How should you measure returns?

measure_returns

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
IRR is used to calculate the returns of a portfolio of funds for a given time period. It takes into account, the investment value and all the cash flow during the said period. Cash flow includes deposits, gains, loses, withdrawals etc.


  • Time Weighed Return
TWR calculates the performance of a fund by measuring the percentage of capital that was invested. It disregards the effects of deposits and withdrawals of capital and their timing, which alters IRR. It adjusts the cash flow for the time value of the investment. It disregards the cash flow by calculating the return for every sub-period separately. Then it adds them all together to arrive at TWR.


  • Compounded Annual Growth Rate
CAGR varies from person to person as it calculates the lifetime return of the investment depending on the timing and period of investment. It doesn't regard the cash flow that happens during the investment period. Unlike other methods, CAGR does not provide a deep insight into the portfolio rather a shallow look which is why it is not recommended when you processing data thoroughly. 

When to use TWR and IRR

IRR is useful to:

  1. Measure returns from illiquid investments like private equity.   
  2. Measure absolute growth of a portfolio.


TWR is used to:      

  1. Compare a fund manager's performance
  2. Compare underlying assets
  3. Measure performance of market indices 


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.

 

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Mutual fund investments are subject to market risks. Please read the scheme information and other related documents carefully before investing. Past performance is not indicative of future returns. Please consider your specific investment requirements before choosing a fund, or designing a portfolio that suits your needs.