Commonwealth's Data Integrity department is responsible for maintaining and reconciling all of the data that appears on our Client360°®, Practice360°®, and Investor360°® platforms. These systems, available to affiliated advisors and their clients, offer the ability to manage numerous aspects of the overall financial picture. But with all this data at their fingertips, one recurring question our advisors often ask is how to go about measuring portfolio performance. Specifically, they want to understand the difference between time-weighted return (TWR) and internal rate of return (IRR), also known as dollar-weighted return.
To clarify this often misunderstood facet of portfolio performance—and to help you determine which method to use when measuring the performance of your clients' portfolios—let's dig a bit deeper into the TWR versus IRR debate.
What Is TWR?
TWR is designed to show how an advisor performed in relation to the money he or she had to invest at that time. But TWR isn't always intuitive—for you or your clients.
- Sometimes, a TWR calculation will be negative when your client has made money overall.
- There may be instances in which a household TWR calculation doesn't give you the results you'd expect.
Because it can be difficult to explain TWR to clients, advisors sometimes turn to IRR, which tends to more closely reflect what the client made. But is IRR a better calculation methodology than TWR?
Is IRR Better?
IRR tends to more closely reflect what the client made. But is it better? To help answer this question, let's say you have two accounts:
If you were to calculate a return from inception through March 31, 2015, you'd expect both accounts to have a 10-percent return, although one was open twice as long as the other. In fact, if you ran either an IRR or TWR calculation for each account separately, that's exactly what you'd get: both would have a return of 10 percent since inception.
What would happen if you calculated IRR for the entire portfolio (both accounts together)? When IRR is calculated for a group:
- The accounts get combined as if they were one account.
- The start date of the oldest account becomes the start date of the group.
- The IRR is a dollar-weighted return, calculated by discounting all the cash flows back to the start date of the account.
Using IRR for the entire portfolio in the example above, performance for the two accounts would start on March 31, 2013, and the $10,000 cash flow on March 31, 2014, would get discounted back to the start date. Since the second cash flow came in halfway during the return period, it would be given half the weight in the denominator of the return calculation. Consequently, there would be a gain of $2,000 on net capital of $15,000 (instead of $20,000) and a return of 13.3 percent (instead of the expected 10 percent).
With IRR, this can also happen within a single account that has experienced multiple cash flows. For example, let's assume the same activity happened within a single account:
With an initial contribution of $10,000, an additional contribution of $10,000 a year later, and total gains of $2,000, the return would be the same as in the previous scenario: 13.3 percent rather than the expected return of 10 percent. The second cash flow would get discounted back to the start date of the performance range, resulting in a smaller denominator and a larger return than you'd expect.
Do IRR calculations always show higher returns? Actually, the reverse holds true for withdrawals. They don't reduce the denominator as much as expected, and you're left with lower-than-anticipated returns. For these reasons, take care when reporting on returns using the IRR methodology.
Another simple example illustrates how TWR and IRR can produce dramatically different results. Let's say you've managed your client's money for 9 years, taking an account with $10,000 and no additional contributions and doubling it to $20,000, for an approximate 8-percent average annual return (with both TWR and IRR). At the beginning of the 10th year, your client asks you to invest $1,000,000 that he's inherited, and you let it all ride on the S&P 500, which loses 30 percent that year.
- From a TWR perspective, you still have positive performance, despite the bad year. The portfolio has achieved approximate annual returns of 3.4 percent.
- From an IRR perspective, what you've done as a money manager for the past 9 years is rendered irrelevant. The client has lost substantial money, and your annualized return over that period—even with the discounted cash flow denominator—will be negative.
Is There a Simpler Way?
Some advisors just want a simple return, where the total gains are divided by the total investment. But doing so with an account that has multiple cash flows would be very challenging. For instance, what if an account started with $50,000, had an additional contribution of $50,000, and then had a withdrawal of $20,000? Should you apply the gains to a $50,000 investment, a $100,000 investment, or an $80,000 investment? A simple return of total gains divided by total contributions just doesn't work on complex, real-world accounts with multiple cash flows.
Both TWR and IRR try to bridge this gap, but they do so in different ways:
- IRR attempts to replicate the client experience by applying total gains to the average investment amount. But IRR is distorted by cash flows, as shown in the previous examples.
- TWR tries to negate the effect of cash flows, which are generally beyond the advisor's control, and show how the advisor performed. But it can also produce results that are not intuitive.
The Bottom Line
Here at Commonwealth, we use TWR on the reports we make available to our advisors, and we prefer the TWR methodology for longer-term performance calculations. In general, we believe TWR is a better representation of an advisor's performance in managing a portfolio. And unlike IRR, it can be compared easily with indices and other investments and money managers that use TWR. Just remember, neither method is perfect. Both perspectives are correct, but it's important to understand the complexities of each before determining which methodology to use when determining the performance of your clients' portfolios.
What method do you use when measuring portfolio performance? Do you agree that TWR provides a better perspective? Please share your thoughts with us below.