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Investment Management: Mutual Funds, Hedge Funds, and Other Funds Contents Time weighted returns (TWR) 3 Importance of Time Weighted Returns to the Investors4References5Time weighted returns (TWR)Time weighted returns measures the compound rate of growth in a portfolio. This method is useful since it eliminates the distorting effects which are created due to inflow of new money. The true TWR of an asset requires as asset to be revalue at the point of each cash flow. The returns are then compounded together to form the TWR for the whole period.
In effect a weighted average of sub period internal rates of return between cash flows is generated. But this method has a drawback of having to capture all the data at the point of each cash flow and in particular the need for the asset revaluation causes significant problems. It is this method that is used for mutual fund performance which is needed to calculate daily unit prices. However for most performance measurement systems the asset revaluation was not easily available. Hence it has long been accepted to calculate as estimated TWR by combining sub period Money Weighted returns (MWR).
The basic minimum period used for this period is one month. Basically one month TWR equates to the one month MWR and the quarterly TWR forms the combination of three monthly MWRs (Bain, 2000, p. 59). The Method of compounding sub-returns to create longer period returns is often referred to as chain linking. The formula for calculating TWR isIn the formula (1+ Ri / 100) form the return and is known as multiplicative form. This method combines any number of returns for any time period. But it is normal to make one further adjustment when the time period is more than one year.
It is known as annualized return and is calculated as shown below. Importance of Time Weighted Returns to the InvestorsTime weighted returns helps the investors in determining the rates of return of a portfolio independent of when the capital is withdrawn or added from the available investment fund. The Time Weighted Returns are more commonly related to find mangers instead of private investors. This is because the fund manager posses limited control when they receive funds from investors or in case investors wanted to withdraw their funds from the portfolio.
In actual scenario, investors often contribute additional cash or withdraw cash as per their wish. But under TWR, it is assumed that a single investment is made the beginning of the period and it was allowed to grow with positive returns and decline with negative returns until the end of the measurement period. Calculating time-weighted investment returns eliminates the effects of any client withdrawals or additions which are beyond the control of investment managers. Thus the result arrived at gives an unbiased and accurate measurement of investment performance which is the same with or without any periodic withdrawals or additions.
Advancement in accounting systems and computer technology has made it easy to access more accurate data. Nowadays the calculation of a true TWR by revaluing the portfolio after each cash flow and computing the resulting returns is already dome in mutual funds and is becoming a common place which is advantageous to the investors (Anson, Chambers, Black and Kazemi, 2012, p. 159). ReferencesAnson, M.J.P., Chambers, D.R., Black, K.H. and Kazemi, H. 2012. CAIA Level I: An Introduction to Core Topics in Alternative Investments.
New Jersey: John Wiley & SonsBain, W.G. 2000. Investment Performance Measurement.