Time-weighted vs. Money-weighted rate of return

Image result for time weighted vs money weighted

With the implementation of CRM2, Canadian banks, investments brokers, mutual funds dealers and other financial entities must disclose the method used to calculate the rate of return of a portfolio or investments like an ETF or a mutual fund.

There are 2 methods used: time-weighted and money-weighted. Both are valid and accepted. Let’s take a look at the 2 approaches.

there is only one big difference between the 2

The time-weighted method does not take into consideration any contribution or withdrawal (cash flows) made to a portfolio. It does not take into account any dividend or interest received either.

The money-weighted method, on the other hand, does take cash flows into consideration, including dividends and interests.

the time-weighted method works best for product comparison

In the time-weighted method, all periods’returns have the same weight, regardless of cash movements. For example, if the return for period 1 is 10%, and the return for period 2 is  -8%, the return would always be 1.2%.

This method works very well to compare products such as mutual funds or ETFs. The majority, if not all, of fund managers uses this method. it is also easier for them, as they have no control on cash flows.

the money-weighted return works best at individual level

The money weighted method, as indicated above, takes cash movements into consideration to calculate return.

It  finds the interest rate or rate of return that would have to have been paid for the investor to obtain the actual ending value, given the beginning value and the deposits and withdrawals that occurred during the period.

The result is way more precise for investors, and can help them understand why they might be loosing money.

The money-weighted return will most likely be a different than the time-weighted return.

conclusion

For most investors, regardless of how experienced they are, the money-weighted return is the best method. It gives a more clear picture of how their portfolio is actually performing .

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s