## Money-weighted Rate of Return

The money-weighted rate of return (MWRR) refers to the internal rate of return on a portfolio. It is the rate of discount, r, at which:

$$\text{PV of cash outflows} = \text{PV of cash inflows}.$$

The money-weighted rate of return on a fund satisfies the equation of value by taking into account the initial and final fund values, as well as the intermediate cash flows. When dealing with an investment portfolio, cash inflows comprise of:

-The beginning value

-Dividends /interest reinvested

Cash outflows, on the other hand, refer to;

-The final value of the fund

-Contributions

## Example

Suppose you buy a stock at $100 and sell it a year later at$110. Let’s assume that the stock pays an annual dividend of 1 per year. Determine the money-weighted rate of return; In this case, the dividends received are outflows, so is the final value of the stock. The cost of the stock is the only inflow. Thus, If we let our MWRR = r, $$\text{PV of outflow}=\text {PV of inflow}$$ $$1(1 + r)^{-1} + 110(1 + r)^{-1} = 100$$ Now, if we let (1 + r) to be ‘x’, then: \begin{align*} & \frac {1}{x} + \frac {110}{x} = 100 \\ & \frac {111}{x} = 100 \\ \end{align*} Therefore, $$x = 1.11$$ But x = 1 + r \begin{align*} 1 + r & = 1.11 \\ r & = 0.11 \text{ or } 11\% \\ \end{align*} Exam tip: The exam usually tests the candidate’s understanding of the concept of money-weighted rate of return. Any calculations are unlikely to require the use of a calculator. ### Shortcoming of the Money-weighted Rate of Return As we stated earlier, the money-weighted rate of return takes into account all the cash flows, including any withdrawal from the fund or contribution. Assuming an investment extends to several periods, the MWRR puts more weight on the performance of the fund during periods when the size of the account is biggest. This is a big disadvantage to fund managers as they may be penalized unfairly because of cash flows that are beyond their control. ## Time-weighted Rate of Return The time-weighted rate of return (TWRR) measures the compound growth rate of an investment portfolio. Unlike the money-weighted rate of return, TWRR is not sensitive to withdrawals or contributions. Essentially, the time-weighted rate of return is the geometric mean of the holding period returns of the respective sub-periods involved. When working out time-weighted measurements, we break down the total investment period into many sub-periods. Each sub-period ends at the point where we have a significant withdrawal or contribution. It could also end after a month, quarterly or even semiannually. We encourage candidates to follow the procedure below when computing TWRR: 1. Establish the holding period return (HPR) for each sub-period 2. Add 1 to each HPR 3. Multiply all the (1 + HPR) terms 4. Subtract 1 from the final product to get the compounded TWRR Summarily, compounded TWRR = {(1 + HPR1)*(1 + HPR2)*(1 + HPR3)…*(1 + HPRn-1)*(1 + HPRn)} – 1 Finally, annual time-weighted rate of return = (1 + compounded TWRR) 1/n – 1 Where n is the number of years ## Example An investor purchases a share of stock at t = 0 for200. At the end of the year (at t = 1) the investor purchases an additional share of the same stock, this time for $220. She then sells both shares at the end of the second year for$230 each. She also received annual dividends of $3 per share at the end of each year. Calculate the annual time-weighted rate of return on her investment. Solution First, we break down the 2-year period into two 1-year periods: Holding period 1: Beginning value = 200 Dividends paid = 3 Ending value = 220 Holding period 2: Beginning value = 440 (2 shares * 220) Dividends paid = 6 (2 shares * 3) Ending value = 460 (2 shares * 230) Secondly, we calculate the HPR for each period: $$\text{HPR}_1 =\cfrac {(220 – 200 + 3)}{200} = 11.5\%$$ $$\text{HPR}_2 =\cfrac {(460 – 440 + 6)}{440} = 5.9\%$$ Lastly, $$(1 + \text{annual TWRR})^2 = 1.115 * 1.059$$ Therefore, $$\text {annual TWRR} = (1.115 * 1.059)^{0.5} – 1 = 8.7\%$$ ## Money-weighted Rate of Return vs. Time-weighted Rates of Return The money-weighted rate of return is sensitive to the amount and timing of cash flows and could lead to an unfair rating of the fund manager – they have no control over the amount or timing of cash flows. This effect is eliminated by the time-weighted rate of return. The money-weighted rate of return would only be superior to the TWRR if and only if the fund manager had complete control over cash flows and their timings. ## Question 1 A stock was valued at$20 on 1 January 2015 and $22 on 31 December 2015, at which time the holder sold his stake. During the year, a dividend of$0.4 per share was paid out to shareholders. Determine the money-weighted rate of return.

A. 1.12

B. 12%

C. 200%

Solution

$$\text{PV of outgo} =\text {PV of income}$$

$$0.4(1 + r)^{-1} + 22(1 + r)^{-1} = 20$$

If we let (1 + r) to be ‘x’,

\begin{align*} \frac {0.4}{x} + \frac {22}{x} & = 20 \\ \frac {22.4}{x} & = 20 \\ x & =\frac {22.4}{20} = 1.12 \\ r & = 1.12 – 1 = 0.12 \text{ or } 12\% \end{align*}

## Question 2

A chartered analyst buys a share of stock at time t = 0 for $50. At t = 1, he purchases an extra share of the same stock for$53. The share gives a dividend of $0.50 per share for the first year and$0.60 per share for the second year. He sells the shares at the end of the second year for \$55 per share. Calculate the annual time-weighted rate of return.

A. 5.9%

B. 12.24%

C. 7%

Solution

We have two 1-year holding periods:

HP1:

P0 = 50

D= 0.5

P1 = 53

HP2:

P0= 106

D = 1.2

P1 = 110

We now calculate the holding period returns:

\begin{align*} \text{HPR}_1 & =\cfrac {(53 – 50 + 0.5)}{50} = 7\% \\ \text{HPR}_2 & =\cfrac {(110 – 106 + 1.2)}{106} = 4.9\% \\ \text{Compounded TWRR} & = 1.07 * 1.049 = 12.24\% \end{align*}

Therefore,

$$\text {Annual TWRR} = (1 + 0.1224)^{0.5} – 1 = 5.9\%$$

Compare the money-weighted and time-weighted rates of return and evaluate the performance of portfolios based on these measures

Share:

#### Related Posts

##### Financial and Non-financial Sources of Risk

Financial risks originate from financial markets and might arise from changes in share...

##### Components of the IPS

There is no standard format to the Investment Policy Statement, but most conform...