Internal Rate Of Return Vs. Time-Weighted Rate Of Return

May 30 2021 | 2 min

No single investment metric captures the entire story or context of historical performance. It is therefore no surprise that investors and wealth managers have long debated the most suitable metrics to monitor investment performance. Depending on the investment strategy and asset class, the invested capital may be paid upfront or staggered over time, while the return is usually a combination of the periodic income from the investment and the capital gain upon its sale. The performance metrics to measure the return on invested capital are countless and provide different results.

This paper discusses the merits and shortfalls of the two most popular metrics; the Internal Rate of Return (IRR) and the Time-Weighted Rate of Return (TWR).

IRR and TWR Defined

IRR measures the return between two dates based on the timing of each, and every capital inflow and outflow in an investment. It is defined as the discount rate at which the net present value (NPV) of capital inflows and outflows would be 0. Since IRR is affected by the size and timing of cash flows, it gives a heavier weighting to larger capital flows and may overlook performance on smaller amounts.

TWR calculates the return on a $1 investment over successive time periods without considering the quantum of capital flows, as it eliminates the effects of additions and withdrawals to the portfolio.

For example, assume that you invested $10,000 in a portfolio which grew 5% to $10,500 a year later. Then you added $100,000 to your portfolio which fell 5% from $110,500 to $104,975 at the end of the second year. In short, you have invested $110,000 in a portfolio that was worth $104,975 after two years. Now let us calculate the returns using IRR and TWR.

In the above example, TWR is only slightly negative at ‑0.125%, offsetting the 5% gain in Year 1 against the 5% loss in Year 2 ( -1).

The IRR, however, is -4.19%, giving far more weight to the negative returns on the larger investment in year 2 than the positive returns on the smaller investment in year 1.

 

Now assume that you invested $100,000 in the same portfolio and added $10,000 a year later. Your portfolio would be worth $109,250 after two years following the positive returns in the first year.

 

Although the portfolio in the second example is worth more than in the first, TWR remains unchanged as it measures the portfolio returns rather than the amounts invested during each period. Meanwhile, IRR improved to -0.36% since most of the investment benefited from the positive returns during the first period.

In the above examples, the IRR differentiated between the different ending values of the portfolio more accurately than did TWR. However, it is possible to have more than one IRR value if the invested capital is staggered in stages and income is received in the interim. When measuring the performance of a portfolio into which capital is added and withdrawn from time to time, the IRR will produce multiple results that render it meaningless. The IRR is thus best suited to measure the return of a single investment.

TWR, meanwhile, is better suited to measure the performance of a portfolio of investments using relatively simple calculations based on portfolio changes between two consecutive dates. It therefore reflects the choices made by the investment manager undistorted by capricious portfolio additions and withdrawals by investors over time.

How The Family Office Measures Performance

The Family Office uses both metrics. TWR is used to compute the performance of each bespoke client portfolio, while IRR is used to gauge the performance of individual investments. Both metrics are made available to clients and updated regularly along with a host of qualitative information.

The Family Office offers bespoke solutions tailored specifically for the unique circumstances, lifestyle and goals of each client.

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