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Time Weighted Return versus Money Weighted Return Performance Metrics
The following provides a summary of the pros and cons of using Money and Time Weighted metrics.
Advantages of using Money Weighted Rates of Return
- Investors can easily determine if they are making a consistent month on month return and place an equivalent interest rate value on the return. If you are not generating a consistent return, your internal rate of return will fall. It cannot be emphasised enough the importance of making a consistent return over time, because as time slips by, the value of money depreciates due to the effects of inflation.
- Ideal for comparing investment performance over time regardless of the size of the investment or when you deposit or withdraw money; for example the Internal Rate of Return is ideally suited to comparing the performance of stocks within a portfolio, or comparing your portfolio with a given market index such as the FTSE or S&P 500.
(To view an example of how you can use timetotrade to measure the Internal Rate of Return or compare your portfolio value to market indices, click on the following link: timetotrade portfolio performance reporting)
Disadvantages of using Money Weighted Rates of Return
- They are not suited to determining the change in the portfolio value between two consecutive dates within a given date range. Using the above example the rate of return changed by 50% from the 1st of May 2007 through to the 1st of June 2007, however using the Unit Valuation System the unit value change was 100%, which accurately reflected that change between the 1st of May and the 1st of June 2007
- They are perceived as difficult to understand and calculate. Hopefully we have made that a little easier by providing this functionality in the timetotrade performance reporting products.
Advantages of using Time Weighted Rates of Return
- It enables investors to determine rates of return independent of when capital is added or withdrawn from the available investment fund. More commonly this relates to fund managers and not private investors, as fund managers have limited control over when they receive funds from investors, or when the investor choose to withdraw their funds.
- Ideally suited to environments where you have shared ownership, as they enable ownership to be allocated based on the value of the assets and the amount invested or withdrawn at any point in time. It is this feature that makes the Unit Valuation System the metric of choice for apportioning ownership between investment club members. It should be noted that the Unit Valuation System is primarily used by unit trusts.
- Relatively simple to understand and calculate; for example when using the Unit Valuation System the unit value is the sum of the assets divided by the number of units in circulation. If you want to invest more money, you simply buy more units at the current unit value.
Disadvantages of using Time Weighted Rates of Return
- They do not factor in how long money has been invested and therefore when it was invested. As an investor, the Money Weighted Return metrics, such as the Internal Rate of Return enable you to track your performance over time. For example the Unit Value might reflect that you have made a return of 100% but if your unit value does not consistently increase, you can find yourself in a position where your Internal Rate of Return is falling month after month, which results in your investment capital devaluing with time.
- Time Weighted metrics are not suited to comparing investment performance for different investment portfolio. For a detailed description of why Time Weighted metrics should not be used to compare performance, please click on the following link: Why Unit Valuation should not be used to Compare Investment Performance
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