By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Measuring investment return is slightly less straight forward than it might appear at first glance. But, it’s not rocket science. Some very simple examples can be used to explain more clearly each measurement. Understanding these different measurements will make you a better and more informed investor.
If you start with a dollar and it grows to two dollars you have had a 100% return. This total return ignores time.
If it took you ten years to achieve a 100% growth, your compound return was 7.18%. Compound return is the single number which produces the reinvestment rate necessary to achieve the growth over the specified number of time periods. The longer it takes to achieve the same result, the lower the compound return. Determining compound returns requires a financial calculator, or some advanced math that most of us probably forgot promptly after graduation.
Average return is always equal or greater than the compound return and is simply the sum of the individual returns divided by the number of time periods. It’s not a particularly useful measurement because an infinite number of individual period investment returns might have achieved the doubling of your funds over that 10 year period. The higher the average return number, the higher variation or risk the portfolio endured to achieve that return over the measured time period. However, regardless of the risk, the compound return is always the same given the same start and end values over the specified time period.
Time weighted returns
Time weighted returns are commonly used by mutual funds to report their results. They are simply compound returns with the simplifying presumption that all investors began and ended their investments at the same time and had no cash flows during the period. The time weighted return measures the performance of the investment pool during the period.
Dollar weighted returns
However, in real life, investors enter at different times, and do have cash flows into or out of their investment pools. Their actual experience may have no similarity to the time weighted return that the investment pool generated. For instance, suppose Jane invests one dollar on January 1, 1990. Her fund has a stellar year and the following year she is pleased to note that she has doubled her investment. She now invests an additional $1,000,000 into the fund. The fund loses 10% during 1991 and Jane is crushed to see that her total investment has shrunk to $900,001.80.
Jane will not be consoled when her fund shows an average return of 45% (100% -10% / 2 years). Nor will the time weighted (compound return) of 34.16% make her feel much better. She knows that her individual experience is a big loss.
From the fund manager’s perspective the fund experienced great performance. After all, they don’t determine the timing of client cash flows. The two year (time weighted) performance of the money they had available to invest is quite enviable. Investors that started the period in 1990 and sat tight are celebrating their good fortune.
Internal Rate of Return
So, how should Jane measure her performance? Internal Rate of Return (IRR) is a more sophisticated measurement which accounts for each cash flow, and then links the beginning and ending values to a single rate which explains them. IRR is a dollar weighted measurement which explains Jane’s investment loss in personalized terms. In Jane’s case the timing and size of her cash flow swamped the apparent good returns of the fund. Another investor with different cash flows would have experienced entirely different results.
So, we might say that compound returns (time weighted) explain the performance of a fund, while IRR (dollar weighted) returns explain the individual investor’s performance where cash flows occurred during the period. Only in the event that there were no cash flows into or out of the fund would the two measurements be the same. Investors that loaded up on a fund before a good period should see higher IRR (dollar weighted) returns than compound returns. Conversely, if investors withdraw funds prior to a good period, their IRR will be lower than the compound returns.