Two choices, simplified.
We are not holy warriors and we have never received a smoking stone tablet that read “Thou Shalt Use IRR”. At Blueleaf, we’re pragmatists. We want to help you answer the question “What is the best calculation choice for my business purpose?”
Breaking down the big two
Typically in advisors’ debates on performance calculation methods (we advisors are a geeky bunch), we focus on 2 main approaches: Time-weighted or Money-weighted (IRR) calculations. Usually it’s an esoteric conversation, but there are differences that have a real impact on clients. Neither is the “one right choice” – they are appropriate for different purposes. Let’s look at both methods and their respective strengths.
The term time-weighting is a bit of a misnomer. Time-weighted returns do not “weight time”—every reporting period, regardless of length or amount invested, is weighted equally. Time-weighted returns eliminate or reduce the impact of cash flows. You can see the calculations here. This makes time-weighting ideal for comparison of asset managers, since asset managers typically have no control over cash flows.
What time-weighting actually means is that each period’s return gets the same weight, regardless of how much money was invested. If, for example, a manager returned 10% the first year and -8% the second year, the two-year return would be 1.2% regardless of how much money was invested each year. This is useful when comparing two managers that had very different inflows and outflows. This is perfect to compare managers but, as we’ll see later, it has some real drawbacks in reporting on a client’s actual experience.
Unlike time-weighting, which eliminates or reduces the impact of cash flows, money-weighting takes the flows into consideration. And, unlike the term time-weighting, which doesn’t involve the weighting of time, money is actually weighted in money-weighted returns. If a client makes money during a period, the return will be positive; if a client loses money, the return will be negative.
The money-weighted approach finds the interest rate or rate of return that would have to have been paid for the investor to obtain the actual ending value, given the beginning value and the deposits and withdrawals that occurred during the period. As a result, the calculation is ideal for communicating with clients about their actual results and can help avoid some of the potential confusion of Time-weighting.
Suppose a client had $5,000 with the manager the first year and earned 10%. The second year, the client added, another $5,000, but lost 8%. At the end of the second year, the investor would have $9,660, less than the total investment. Overall, the client is down $340. However, the time-weighted return would still be 1.2%.
This can be quite confusing, as clients will wonder how there can be a positive return when they lost money. Explaining that it is just “the way time-weighting works” is not likely to win the trust of a client who has lost money.
Alternatively, the money-weighted return for the example above, where the investor lost money, would be -2.3%, which is a far more intuitive return when money is lost than the +1.2% calculated using time-weighted return. The 1.2% tells the investor how the manager did, eliminating the impact of the cash flow that was introduced in year two. The money-weighted calculation, however, tells the investor how his or her money actually performed.
So why is time-weighting still used for client reporting? One main reason that Time-weighting has remained popular is a misunderstanding of the GIPS standard.
The GIPS requires many things, but what many people remember about GIPS is one part of the standard: that the returns within the firm composite must usually be calculated using a time-weighted returns calculation. There are also some cases, such as private equity and direct real estate, where GIPS standards require money-weighted returns.
GIPS standards provide guidelines for reporting overall performance of a composite, which is intended to be given to prospective clients for comparison purposes. However, GIPS standards have no rule for reporting actual performance to existing clients.
Unfortunately, in the absence of any client reporting standards, some investment firms have made a leap to all time-weighted performance. This has unfortunate consequences for the client. Instead of informing clients about account performance or progress toward goals, clients are actually learning how their manager (or the person making investment decisions) is performing. Although it’s useful at times to know how a manager is doing, it is vastly more important for clients to understand their individual performance.
Next: Learn more about effective client reporting in the article “Two must-have client communication elements you might be missing”.