Time-Weighted Return

Time-weighted return (TWR) is a performance statistic that's frequently used to evaluate a portfolio's investment performance over a given time frame. It provides a more accurate indicator of the investment manager's ability to generate returns than other return computations since it does away with the influence of external cash flows.

The main objective of time-weighted returns is to isolate the performance of the investment plan from the effects of external factors, such as deposits and withdrawals. In this approach, the performance of the portfolio over time can be compared, independent of the quantity and timing of cash inflows or withdrawals.

The Time-Weighted Return (TWR) is a performance indicator that accounts for the impact of external cash flows when evaluating the compounded rate of return on an investment portfolio. Taking the client deposits and withdrawals out of the calculation provides a more accurate measure of an investment manager's skill. TWR's calculation joins the sub-period returns in order to prevent the timing and size of cash flows from distorting the assessment of overall performance.

TWR is a return metric that came from the portfolio management industry. It came to light because of the shortcomings of existing return metrics, such as the money-weighted return (MWR). Because MWR takes into account the timing and amount of cash flows, it is susceptible to changes in the amount and timing of contributions to and withdrawals from investments. However, TWR was in response to the need for a more objective and comparable metric. TWR's emphasis on eliminating the impact of external cash movements makes it an indispensable tool for accurately evaluating the long-term actual performance of investments.

Here's how TWR's formula works:

1. Segmentation:
   • Divide the investment timeline into distinct periods based on cash flow activity (deposits or withdrawals). Each period operates as a mini-investment journey.
2. Individual Returns:
   • For each period, calculate the return using this simple formula:
   • Return = (Ending Value - Beginning Value - Cash Flow) / (Beginning Value + Cash Flow)
3. Geometric Linkage:
   • Assume each period's return as a building block. TWR chains them together, reflecting the compounding effect of time. The formula stitches these blocks together:
   • TWR = - 1

Let us understand it better using examples:

Example #1

Let's consider an imaginary investment scenario to demonstrate the calculation of Time-Weighted Return (TWR) using the given formula:

Segmentation:

Period 1: Investment starts with $10,000.

2: Withdrawal of $2,000, leaving $8,000.

3: Investment gains $1,000, ending with $9,000.

Individual Returns:

Return for period 1: (10,000-10,000-0)/(10,000+0) = 0%

2: (8,000-10,000-(-2000))/(10,000+(-2000)) = -25%

3: (9000-8000-0)/(8000+0) = 12.5%

Geometric Linkage:

• TWR = (1+0) x (1-0.25) x (1+0.125) – 1
• TWR = 1 x 0.75 x 1.125 – 1
• TWR = 0.84375

Here, the Time-Weighted Return (TWR) is approximately 84.38%. This reflects the compounding effect of time and accurately accounts for the distinct periods of investment activity, providing a more precise measure of performance.

Example #2

According to a 2023 Morningstar analysis, poor market timing costs investors one-fifth of their fund returns. The research highlights the significance of time in investing decision-making, in addition to fund performance. The 20% average decline in fund returns that investors saw due to poorly timed buys and sells serves as further evidence of the necessity for strategic investment methods. In order to provide an accurate picture of investment performance, time-weighted return (TWR) removes the impact of external cash flows.

TWR is essential because of the following:

1. Uncovering the Real Picture: TWR separates the unadulterated influence of market performance on the portfolio as opposed to fundamental returns, which are influenced by cash flows. It is evident from this which choices made waves versus those that actually aided in growth.
2. Equitable Comparisons: To ensure relevant comparisons, TWR creates an even playing field. TWR removes cash flow distortions and is beneficial for assessing fund managers, selecting investment strategies, or monitoring performance against benchmarks.
3. Dilution of Wisdom: Recall that investments compound over time. Early gains amplify compounded returns, and TWR aptly illustrates this phenomenon. One is then more equipped to maximize the long-term wealth and reinvest dividends.
4. Risk-Adjusted Insights: TWR encompasses more than just pure profits. TWR assists in determining the actual cost of pursuing rapid profits as opposed to concentrating on sustained growth by accounting for volatility and return timing.
5. Establishing Trust Through Transparency: TWR promotes accountability and transparency through its rigorous time-based methodology. By strengthening bonds with advisers and fund managers, investors can be assured that returns are computed relatively and consistently.