Money-Weighted Rate of Return: Calculation, Usage, and Examples
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Summary:
The money-weighted rate of return (MWRR) is a metric used to assess investment performance, considering the size and timing of deposits or withdrawals. It’s calculated by determining the rate of return that equalizes the present values of all cash flows to the initial investment. Equivalent to the internal rate of return (IRR), MWRR factors in initial investment values and future cash flows, such as dividends, withdrawals, deposits, and sale proceeds.
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Understanding the money-weighted rate of return
The money-weighted rate of return (MWRR) holds significance in assessing investment performance by considering the timing and scale of deposits or withdrawals. Unlike some other metrics, the MWRR precisely factors in the influence of alterations in cash flows on investment returns.
This measurement aligns the initial investment value with future cash flows, incorporating dividends, withdrawals, deposits, and sales. Essentially, it identifies the required rate of return to initiate with the initial investment amount, encompassing all cash flow modifications during the investment period, including proceeds from sales.
Calculating the money-weighted rate of return
The formula for computing MWRR is intricate and involves present values of both cash inflows and outflows. It necessitates iterative calculations or specialized financial software. However, employing a spreadsheet and utilizing the IRR function can streamline the estimation process.
For instance, consider buying a stock for $50, receiving annual $2 dividends, and selling it for $65 after three years. The IRR function within a spreadsheet can calculate the MWRR based on these cash flows.
Cash flows and the money-weighted rate of return
Accurate identification of cash flows in and out of an investment portfolio is critical for precisely calculating MWRR. Outflows may encompass initial investment costs, reinvested dividends, or withdrawals, while inflows might include proceeds from sold investments, received dividends, or contributions.
The difference between money-weighted rate of return and time-weighted rate of return
Comparing MWRR to the time-weighted rate of return (TWRR), both serve as performance metrics but operate differently. TWRR eliminates distortions caused by money inflows and outflows, providing a clearer measure of portfolio growth. Meanwhile, MWRR accounts for the impact of cash flows on performance but doesn’t segment the intervals where cash flows occurred, as TWRR does.
Limitations of using money-weighted rate of return
MWRR has limitations as it significantly considers fund performance when the fund is at its largest due to cash inflows. This method could penalize fund managers due to factors beyond their control, such as large capital injections influencing performance assessments.
Frequently asked questions
What is the difference between MWRR and TWRR?
The MWRR accounts for cash flow impacts on performance, whereas the TWRR eliminates the effects of cash inflows and outflows.
Should I use money weighted or time weighted?
Choosing between MWRR and TWRR depends on your analysis objectives. MWRR accounts for changes made by investors, while TWRR portrays performance without considering those changes, facilitating comparisons.
Which rate of return calculation should I use?
Choosing between MWRR and TWRR depends on the analysis goal. MWRR considers investor changes, while TWRR aids in comparing portfolio growth.
Key takeaways
- The MWRR accounts for the size and timing of deposits or withdrawals.
- MWRR is comparable to the IRR and calculates future cash flows against the initial investment.
- Identifying cash flows accurately is vital for precise MWRR calculation.
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