Making sense of the reported rate of return calculation on your investment statement
Updated: Aug 6, 2019
Brendan Greenwood CIM, B.Comm | July 2, 2019
There’s a lot of confusion amongst investors and advisors on how investment returns are reported. This confusion starts to grow when investors make contributions or withdrawals to their investment portfolio.
It’s not uncommon for an investor to get a performance statement and find that the rate of return reported is higher or lower than they expected. This difference can raise concerns about the validity of the performance figures on their personal investment statement. You can google rates of return calculations or ask your financial advisor and still be confused. It’s hard to get a good explanation of why the reported returns appear different from what you expect.
To address this confusion let’s start by looking at what the investment reporting landscape looks like today. In July of 2016 the Canadian investment industry regulators started to require all investment dealers to report money-weighted returns instead of time-weighted returns, as money-weighed returns more accurately represent an individual’s personal investment return.
You may be asking yourself what’s the difference between money-weighted return, also known as internal rate of return and time-weighted return? The answer isn’t straight forward and requires looking beyond the equations to understand how these rates of return are impacted by different variables.
Let’s start with time-weighted return. The method tracks the value over time of a fixed investment. Every time there is a contribution or withdrawal to the investment portfolio the new value of the portfolio is recognized, starting the new return period. Each return period is geometrically linked, effectively time-weighting each return period.
Time-weighted returns only reflect market performance over individual periods regardless of the length of the periods. The sequence of these returns also has no impact on time-weighted returns. This means that if you have bad returns at the beginning of the year and good returns toward the end or vice versa, the time weighted return will be no different in either scenario.
Time-weighted returns are also independent of timing and size of external cash flows. This is important to remember because timing and size of external cash flows can have a significant impact on the amount of money you’re left with in your portfolio.
Example 1 – Time-weighted Return compared to Money-weighted Return (Rising Market Followed by Declining Market)
To understand the difference between money-weighted returns and time-weighted returns I’ve built a visual model reflecting one year of monthly market returns. The first table reflects positive market performance in the first 6 months followed by negative performance in the next 6 months. Our portfolio begins with $1 million dollars as the initial investment. To understand how the timing of cash flows impacts money-weighted return, the model calculates what our time weighted return would be given the sequence of monthly returns in our table and the month in which we make a $100,000 contribution to the portfolio.
Notice that the time weighted return (blue line) stays constant at an approximate annualized return of 5.40%. This is because no matter what month we contribute the $100,000 during the year, it has no impact on the time-weighted return. In contrast when we look at the money-weighted return (orange line) the timing of our $100,000 contribution has a significant impact on the annualized rate of return depending on when we make the contribution. If we contribute early in the year or towards the end of the year, the cash inflow has less impact on the annualized rate of return and therefore the money weighted return will be close too or equal to the time-weighted return. But if we make the $100,000 contribution in the middle of the year right before a change from positive performance to negative performance the large inflow of cash magnifies the loss due to the sequence of market returns resulting in a much lower annualized rate of return when compared with the time weighted return.
Example 2 – Time-weighted Return compared to Money-weighted Return (Declining Market Followed by Rising Market)
To better understand how the timing of external cash flows impacts money-weighted return we’ve reversed the sequence of returns with negative performance occurring at the beginning of the year and positive performance happening in the second half of the year. Notice this change in sequence of returns has no impact on the time weighted return. This is because the order of time periods when the investment manager performs poorly or well does not matter. It is the overall performance for the year that is being measured independent of cashflow timing and size, and sequence of returns.
In this second example above the closer the $100,000 contribution is made right before the change to positive performance the greater the annualized money-weighted return will be because the contribution misses out on the negative performance and benefits from getting the maximum exposure possible to positive returns. The later or earlier in the year the contribution is made the closer the return gets to equaling the time-weighted return.
So, what return number matters? If the investor is looking to isolate the performance of the portfolio from cash flow decisions, time-weighted returns are sufficient. But if the investor wants to see the impact of cash flow decisions on their portfolio performance, they should be looking at money-weighted returns. Money-weighted return is the best measure in understanding the end dollar value of your portfolio.
A full-service advisor should not only be providing money management, but also be helping the client optimize cash flow decisions as this is a major part of the value that your advisor can bring to the table maximizing the potential of your investment portfolio.
Brendan Greenwood is an Investment Advisor with Worldsource Securities focused on personal pension strategies and leveraging technology to provide progressive institutional style investment solutions for professionally incorporated individuals and business owners.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. Neither Brendan Greenwood nor Worldsource Securities Inc or its affiliates provide tax, legal or accounting advice. This material is based on the perspectives and opinions of the writer only and does not necessarily reflect views of Worldsource Securities Inc. The opinions or analyses expressed herein are general, and do not take into account an individual’s or entity’s specific circumstances. Investors should always consult an appropriate professional regarding their particular circumstances before acting on any of the information here. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Investments are provided through Worldsource Securities Inc., sponsoring investment dealer and Member of the Canadian Investor Protection Fund and of the Investment Industry Regulatory Organization of Canada.