Time-weighted vs. Money-weighted rate of return

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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 .

 

New fee disclosure rules for Canadian investments (CRM2)

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Last July, long-awaited changes to the way fees on investments are disclosed came into effect. Under the auspices of securities regulators and the Mutual Funds Dealers Association, CRM2 finally rolled out. CRM2 stands for Customer Relationship Model 2.

This new model is primarily aimed at mutual funds and exchange-traded funds (ETFs).

the goal of crm2 is to provide better clarity on the cost and performance of investments, but does it really?

Here is what is changing:

some fees will now be disclosed in dollar amounts instead of percentages

Under the new rules, investors will know the dollar value of trailing fees, annual fee-based charges, commissions and administrative fees. Trailing fees are commissions a broker receives for as long as an investor holds a mutual fund or ETF.

This is interesting for D.I.Y. investors. Many banks now offer “low-cost” mutual funds, on the basis that self-directed investors do not ask or receive advice. Yet, they are still paying for it!

performance will be calculated using the money-weighted method

The money-weighted method is more encompassing as it includes all contributions and withdrawals as well as dividends and capital gains. The time-weighted method only looks at the length of time the money is invested. It is the financial industry’s preferred method, as it is a good indicator of a fund’s performance. This method does not give an investor any indication as to how their own portfolio is doing.

Statements will also need to show returns for previous years.

unfortunately, this is only half of the story. crucial info will still not be disclosed

Mutual fees and ETFs -the latter to a lesser extent- both cost money to manage. This is known as Management Expense Ratio, M.E.R. The ratio encompasses various expenses such as professional fees, administrative fees, advertising , accounting and legal fees…etc. These expenses are paid regardless of the fund’s performance.

The new rules do not require fund companies to give a detailed breakdown on the M.E.R. This is where CRM2 is lacking, as it is the most important piece of information! The M.E.R. has the biggest impact on a fund’s return.

investors won’t know how much their ADVISER is paid

The fee disclosed is the one paid to the firm not to the adviser. It is a lump-sum.

CRM2 does not address the elephant in the room

Although it is a step in the right direction in terms of transparency, Canadian investors are still largely kept in the dark when it comes to the true cost of having mutual funds and ETFs.

Most importantly, Canadians pay the highest fees on their investments. CRM2 fails to address this.