investment Performance?
An investor’s path to wealth and their financial goals involves the coordination and proper management of many different financial disciplines outside of just their investments. Regardless of this truth, the most noticeable measure of a financial plan’s success to many over time is investment performance. With so many different, and often confusing, metrics to determine how an investment has performed, how are we to know which is best for our needs? Investment results can be sliced and measured more ways than the average investor could ever have a practical need for. Therefore, it is even more important to cut through the noise and determine what is the most appropriate measure of performance.
While a simple total return calculation of taking the total value of an investment portfolio and dividing it by the capital contributed can tell you how much money you’ve made, it won’t take into account the rate or pace at which wealth has accumulated (or not), nor will it tell you if the growth achieved is acceptable for the time that has passed.
For purposes of measuring an investment portfolio’s performance, the two most common rate of return methodologies are dollar-weighted and time-weighted return metrics. These two approaches are fairly similar but each tell a separate story and are appropriate to use in different situations. For our discussion pertaining to individual investors, we’ll solely focus on these two metrics. Let’s discuss each method to first better understand them and then determine when each is most appropriate to use.
Dollar-Weighted Rate of Return
The dollar-weighted rate of return, often also referred to as the internal rate of return (IRR), is the discount rate at which the cost of an investment will equal the sum of its cash flows. In more practical terms, a dollar-weighted return is the performance of actual dollars invested over time in order to obtain the actual ending value. This method reflects all cash inflows and outflows to measure investment performance over a period of time. Therefore, dollar-weighted returns are heavily dependent on the timing of cash flow events in or out of a given investment. The dollar-weighted approach to calculating rates of return will capture investor behavioral biases and timing of cash flows. This fact and its relevancy towards what an investor is attempting to measure will be an important consideration in determining whether this metric is appropriate to use.
To calculate the dollar-weighted return, an investor takes the appreciation over the total investment and divides this figure by the average capital contributed. Average capital contributed is a figure that takes into account not only how much was invested but weights capital for the portion of time an amount was actually invested. The advantage of this approach to calculating returns is that it modifies performance to accurately reflect gain relative to the funds actually available for investment.
Time-Weighted Rate of Return
The time-weighted rate of return is the rate an investment produces without consideration of any contributions or withdrawals. It is akin to the “buy and hold” or passive style of investing. In simple terms it is the return on investment of the very first dollar contributed. Since the time-weighted return does not consider cash flows, the rate generated will not be dependent on the same inflows and outflows that a dollar-weighted calculation will take into account. This is the primary difference between the two measurements. The return at the end of a period is measured as a product of the growth of an investment from the start of a period of time.
Calculating time-weighted returns is similar to its dollar-weighted counterpart, but calculates performance many times over much shorter time periods (as opposed to one entire period with dollar-weighted). The periods are typically as short as a day, a week or a month - depending on the calculation. The results for each of these smaller periods is compounded upon one another to generate a time-weighted return for the entire period. Due to the short time periods being compounded the impact of cash flows in or out of an investment or pool of funds is negated.
Examples
Lets take a look at each through some basic examples and compare the results to see the differences in action. Suppose you invested $500,000 in an investment portfolio at the beginning of 2019 and measure investment performance over the subsequent five years. In this instance, when no funds move in or out of the investment portfolio the dollar-weighted and time-weighted rates of return are equal: 5.22% on an annualized basis. This is to be expected, as above we articulated how the key difference between the two measures is that dollar-weighted will factor in cash flows. If there were no cash movements over the investment period, no differences in performance are to be expected.
If we assume the same facts as above, but that at the beginning of the second year, $100,000 of additional capital is contributed to and invested within the portfolio. The results again, are what we would expect. The cash flow event does not impact the time-weighted return at all. However with capital entering the portfolio to increase the overall balance, the annualized and cumulative dollar-weighted returns are diminished.
The below example assumes a $100,000 distribution from the portfolio at the beginning of the third year and no other cash flow activity. Again, the time-weighted return holds steady, while the dollar-weighted return will slightly change from the previous example.
The final example displays how even if there are unequal inflows and outflows over time, the time-weighted return method will still yield the same rates of return as they are only focused on overall investment performance – without considering fund flows. Again, with different fund flows the dollar-weighted return changes once more.
So which indicator of performance is appropriate to use?
The answer is, “it depends”.
To best assess the performance of your investment advisor or portfolio manager the time-weighted approach is generally viewed as the most appropriate fit. This is accurate if the advisor does not control the timing or amounts of fund flows into or out of an investment portfolio and investors typically have a long-term investment horizon. The investor and their needs should largely dictate those fund flows. Accounting for these figures in a return calculation could improperly enhance or diminish the perception of the advisor’s management abilities. Therefore, when assessing a long-term investment strategy and its performance in relation to an underlying benchmark, a time-weighted return is most appropriate.
The dollar-weighted return approach is a better tool to assess a specific investment or project that is cash-flow intensive. This measure of return will capture the weighting and volume of inflows and outflows and therefore is acceptable for active traders, investors and managers. This measure is often used in assessing private equity strategies or other pooled capital investments in which capital may be strategically called from, or distributed to, investors to be in relation to certain underlying projects. The dollar-weighted metric (also know as internal rate of return) is commonly used in business to assess the performance of a project.
In the end it is important to keep in mind that any rate of return on its own is meaningless unless taken into account with the context of a comparable and accurate benchmark. Whether this is an established benchmark that is widely publicized or compared to project-specific metrics - a measure of return is best used when compared relative to a known goal. No rate of return on it’s own tells the entire story, however properly understanding when each of these two common performance measurements may be appropriate can ensure you are at least using the right figure when measuring your own performance.
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