Money Weighted and Time weighted

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Andys

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When to use Money weighted and when to use time weighted?

I thought when there is a inflow and outflow of the money invested, Money weighted rate of return is used. This is also know as internal rate of return.

And time weighted retrun is used when there is a fix amount invested( no inflow and outflow) and geometric mean of holding period is calcuated( when investment is greater than 1 year)

Can anyone please explain this in detail.
 
Time weighted returns are used for performance reporting a lot. When reporting portfolio performance relative to a benchmark it is unfair to compare your portfolio's IRR (money weighted) to the benchmark return (time weighted).

The index does not have any cash flows associated with it, so in order to make direct comparison you have to adjust the money weighted return for significant cash flows.

As an example, you are a portfolio manager and you receive a bunch of new cash inflows (and are obligated to investment them). You do so and right afterwards the market drops. Is this an indication of poor performance? Your MWR would indicate so but your TWR wouldn't.

On the other side say some client send you a bunch of money which you invest immediately (like you always do) and the market shoots up right afterwards. Your money weighted return would be higher than the time weighted return of the index. Does this mean you are a brilliant portfolio manager? Probably not.

So to make an apples to apples comparison you have to remove the effect of cash flows.

Keep in mind that the MWR is what your client have actually received. It is what pays the bills.

Hope this helps.
 
Good to see we have Experts in every domain(be it FSA or Quanta) here in AF
keep it up,mwvt9
 
Thanks mwvt9, that is very detailed explanation.
 
I'm a little unclear on the calculation of the time-weighted return. The textbook says that if the investment is longer than one year, we have:

TWR = [(1+r1)(1+r2)...(1+rn)]^(1/n) -1

This makes intuitive sense to me. It seems that if the returns are less than one year, however, the TWR is calculated simply as:

TWR = (1+r1)(1+r2)...(1+r365) - 1 (assuming daily returns here)

Why not also take the 365th root of the product of these returns?

Page 225 in book 1 makes reference to the fact that "taking the root is only appropriate to rates that apply to one full year". Why is that?

Thanks
 
TWR = (1+r1)(1+r2)...(1+r365) - 1 (assuming daily returns here)
Why not also take the 365th root of the product of these returns?

Here we are looking for annual timeweighted return. So if the time span given is less than 1 year. Then find the HPY for each sub period and multiply them as above specified.

If the investment peroid is greater than 1 year then we have to take the geometric mean.

TWR = [(1+r1)(1+r2)...(1+rn)]^(1/n) -1
 
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