Money-Weighted Rate of Return

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21 Aug, 2024

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The Money-Weighted Rate of Return (MWRR) is a significant financial metric utilized to calculate the rate of return on an investment portfolio, incorporating the influence of cash flow size and timing. Its primary objective is to precisely measure investment performance, distinguishing it among various financial metrics.

Investors deploy the MWRR to assess investment performance while factoring in deposits, withdrawals, and the timing of cash flows within a firm. Both fund managers and investors rely on it extensively to evaluate investment performance and guide well-informed decisions regarding portfolio management and asset allocation.

What is the money-weighted rate of return (MWRR)?

The money-weighted rate of return (MWRR) is a crucial financial indicator that considers the timing and size of cash inflows and outflows to calculate an investment portfolio's rate of return.
MWRR is designed to offer a precise and reliable measure of investment performance, setting it apart from other financial metrics.
MWRR is particularly valuable when assessing individual investments with significant cash flows. In contrast, the time-weighted rate of return (TWRR) is employed to compare the performance of various investments during specific durations, regardless of cash flows in and out of investments.

Money-Weighted Rate Of Return Explained

The money-weighted rate of return (MWRR) serves as a pivotal tool to gauge the profitability of a project or investment by comparing the initial investment with the current value of the project or investment while concurrently determining the discount rate that balances the two. Often used interchangeably with Internal Rate of Return (IRR), the MWRR consistently accounts for total cash flows and investment duration during the comprehensive calculation of overall investment returns. Essentially akin to the IRR, the MWRR sets the initial investment value in alignment with future cash flows.

The intrinsic value of the MWRR lies in its ability to accurately represent investment performance, encompassing the entirety of cash flows and investment duration. Consequently, it proves invaluable for investors analyzing investments characterized by regular cash flows. However, due to its cash flow-inclusive nature, a notable drawback emerges in its inability to effectively benchmark against figures like the S&P 500 or the London Stock Exchange.

Furthermore, the implications of MWRR on investments can be summarized as follows:

An investment is deemed successful if its MWRR surpasses the required rate of return.
Conversely, an investment is deemed unsuccessful if its MWRR falls short of the required rate of return.

MWRR manifests in two distinct forms:

Gross MWRR: This variant does not incorporate the impact of expenses or fees on the investment.
Net MWRR: Similar to Gross MWRR, it neglects the influence of expenses or fees on the investment.

MWRR stands as a fundamental tool enabling investors to assess investment profitability, guide prudent decision-making, and evaluate investment performance. Utilizing resources such as the money-weighted rate of return calculator, investors can effectively leverage this metric to enhance their financial insights and endeavors.

Formula

The money-weighted rate of return serves as a pivotal financial metric for calculating the comprehensive return on investment, taking into account both total cash flows and investment duration. This leads us to the following formula:

MWRR = / Beginning Value of Investment

Furthermore, an alternative formula for MWRR can be derived by solving for the discount rate that satisfies the equation:

PV Outflows = PV Inflows

Where:

PV Outflows represent the present value of all cash outflows, encompassing subsequent cash flows and initial investments.

PV Inflows correspond to the present value of all cash inflows, including annual dividends and selling prices.

Examples

Let’s look into a few examples:

Example # 1

Let's consider a scenario where an individual makes regular deposits into a savings account over two years. The initial deposit is $1,000, and at the end of each year, an additional $500 is deposited. Let us calculate the MWRR for this savings account investment.

Solution:

Year 1:

Beginning Value of Investment: $1,000

Net Cash Flows: $500 (deposit)

Ending Value of Investment: $1,500

Year 2:

Beginning Value of Investment: $1,500

Net Cash Flows: $500 (deposit)

Ending Value of Investment: $2,000

MWRR = / Beginning Value of Year 1

MWRR = / $1,000 MWRR

= $500 / $1,000

MWRR = 0.5 or 50%

Example # 2

Consider a brief scenario where an individual invests in a mutual fund. The individual starts by investing $1,000 in the fund. Over the next year, the mutual fund's value increases, and the individual decides to invest an additional $500. At the end of the year, the total value of the mutual fund is $1,700. Let us calculate the MWRR for this mutual fund investment.

Solution:

Year 1:

Beginning Value of Investment: $1,000

Net Cash Flows: $500 (additional investment)

Ending Value of Investment: $1,700

MWRR = / Beginning Value

= / $1,000

= $200 / $1,000

MWRR = 0.2 or 20%

Money-Weighted Rate Of Return vs Time-Weighted Rate Of Return

Let us use the table below to compare the money-weighted rate of return and time-weighted rate of return:

Money-Weighted Rate of Return	Time-Weighted Rate of Return (TWRR)
Less accurate in reflecting a firm's performance when cash flows in and out of investments are significant.	Functions as a performance measurement tool by calculating returns based on the periods during which investments were made, irrespective of cash flows in and out of the investment.
Useful when assessing individual investments with significant cash flows in and out.	Utilized for comparing the performance of various investments over a specific duration, regardless of cash flows in and out.
Highly sensitive to the number and timing of cash flows in investments.	Exhibits no sensitivity to the number and timing of cash flows in investments.
Less accurate in reflecting the performance of a firm when cash flows in and out of investments are significant.	More accurate in predicting firm performance as it is based on periods of investment holding, irrespective of significant cash flows in and out.
Biased in favor of investments with higher cash flows, impacting overall return significantly.	Not biased toward investments with higher cash flows; all periods are treated equally.
Assumes reinvestment of each cash flow at an equal rate of return to the investment.	Assumes reinvestment of each cash flow at the benchmark rate of return throughout the assessed investment's duration when not actively invested.

Frequently Asked Questions (FAQs)

1. What are the advantages of MWRR?

MWRR accounts for cash flows' timing and size, providing an accurate performance measure in cases of changing investments. It reflects real-world scenarios and is useful for evaluating individual investments with significant cash flows, making it particularly suitable for assessing investment strategies in dynamic environments.

2. What are the applications of MWRR?

MWRR assesses investment performance, aiding decisions by considering deposits, withdrawals, and cash flow timing. Fund managers and investors utilize it to analyze investments, assess portfolio managers, compare investment options, evaluate specific investments, and determine the impact of irregular cash flows on returns.

3. What is the disadvantage of a money-weighted rate of return?

MWRR's drawback lies in its sensitivity to the timing and frequency of cash flows, which could lead to distorted results when cash flows significantly affect returns. It might inaccurately represent performance if cash flows are not well-timed or if significant inflows/outflows occur.