When it comes to investing, performance measurement is more than just a figure. Frequent deposits, withdrawals, and cash flows can distort returns, leaving investors puzzled about the true performance of their investments. Imagine trying to gauge a fund’s performance through a series of misleading shadows—it’s challenging, right?
This is where Time-Weighted Rate of Return (TWRR) shines. Unlike other metrics, TWRR removes the impact of cash flows, offering a clearer and unbiased look at investment performance.
This article demystifies TWRR meaning in depth, explaining how it works, how to calculate it, and how it stacks up against other return metrics like XIRR and CAGR.
What is TWRR?
The Time-Weighted Rate of Return (TWRR) is a financial metric used to measure the compound growth rate of an investment portfolio, excluding the impact of cash flows like deposits and withdrawals.
TWRR breaks down performance into distinct periods, each between cash flow events, and calculates the return for each period. This approach ensures that the metric reflects the fund manager’s performance, unaffected by investor actions. It’s like tracking how well a runner performs without factoring in interruptions like breaks or water stops.
Why is TWRR Important?
- Objective Comparison: TWRR allows for an unbiased comparison between funds, as it neutralises the effect of cash flows.
- Suitable for Fund Evaluation: It’s particularly useful for assessing fund managers, as it focuses solely on investment performance.
- Useful for Benchmarking: By comparing TWRR with a benchmark index, investors can understand whether the investment strategy meets its objectives.
How to Calculate TWRR?
Calculating TWRR is a straightforward task and can be done in a few steps.
To calculate TWRR, you must first break down the mutual fund’s/portfolio’s performance into multiple periods between each cash flow (deposit or withdrawal). Calculate the potential return for each period separately and then compound them together.
- Spot the points at which cash flows occur. Each of these points marks the end of one sub-period and the beginning of another.
- For each period, calculate the return using this formula:
HP (Holding period return) = (End Value – (Beginning Value + Cash Flow)) / (Beginning Value + Cash Flow)
- Multiply the potential returns of all periods together to get the total compounded growth rate.
TWRR formula = [(1+HP1) x (1+HP2) x (1+HPn)] – 1
Example of TWRR Calculation
Let us use these steps to calculate TWRR.
Assume you want to use TWRR to calculate your mutual fund’s performance. Say, you initially invest ₹1,00,000. At the close of the first month, your mutual fund portfolio stands at ₹1,01,000.
Here, calculate the first holding period return.
HP1 = (101,000 – 100,000)/100,000 = 1%
In the following month, you contribute an additional ₹1,000. By the end of this period, your portfolio balance stands at ₹1,03,000.
Calculate the second sub-period return:
HP2 = (103,000 – (101,000 + 1,000)) / (101,000 + 1,000) = 0.98%
In the third month – let us assume you redeem ₹1,000. At the month’s end, your portfolio balance stands at ₹1,04,000.
The third sub-period return is as follows:
HP3 = (104,000 – (103,000 – 1,000))/(103,000 – 1,000) = 1.96%
The final step is to calculate the TWRR for 3 months:
TWRR = [(1+.01) x (1+.0098) x (1+ .0196)] – 1 = 2.04%
Over a 3-month period, the TWRR was 2.04%.
| Month | Transaction | Beginning Portfolio Value (₹) | Ending Portfolio Value (₹) | Holding Period Return |
| 1 | No additional transaction | 1,00,000 | 1,01,000 | 1.00% |
| 2 | Invest ₹1,000 | 1,02,000 (₹1,01,000 + ₹1,000) | 1,03,000 | 0.98% |
| 3 | Redeem ₹1,000 | 1,02,000 (₹1,03,000 – ₹1,000) | 1,04,000 | 1.96% |
| Total | – | – | – | 2.04% (TWRR) |
TWRR vs XIRR and CAGR
TWRR vs XIRR
Many investors confuse TWRR with XIRR (Extended Internal Rate of Return), but they serve different purposes:
- TWRR focuses purely on the timing of cash flows, providing an accurate measure of performance that disregards the amount of money involved.
- XIRR, on the other hand, considers both the timing and the size of cash flows, offering a complete picture of investment returns.
In essence, while TWRR is best for comparing fund performance, XIRR is more suitable for tracking individual portfolio returns, considering cash inflows and outflows.
TWRR vs CAGR
CAGR (Compound Annual Growth Rate) measures the average annual growth rate over a specified period.
- CAGR does not account for cash flows during the period.
- TWRR, by contrast, adjusts for cash flows, making it more precise for funds with frequent cash movements.
While TWRR is a superior performance metric for funds with high cash flow frequency, CAGR remains useful for investments with consistent growth over time.
Limitations of TWRR
While TWRR is a powerful metric, it’s not without its limitations:
- Complex Calculation: Frequent deposits and withdrawals mean multiple sub-periods, making manual TWRR calculations tedious.
- Software Requirement: Accurately computing TWRR often requires sophisticated software, limiting its use among retail investors.
- Cash Flow Exclusion: By design, TWRR excludes the impact of cash flows, which may not always align with an investor’s real experience.
Despite these drawbacks, TWRR remains one of the most reliable ways to gauge true investment performance over time.
Final Thoughts: Is TWRR Right for You?
TWRR is a robust tool that reveals the true performance of an investment by eliminating the distortions caused by cash flows. However, it should not be the sole metric for decision-making. A well-rounded evaluation that includes other metrics like XIRR, expense ratios, and risk-adjusted returns will offer a more comprehensive view.
The essence of TWRR lies in its focus on pure performance, making it particularly useful for comparing mutual funds and portfolio management services. By understanding its mechanics and limitations, investors can use TWRR to gain deeper insights into how well their investments are really performing.
Frequently Asked Questions
What is the meaning of TWRR?
TWRR, or Time-Weighted Rate of Return, measures the compound growth rate in a mutual fund/ investment portfolio, excluding the impact of cash flows such as deposits or redemptions.
It breaks down the mutual fund’s/portfolio’s performance into multiple periods between each cash flow, then calculates the return for each period separately and then compounds them together.
What is the difference between TWRR and XIRR?
TWRR and XIRR (Extended Internal Rate of Return) are not the same. TWRR focuses on the timing of the cash flows; it ignores how much money one has invested or redeemed (it’s weighted on time), whereas XIRR accounts for both cash flows and the timings of the cash flows. Thus, providing a true picture of the performance.
How to explain time-weighted return?
TWRR employs a unique formula that eliminates the impact of cash flows (deposits and withdrawals), providing a better understanding of an investment’s performance. It takes into account when cash flows occur by segmenting returns into sub-periods. Thus, it provides us with a reliable indicator for determining how well such funds have performed over time.
What is the difference between TWRR and CAGR?
For an investment – the CAGR measures the average annual growth rate over a period greater than one year. TWRR indicates a return on investment that has been compounded after adjusting for any cash inflows or outflows arising from the portfolio.
TWRR is seen as a better performance measure when compared to CAGR because it accounts for any inflows or outflows that may occur, unlike CAGR, which treats these events as external to the investment process.