When it comes to measuring returns, there are three different methods to do it – Internal Rate of Return, Time Weighed Return and Compounded Annual Growth Rate. CAGR is usually preferred by online platforms because of its simplicity though internal rate of return is deemed to be more accurate in providing information. The Global Investment Performance Standards and the Charted Financial Analyst Institute prefer TWR as a standard metric.
- Internal Rate of Return
- Time Weighed Return
- Compounded Annual Growth Rate
When to use TWR and IRR
IRR is useful to:
TWR is used to:
Internal rate of return helps us to understand how much the portfolio has grown. It is an intuitive metric and helps us understand visually the rate of portfolio growth. The IRR of a portfolio helps the investor conclude if the portfolio can meet the financial goals or not. IRR is affected by the timing and amount of cash flow since it includes cash flow in its calculations.
TWR calculates the true performance of the portfolio by removing the distracting factors of cash flow from the portfolio. This helps us evaluate the fund manager's performance. It is also the reason why it is used to compute the performance of liquid investments because cash flows are recurrent there.
When measuring returns, it is important to note that the proper technique is being implanted to determine the appropriate metric.