Search
Investors seeking to differentiate true managerial skill from mere timing of inflows and outflows need a metric that isolates decision-making prowess. Time-weighted returns (TWR) emerge as a powerful tool in this quest, stripping away noise and ensuring clarity. In this article, we delve into the essence of TWR, explore its calculation, and demonstrate why it reigns supreme for fair manager comparisons.
By adopting TWR, financial professionals and everyday investors alike can gain unbiased insights into manager performance and build confidence in their selection process.
At its core, TWR measures a portfolio’s compound growth rate over a specified period while eliminating the impact of cash flows. It intentionally disregards deposits and withdrawals, attributing fluctuations solely to investment decisions. This methodology contrasts sharply with money-weighted returns, which reflect the actual investor experience and can be distorted by the size and timing of inflows.
When managers are compared on a consistent basis, TWR offers an apples-to-apples comparison of manager skill. Regardless of how investors add or remove capital, the manager’s pure performance shines through.
Imagine two fund managers with identical portfolios but different cash flow patterns. One attracts large deposits during a rally, while the other sees withdrawals before downturns. A money-weighted return might suggest one outperforms the other, but the reality is muddied. TWR counters this by neutralizing the effect of external cash flows, ensuring each segment of performance carries equal weight.
Industry standards and global regulations, such as the Global Investment Performance Standards (GIPS®), mandate or recommend TWR for external reporting. This endorsement highlights its role as the benchmark for comparing manager results on a level playing field.
The computation of TWR unfolds in three straightforward stages:
Each sub-period reflects pure performance without investor-driven changes, and the geometric link ensures an accurate overall figure. It may appear more complex than simple return metrics, but its precision justifies the effort.
Consider Portfolio A with the following timeline:
Sub-period returns calculate as:
First period (Jan 1 to June 1): (526,709 ÷ 500,000) – 1 = 5.34%.
Second period (June 1 to Dec 31): (537,908 ÷ 576,709) – 1 = –6.73%.
Overall TWR: (1 + 0.0534) × (1 – 0.0673) – 1 = –1.87%.
This figure reflects only the manager’s buy, sell, and asset-allocation decisions, devoid of the investor’s timing choices.
To highlight the differences, consider the following comparison table:
This table underscores why TWR reigns supreme when assessing manager ability: it eradicates distortions from cash movements and focuses exclusively on strategy execution.
While TWR offers unmatched fairness for manager comparisons, it also carries certain caveats:
In scenarios where investor experience is vital—such as private equity or individual portfolios—money-weighted metrics may complement TWR to provide a full picture.
Global regulatory bodies and professional organizations champion TWR in performance reporting. Adhering to industry performance standards organizations like the CFA Institute’s GIPS® ensures transparency and trust. Asset managers, mutual funds, and pension plans routinely publish TWR figures to facilitate meaningful peer comparisons.
For investors evaluating multiple funds or managers, requesting TWR data alongside contextual narratives empowers more informed decisions and fosters accountability.
By leveraging time-weighted returns, investors and financial professionals gain a clear, unadulterated view of manager performance. This fair platform for benchmarking performance empowers stakeholders to reward genuine skill and maintain confidence in their allocations.
While no single metric is perfect, the adoption of TWR represents a cornerstone of rigorous, principled analysis. Embrace its methodology, incorporate it into your evaluation toolkit, and elevate the standard of informed investing.
References
