In the investment world, there are different goals for calculating the rate of return. Consequently, there are different calculation methodologies. Each of them has its pros and cons and should be applied wisely, taking into account the needs of the person who owns or manages the wealth. In this article, you will learn what are the global standards of investment performance calculation and how they differ.
How to Calculate Rate of Return on Investment? Three Methods
There are three main methods of calculation which are frequently used. They sound similar, but the way they work and the conclusions they provide vary greatly. These methods are:
Simple Rate of Return (SRR)
The simple rate of return (SRR) is a very basic formula that considers only the beginning and ending market value, giving the percentage change between them. The formula cannot be used when there are any changes in the capital through deposits or withdrawals during a given period. Usually, it is used only to calculate the performance of an index or a particular instrument.
You may also use SRR to quickly verify whether multiple investments match your essential criteria. Nevertheless, it takes an insufficient amount of factors into account to be useful in most cases.
Money-Weighted Rate of Return (MWR)
The money-weighted rate of return (MWR), also known as the internal rate of return (IRR), is a more complex approach than the SRR. It takes into account the cash flows that occurred when the money was invested and is excellent for estimating long-term gains and losses. However, the money-weighted rate of return is less effective than the simple or time-weighted rates of return for comparing investments.
- Initial investment (C0)—the amount invested at the beginning (negative).
- Interim cash flows (C1, C2, etc.)—deposits(negative) and withdrawals(positive).
- Final value (Cn+1).
- Time in years (t).
Time-Weighted Rate of Return (TWR)
The time-weighted rate of return (TWR) removes the impact of cash flows from the equation. Instead, it divides the time into separate periods and measures the performance of an investment over each of them and then uses this data to calculate the overall return on investment.
- Ve—Ending value of the investment.
- Vb—Beginning value of the investment.
- X—Given period.
- Rx—Return on investment during a given period.
Rx=(Vex-Vbx)/Vbx
TWR = (1 + R1) * (1 + R2) * ... (1 + Rn) - 1
Simple Rate of Return vs. Money-Weighted Rate of Return vs. Time-Weighted Rate of Return
How do all these methods of calculating the rate of return on investment compare? We’ve prepared a brief overview of the most important differences between them.
Which Way of Calculating the Rate of Investment Is the Best for External Asset Managers?
There is no straightforward answer to the question from the header. As an external asset manager, you will likely be using all three of these formulas (and some additional ones), depending on the situation. Therefore, instead of consistently using one of these formulas, utilize them interchangeably based on your goal.
Global Standards of Calculating Investment Performance
There are more investment performance calculation methods than the three main ones presented in this article. They were created, for example, to make the formula simpler or put fewer restrictions on the data completeness. Leading industry institutions aim to standardize these methods, promote transparency, and enforce high-quality performance calculation practices.
One of the most recognized financial bodies is the Chartered Financial Analyst (CFA) Institute, which publishes the Global Investment Performance Standards (GIPS). Guidance statements included in the GIPS publications are developed to ensure the financial world follows the appropriate calculation methodologies. According to the CFA Institute, the most common methods of calculating the rate of return outside TWR are IRR, the Original Dietz Method, the Modified Dietz Method, and the Modified Bank Administration Institute (BAI) Method. However, all of them are just approximation methods of calculating the rate of return, while the most accurate and recommended by the CFA Institute method is TWR.
WealthArc’s Approach to Calculating ROI
WealthArc allows using different methods of the rate of return calculation, especially when custodians use them in their system. However, the recommended and default methodology used in WealthArc is the TWR. High-quality data reconciliation and the following principles of the GIPS calculation process ensure compliance with global standards. Calculating TWR is not an easy task and may be cost-intensive; therefore, many professional wealth managers entrust this task to us, which allows them to work smarter and meet the highest market expectations.
The Takeaway
You now understand the three main methods for calculating investment rates of return. You've seen a comparison between the simple rate of return vs. time-weighted rate of return vs. money-weighted rate of return. Remember that you can calculate them all in WealthArc, so do not hesitate—it’s time to invest in our platform and take your wealth management to the next level!
You might also read: Well-suited Portfolio Management System for EAM - how to choose the best one for your company
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