Question

Compare and contrast the time-weighted rate of return with the money-weighted rate of return. In general terms, how is each calculated? Are there certain situations that would cause the two methods to have drastically different rates of return?

Answer 1

Difference between time weighted and money weighted return

Time weighted rate if return	Money weighted rate if return
1. It is not affected by inflows and outflows	1. It is affected by inflows and outflows
2. It is data intensive as it requires all the cash flows data.	2. It doesn't require data of all the external cashflows.
3. It is used when timing of the cash flow cannot be controlled	3. It is preferred when timing of the cash flows can be controlled.
4. It is preferred for reporting under GIPS.	4. It is not preferred by GIPS under normal circumstances.

In general terms, time weighted rate of return is the compounded growth rate on the one unit of money invested.

The formula for time weighted return, when the external cash flow is at the beginning of the evaluation period.

Rate = MV1 - (MV0 + CF) / MV0 + CF

When the the external cashflow is at the end of evaluation period.

Rate= (MV1 - CF) - MV0 / MV0

After calculating the return using the above formula, we multiply it and get the the TWR.

Where as money weighted return is the internal rate of return on the fund inveted. We can use the same formula as we use in case of internal rate if return in capital budgeting.

The two methods drastically give different results when their is external contribution or withdrawals .