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Understanding Your Personalized Rate of Return

You may have noticed that your year-end account statement has been enhanced with additional information that includes the performance of your investments. These enhancements are aligned with the financial industry's new  
regulatory reporting requirements.

A key aspect I want to highlight for you is how your investment performance is calculated. In keeping with the performance reporting requirements, we use what's known as a money-weighted rate of return calculation, also known as Internal Rate of Return (IRR).

This method takes into account any contributions or withdrawals you've made in your portfolio during the time period reported. This is important because the movement of money (both the amount and the timing) into, or out of, an investment can change an investor's personal return in a big way.

Independent from us, you may also receive performance reports from each of the fund managers that hold your investments. These reports usually (though not always) use a time-weighted rate of return calculation. This method of reporting reflects the performance of the funds during the time period reported. However, it's essential for you to know that it may not accurately reflect your personal investment performance.
Quick Summary
  • The timing of cashflows that you direct, such as contributions (which includes transfers in-kind) and withdrawals, can affect your portfolio’s rate of return
  • Money-weighted rate of return includes the effect of these cash flows
  • Time-weighted rate of return does not include the effect of these cash flows
  • If there are no cashflows, the two methods will produce the same rate of return
An Example of Widely Differing Results
If there are no subsequent cashflows into an account after the initial investment, or if the cashflows are small relative to the initial investment, the money-weighted rate of return and time-weighted rate of return methods will return similar results. But when there are large cashflows relative to the initial investment amount, the two methods can produce quite different results.

The following scenario reflects the activity of a client account opened in March 2009, with the performance reporting period ending September 2010. The Account Activity table on the client statement shows the activity since inception:

 
Transactions
Amount
Beginning market value
$25,000.00

Contributions
$425,000.00

Redemptions
($5,000.00)

Gain/loss
$12,970.02

Ending market value $457,970.02
 
For this investment period, the time-weighted rate of return for the account is 20%. From the client's point of view, this rate of return is not very intuitive. Over 18 months, the client invested a net amount of $445,000 and realized a gain of about $13,000 — which is not even close to a return of 20% (typically, clients do a mental calculation of dividing 13/445, resulting in a total return of about 3%).

The reason for the disparity is that the time-weighted rate of return method does not account for the cashflows. Digging deeper, we see that much of the return was realized in 2009 when the amount invested was only $25,000.

Incidentally, March 2009 was the market low after the 2008 financial crisis, so this was an excellent time to invest.

This graphic of the account history helps illustrate the timing of the cashflows:

 

The calculated money-weighted rate of return for the account since inception is 4.9%, considerably less than the time-weighted rate of return. We can visualize the calculation of the money-weighted rate of return using the following table, which shows each cashflow, the number of days it was in the performance period (cashflow days), and the resulting contribution to the ending value (money-weighted rate of return cashflow).

Note that the ending market value is shown as a negative cashflow.

 
Date Amount Cashflow Money-Weighted Rate of Return Cashflow
2009/03/09 $25,000.00 570 $26,928.62
2010/02/22 $370,000.00 220 $380,766.21
2010/08/20 $50,000.00 41 $50,267.99
2010/08/27 $5,000.00 34 $5,022.21
2010/09/07 ($5,000.00) 23 ($5,015.02)
2010/09/30 ($457,970.02) 0 ($457,970.02)

Total money-weighted rate of return-cashflow:

0.0
 

Clearly, from an intuitive perspective when considering the performance of the investment, the 4.9% return matches more closely with the returns experienced by the client.

If you are looking for more information on the enhanced performance reporting in your account statements, download our Account Statement Guide.
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