Time-Weighted Rate of Return
Time-weighted rate of return (TWR) is the compound rate of growth over a period on one unit of currency invested at the start of the period. It is called time-weighted because it gives equal weightage to each of the sub-period returns.
It is one of the two methods for calculating rate of return over multiple periods: the other being the money-weighted rate of return which calculates the compound rate such that the rate of return in the periods of high amount of invested money is given higher weightage and vice versa.
The basic formula for a time-weighted return for a period is given below:
|Time-weighted Rate of Return|
|=||Ending Value − Beginning Value|
It is the same as the formula for holding period return. In case of any external cash flows: new investments, withdrawals, dividends, etc., the time-weighted return is calculated for each sub-period and then chain-linked using the following formula:
Time-weighted return for multiple periods
= (1 + 1st period return) × (1 + 2nd period return) – 1
Guddu Gupta is a client of RAK Asset Management. He started his portfolio with an investment of $10,000 on 1 January 20X9. The value of his portfolio on 31 December 20X9 was $13,050. Impressed with the performance, he invested a further amount of $10,000 on 1 January 20Y0 with the firm. On 31 December 20Y0, he withdrew $5,000. The value of his portfolio before withdrawal was $25,000. The value at the end of 31 December 20Y1 was $22,500.
Calculate the time-weighted rate of return for his portfolio and tell how it differs from money-weighted return.
We have to calculate the compound rate of return from 1 January 20X9 to 31 December 20Y1. The period has three sub-periods:
- 1 January 20X9 — 31 December 20X9
- 1 January 20Y0 — 31 December 20Y0
- 1 January 20Y1 — 31 December 20Y1
Sub-period rates of return are calculated as follows:
|Return for Period 1|
|=||13,050 − 10,000||= 30.50%|
In Period 2, $10,000 is added because it is a new investment that increased the beginning portfolio value.
|Return for Period 2|
|=||25,000 − (13,050 + 10,000)||= 8.46%|
|13,050 + 10,000|
At the start of Period 3, there is a deduction of $5,000 so beginning portfolio value for Period 3 should be $20,000 [= $25,000 minus $5,000].
|Return for Period 3|
|=||22,500 − 20,000||= 12.5%|
The sub-period returns are then chain-linked as follows:
Time-weighted return for the whole period
= (1 + 30.50%) × (1 + 8.46%) × (1 + 12.5%) – 1
Please note that this is not an annual rate. However, it can be converted to an annual rate using CAGR.
The point to note here is that time-weighted rate of return assigns equal weight to all the periods. The money-weighted rate of return, on the other hand, will weight Period 2 higher because the highest amount of money that remained invested during that period.