3 ways to calculate the rate of return on an investment – and which is best for EAM?
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 what are the differences between them.
Three measures of return - how to calculate
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)
- Money Weighted Return (MWR) equivalent to the Internal Rate of Return (IRR)
- Time-Weighted Return (TWR)
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 were 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.
MWR and TWR are the methodologies which take into account all cash inflows and outflows during the analyzed period and they are the most adequate formulas for portfolio analysis. However, they treat cash flow in different ways and therefore lead to a quite different understanding of the result.
Pros and cons of MWR and TWR
The common part of MWR and TWR is that they require to have the precise classification of the cashflow transactions for every sub-period, where the common most precise sub-period is the daily one. Then the sub-period rates of return are compounded – for TWR it is the multiplication returning the geometrical average and for MWR the Net Present Value (NPV) function is used. These characteristics make them more precise although more complicated than SRR.
The main difference between MWR and TWR is that the first one includes the effects of cashflow (deposits, withdrawals) on return and the second one eliminates this effect. It is worth noting that MWR is significantly affected by both the volume and timing of any cash inflows and outflows. On the other hand, TWR is perceived as a true investment strategy performance. The table below should help you understand what are the pros and cons of using each method.
There are more investment performance calculation methods than the three main methods presented in this article. They were created for example to make the formula simpler or put fewer restrictions on the data completeness. Therefore, the leading industry institutions try to organize them, evangelize the market, and force the transparent and high-quality performance calculation standards.
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, Original Dietz Method, Modified Dietz Method, 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 allows to use 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 following the GIPS calculation process principles 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 what allows them to work smarter and meet the highest market expectations.