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 .

 

Mutual funds vs. ETFs: basic comparison

Mutual funds remain Canadians’ favourite investment. It is estimated a trillion dollars sits in mutual funds in the country.

Although Exchange-Traded Funds – ETFs- have been introduced in the late 80’s, they have only started becoming increasingly popular a few years ago.

Mutual funds and ETFs are a bit like cousins. They share a few common traits but are actually very different.

Mutual fund ETF
definition An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. An exchange traded fund is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
Management style Usually active; Fund managers tries to outperform the market/index. Rebalancing portfolios is common Usually passive; an ETF merely tries to replicate the index it is tracking. Rebalancing is seldom necessary.
Management fees (MER/TER) Usually on the high side, as mutual funds are actively managed.The MER directly impacts the fund’s return. On the low side, due to the passive approach.
Other fees Mutual funds are notorious for carrying various fees such as trailer fees, switch fees, redemption fees, sales charges etc…. Trading fees paid to broker
Risk Both products have a similar risk level. You can lose or make money.
Unit value Calculated at the end of the day Varies throughout the day as ETFs are listed on stock-exchanges
Buying Most MFs require a minimum amount for buying. Some also require additional contributions. No minimum required but need to buy “in bulk” or “lump sum”. Some brokers charge additional fees for low volumes.
Selling Cash In-kind. Investors usually exchange their units.Cash is possible, but usually at a discount
Dollar cost averaging/monthly contributions Yes No, because of the trading fees
Tax efficiency Usually lower Usually higher

 

ETFs are cheaper and more transparent. Investors know exactly what they are getting. Their downside is that they are more for people with larger amounts of cash available. They also have a more long-term range, because of the “in-kind” consideration and the trading fees.

Most mutual funds are expensive and very few outperform their indexes. But, they are a good starting point for the beginner investor and for people who don’t necessarily have tons of cash.

Some funds are specifically targeted at D.I.Y investors with lower fees. Others also start having a more passive approach and actually generate decent results.

Just like any financial product, do your own research before investing. Don’t just look at the amount of fees you may be paying –or not- or the return. You need to understand what you are buying into.

Understanding fees in mutual funds

There are a lot of discussions on how the Management Expense Ratio –or MER- of a mutual fund directly impacts its returns.

As a reminder, mutual funds are actively and professionally managed. It results in a myriad of expenses, paid from the fund, regardless of its performance. These are the MER.

However, there are other charges that you may have to pay out of your own pocket. When reading documents pertaining to a fund, watch out for these common terms:

Front-end load: The amount you pay when investing into the fund. It is usually a percentage, and yes, it is taken out of your money.

Back-end load or sale-deferred charge: The amount you pay when redeeming or selling units. Usually, the longer you keep the fund, the lower the charge will be. After a certain number of years, it is eliminated.

Low load: this works like a back-end load, except the period of time is usually shorter.

No load: means you don’t have to pay to buy or sell units. However, because a fund is “no load” doesn’t necessarily mean it costs less.

Switch fee: amount you pay to transfer into another fund of the same family

Redemption fee: amount you pay when selling; usually a flat fee.

Short-term trading fee: Fee for buying and selling within a short period of time, e.g. 30 days.

Administrative or account fee: some funds charge you a fee if you don’t have a minimum amount invested or to open an account.

Although it is important to understand all the fees associated with a mutual fund, it is not the only aspect to look at before investing.

Mutual funds basics

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This investment product is very popular in North America. But what is a mutual fund and how does it work?

A mutual fund is a pool of money collected from many investors and used to buy securities such as stocks, bonds, money market instruments and other similar assets.

The securities in the fund are known as the portfolio.

As an investor, you own units, which represent a portion of the holdings of the fund.

A mutual fund is professionally and actively managed. The funds are invested to generate capital gains and income for investors.

Most mutual funds are open-end, meaning you can buy and sell units at any time, without any restriction. You can purchase units by lump-sum or regular contributions.

The unit value is called NAVPU or Net Asset Value per Unit. It is calculated daily, at the end of business day. The formula is:

(Assets- liabilities) / Outstanding # of units

A capital gain is triggered when the fund sells some of its securities at a higher price than purchased. Income is earned from interests on bonds and dividends on stocks.

Both are distributed to investors throughout the year. A lot of mutual funds automatically reinvest these earnings and investors receive more units.

If the securities increase in value and the fund doesn’t sell them, the unit value increases and investors can sell for a profit.

A mutual fund will usually earn you more than a plain savings account at your bank. OK, during a recession, you will probably lose money, but quite frankly who won’t?

The main disadvantage of a mutual fund is its cost, and particularly in Canada. It is said the costs of mutual funds here are amongst the highest in the world.

As stated above, mutual funds are professionally and actively managed. This results in a myriad of expenses. These expenses are paid from the fund, regardless of its performance.

They impact the fund’s returns to the investors. They are called MER, or Management Expense Ratio.

Let’s assume a fund returns 6%, excluding MER. Let’s assume the MER is 3%. The fund’s return to the investors will then only be 3%.

You have to carefully look at both the fund’s performance and the MER when purchasing.

There are also additional charges that you could pay out of your own pocket as an investor:

  •  Sale charges or loads: amount paid when buying or selling
  • Other transactions and administrative fees: switch or redemption fees, account fees

There are thousands of mutual funds available in Canada. There are also websites that compile data and info on them, such as Fund Data Canada or The Fund Library.