Few numbers matter more to investors than the rate of return on their portfolio. Despite its apparent simplicity, calculating a portfolio’s return can be complicated, especially when you add contributions or withdrawals during the measurement period. Multiple calculation methods exist, and they can produce notably different results. Each approach has strengths and weaknesses, which is why many investors struggle to measure and interpret their returns accurately.
In the accompanying white paper, Understanding Your Portfolio’s Rate of Return, Justin Bender and I review the most common methods for computing portfolio returns, explain why they can diverge, and offer guidance on which approach best fits different situations. Updated calculators are also available for free on the PWL Capital website to help you run these calculations yourself.
Time and money
Return calculations generally fall into two categories: time-weighted and money-weighted. When a portfolio experiences no cash flows—that is, the investor makes no contributions or withdrawals—both methods yield the same result. Differences arise only when money moves in or out of the portfolio during the period being measured.
To illustrate, consider two hypothetical investors who both start 2014 with Canadian equity portfolios valued at $250,000. Investor 1 contributes $25,000 on September 15, while Investor 2 withdraws $25,000 on the same date. The year saw strong gains in the first eight months followed by a sharp downturn in September and October. Making a large deposit or withdrawal near that downturn has a meaningful effect on an individual’s measured return, depending on which calculation method you use.
We’ve got nothing but time
A time-weighted rate of return (TWRR) strips out the influence of cash flows to measure how the portfolio itself performed, independent of investor actions. This is the standard used by mutual funds and ETFs when reporting performance and is commonly used to judge a manager’s skill.
In the example above, both investors would record the same TWRR because the method neutralizes the impact of their opposite cash flows. Their time-weighted performance would also match the index the portfolios track, since the TWRR isolates the assets’ returns from the timing of deposits and withdrawals.
When a TWRR is appropriate: Use a time-weighted return when you want to evaluate the performance of a portfolio manager or strategy against a benchmark. If a manager applies the same approach to different client accounts, they shouldn’t be credited or penalized for cash flows they don’t control.
Limitations of the TWRR: Calculating a true time-weighted return requires knowing the portfolio value on every date a cash flow occurred, which individual investors often cannot obtain from brokerages. Some investors also find TWRRs less relevant for personal performance tracking because they ignore the timing of contributions and withdrawals that determine the investor’s actual experience. For example, an investor who made a large deposit just before a market crash could see a modest TWRR even though their personal wealth dropped significantly.
How to estimate your TWRR: If you can access month-end portfolio values, the Modified Dietz method offers a practical approximation of a time-weighted return. PWL Capital provides a Rate of Return Calculator you can use to compute an approximate TWRR from monthly statement data.
Show me the money
A money-weighted rate of return (MWRR) incorporates the timing and size of cash flows and therefore reflects the investor’s actual experience. Because it weights returns by when money entered or left the portfolio, the MWRR can diverge considerably from the TWRR during periods of high volatility or when significant cash flows occur.
Returning to our example, Investor 1’s MWRR would be noticeably lower than the TWRR because the extra $25,000 was added before a period of weaker performance. Conversely, Investor 2’s MWRR would be higher, since they removed funds prior to the downturn.
When a MWRR is appropriate: A money-weighted return is the better choice when you want to know the return you personally experienced, including the effects of your contributions and withdrawals. Regulators in some jurisdictions have moved toward requiring money-weighted reporting for client accounts, so advisors increasingly provide MWRR figures to reflect real investor outcomes.
Limitations of the MWRR: Because the MWRR depends heavily on cash-flow timing, it is not ideal for comparing manager skill or strategy performance against a benchmark. Large, one-off deposits or withdrawals—such as a lump-sum RRSP contribution or an RRIF withdrawal—can distort the MWRR relative to a benchmark and lead to misleading conclusions about manager performance. Also, the underlying equation for a traditional MWRR often requires iterative numerical methods to solve, although calculators and spreadsheets have made that technical hurdle trivial.
How to measure your MWRR: If you have the starting and ending portfolio values and the dates and amounts of all cash flows during the period, you can calculate a money-weighted return. PWL Capital’s Money-Weighted Rate of Return Calculator is designed for this purpose and can help you compute an accurate MWRR for your account.
Understanding the distinction between time-weighted and money-weighted returns is essential for interpreting performance reports, assessing advisors, and evaluating your own investing results. In a follow-up discussion, I will present additional examples to further clarify how these measures differ in practice and how to choose the right metric for your needs.
This article originally appeared on canadiancouchpotato.com.