What Is Time-Weighted Return & How Is It Calculated?

Time-weighted return measures an investment’s performance over a specific period. It removes the distorting impact of cash inflows and outflows, such as deposits or withdrawals, on the overall performance calculation. This measurement provides a clearer picture of the investment manager’s skill and the inherent growth rate of the assets under management. Its purpose is to assess the efficiency and effectiveness of investment decisions, independent of investor behavior.

Understanding Time-Weighted Return

Time-weighted return is the standard for evaluating investment managers and comparing portfolios. This approach isolates the actual performance generated by assets, irrespective of when an investor added or removed funds. It achieves this by breaking down the investment period into smaller sub-periods, with each sub-period ending just before any cash flow occurs.

The methodology ensures that investor contributions or withdrawals do not artificially inflate or deflate reported returns. For instance, if a large deposit is made just before strong market gains, another calculation method might overstate the manager’s skill. Time-weighted return mitigates this by focusing on the growth rate of the capital invested during each distinct period.

Investment professionals, such as mutual fund managers and hedge fund operators, commonly use time-weighted return when reporting results to clients. This allows for a fair comparison of performance across various funds and managers, as it standardizes the measurement by removing external influences. The principle behind it is to reflect the compound growth rate of an initial investment over time, assuming all interim cash flows were reinvested.

Calculating Time-Weighted Return

Calculating time-weighted return involves a multi-step process that accounts for cash flows within the investment period. The process begins by dividing the entire investment period into distinct sub-periods. Each cash inflow or outflow triggers the end of one sub-period and the start of another. This segmentation ensures the return for each segment accurately reflects the performance of the capital present during that timeframe.

For each sub-period, the return is calculated by taking the ending value of the portfolio, subtracting the beginning value, and then dividing by the beginning value. If there was a cash flow at the start of a sub-period, that cash flow is added to the beginning value for the calculation.

Consider a simplified example: an investment begins with $10,000. After six months, the value grows to $11,000, and an additional $2,000 is deposited. The return for the first sub-period is ($11,000 – $10,000) / $10,000 = 0.10 or 10%. The portfolio value then becomes $11,000 + $2,000 = $13,000.

After another six months, the investment grows to $14,500. The return for the second sub-period is ($14,500 – $13,000) / $13,000 = 0.11538 or approximately 11.54%. To find the total time-weighted return, these sub-period returns are geometrically linked by adding 1 to each return, multiplying them together, and then subtracting 1 from the final product. In this example, (1 + 0.10) (1 + 0.11538) – 1 = 1.10 1.11538 – 1 = 1.226918 – 1 = 0.226918 or approximately 22.69%.

Comparing Time-Weighted and Money-Weighted Returns

While time-weighted return focuses on asset performance, money-weighted return considers the timing and size of cash flows. Money-weighted return, often called the Internal Rate of Return (IRR), calculates the rate of return that equates the present value of all cash inflows with the present value of all cash outflows. This method is relevant for individual investors because it directly reflects the impact of their personal investment decisions, such as when they contributed or withdrew funds.

The core distinction lies in their purpose and application. Time-weighted return is suitable for evaluating an investment manager’s skill, as it isolates portfolio performance from investor behavior. It answers: “How well did the manager perform with the money they had available?” Conversely, money-weighted return is more appropriate for an individual investor assessing their personal investment success, as it answers: “What was my actual return on the money I invested?”

For example, if an investor consistently adds funds just before market downturns, their money-weighted return might be lower than the time-weighted return of the underlying investment. This is because money-weighted return accounts for the investor’s timing of contributions. A portfolio manager, however, would still report a higher time-weighted return, as their performance is measured independently of these cash flow decisions. The choice between these two methods depends on whose performance is being evaluated and for what specific purpose.