Difference Between Time Weighted And Dollar Weighted Returns
Investing in any financial product requires a clear understanding of various return metrics. The most common ones are time-weighted returns and dollar-weighted returns. While both metrics measure investment performance, they differ in terms of computation and usage.
Definition of Time-Weighted Returns
Time-weighted returns calculate the compound rate of growth of a portfolio over a specific period, considering only the returns generated by the underlying investments. This metric measures how well the investments performed without considering the impact of external factors, such as cash flows.
Definition of Dollar-Weighted Returns
Dollar-weighted returns, also known as internal rate of return (IRR), consider cash flows into and out of the portfolio. This metric measures the actual returns earned by an investor, taking into account the timing and amount of cash flows.
Calculation of Time-Weighted Returns
To calculate time-weighted returns, the following steps are taken:
- Calculate the daily returns of each investment in the portfolio
- Calculate the geometric average of daily returns over the investment period
- Add 1 to the geometric average return
- Raise the result to the power of 365/n, where n is the number of days the investment was held
- Subtract 1 from the result
Calculation of Dollar-Weighted Returns
To calculate dollar-weighted returns, the following steps are taken:
- Calculate the present value of all cash inflows and outflows of the portfolio
- Calculate the IRR of the cash flows, which is the discount rate that makes the present value of all cash inflows equal to the present value of all cash outflows
Usage of Time-Weighted Returns
Time-weighted returns are commonly used to compare the performance of different investment managers or to measure the performance of a portfolio over a specific period. This metric eliminates the impact of external factors, such as cash flows, making it a reliable measure of investment performance.
Usage of Dollar-Weighted Returns
Dollar-weighted returns are commonly used to measure the actual returns earned by an investor, taking into account the impact of cash flows. This metric is useful in evaluating the performance of an investor's portfolio or a specific investment, as it considers the timing and amount of cash flows.
Advantages of Time-Weighted Returns
The main advantages of time-weighted returns are:
- Eliminates the impact of cash flows on investment performance, providing a reliable measure of investment manager performance
- Allows for easy comparison of investment performance over different periods
- Useful in analyzing the performance of a portfolio or specific investment without the impact of external factors
Advantages of Dollar-Weighted Returns
The main advantages of dollar-weighted returns are:
- Consider the impact of cash flows on investment performance, providing a measure of actual returns earned by an investor
- Useful in evaluating the performance of a portfolio or specific investment that involves significant cash flows
- Allows for easy comparison of investment performance over different periods, taking into account the timing and amount of cash flows
Limitations of Time-Weighted Returns
The main limitations of time-weighted returns are:
- Cannot reflect the actual returns earned by an investor, as it eliminates the impact of cash flows
- May not be suitable for evaluating the performance of a portfolio that involves significant cash flows
- May not reflect the impact of taxes and fees on investment performance
Limitations of Dollar-Weighted Returns
The main limitations of dollar-weighted returns are:
- May not reflect the actual performance of an investment, as it considers the impact of cash flows
- May not be suitable for comparing the performance of different investment managers, as it considers the timing and amount of cash flows
- May not reflect the impact of taxes and fees on investment performance
Conclusion
Time-weighted returns and dollar-weighted returns are essential metrics for measuring investment performance. Both methods have advantages and disadvantages, and the choice of metric depends on the investment objectives and the type of investment. Understanding these metrics is crucial for making informed investment decisions and evaluating the performance of investment managers or portfolios.