Understanding Time-Weighted, Money-Weighted, and Total Returns in Investment Analysis
Performance metrics are pivotal in evaluating investment success. Among these metrics, Time-Weighted Returns (TWR), Money-Weighted Returns (MWR), and Total Returns play crucial roles. In this article, we'll explore the definitions, calculation methods, and distinctions between these metrics, providing practical examples to enhance your comprehension.
Total Returns: Total Returns encompass the overall performance of an investment, considering both price appreciation and any income generated. It accounts for capital appreciation, dividends, interest, or distributions received.
The TR formula is:
TR = ((total balance - initial balance) / initial balance) * 100
Example: If your starting balance is $10000 and you closed a position that netted you 3000, your total return is:
((13000 - 10000) / 10000) * 100 = 30%
Now, let's say that you also received $500 as a dividend, your total return is:
((13500 - 10000) / 10000) * 100 = 35%
It doesn't take into account when the dividend was received.
Time-Weighted Returns (TWR): TWR measures the compound rate of growth in an investment portfolio, excluding the influence of external cash flows. Its calculation involves breaking down the investment returns into distinct intervals, disregarding the volume of cash movements.
The TWR formula is:
TWRR = (1 + R1) * (1 + R2) * ... (1 + Rn) - 1, where R is the simple return for each time period
Example: Suppose an investment portfolio starts with a value of $10,000, grows to $13,000 by the end of the year, and had an additional $500 deposited the week after the year ended.
- R1 = ($13000 - $10000) / $10000 = 30%
- R2 = ($13500 - $13000) / $13000 = 3.84%
Your time-weighted return is: 33.84%
Seems more reasonable than TR as it takes into account the balance at the time you made an additional deposit and strips away any noise of cash adjustments.
Money-Weighted Returns (MWR): Unlike TWR, MWR considers the impact of cash inflows and outflows on investment returns. MWR calculates returns based on the timing and volume of these cash movements, making it influenced by the investor's actions. The formula for MWR can be complex and often requires iterative calculations or the use of specialized financial software like Trademetria.
Key Differences: While TWR isolates the investment performance from external cash flows, Total Returns provide a comprehensive view, including income and price changes, and MWR considers the impact of investor actions on returns, thus reflecting the actual experience of the investor.
Conclusion: Understanding the nuances between TWR, MWR, and Total Returns is crucial for effective investment analysis. Each metric offers unique insights into investment performance. By using a combination of these metrics, investors can gain a more comprehensive understanding of their investments' success.