Financial Jargon Busting What is time-weighted rate of return?

What is the time-weighted rate of return?

Time-weighted rate of return measures the compound rate of growth in a portfolio while accounting for inflows and outflows of money. This measure is typically used by portfolio managers and investors to compare performance to other investments, portfolios and indexes.¹

The timing of cash flows, including contributions and withdrawals, can affect a portfolio’s rate of return. Time-weighted rate of return calculation removes the effect of these cash flows when evaluating portfolio performance, so it is unaffected by deposits in and withdrawals from the account.²

Another way to think about this performance measure is the change in value your investments would have experienced if all the funds you ever deposited into this account were invested at the same moment as your first deposit.

How do you calculate time-weighted rate of return?

Time-weighted rate of return is a measure of the compound rate of growth in a portfolio. Calculating time-weighted rate of return requires breaking up a portfolio across several time intervals and evaluating performance during each interval.³

With the time-weighted rate of return calculation, you can break down the return into subperiods (in the example below, we use quarters) determined by when money is added or withdrawn from the portfolio. You then get a return for each subperiod. By isolating the cash flow into these smaller intervals, the calculation will be more accurate than subtracting the beginning balance from the ending balance. These subperiod returns are then linked together to produce a total return for the overall period.⁴

Here is the formula for calculating quarterly rate of returns:

[End of quarter value – net additions / Beginning quarter value – 1] × 100 = Rate of Return (%)

To calculate the annual rate of return:

[(1 + Q1 Return) × (1 + Q2 Return) × (1 + Q3 Return) × (1 + Q4 Return) – 1.00] × 100 = Rate of Return (%)

Two things to note:

• First, use net withdrawals (a negative number) if total withdrawals are greater than total additions; subtracting a negative number is equivalent to adding a positive number.
• Second, the return figures should be calculated in decimal form – for example, 10% = 0.10.⁵

We can calculate the rate of returns for each quarter.

Q1 rate of return:

[$275,805 – (–$1,200) / $260,000 – 1.00] × 100 = 6.5%

Q2 rate of return:

[$340,273 – ($48,800) / $275,805 – 1.00] × 100 = 5.7%

Q3 rate of return:

[$347,577 – (–$1,200) / $340,273 – 1.00] × 100 = 2.5%

Q4 rate of return:

[$356,714 – ($3,800) / $347,577 – 1.00] × 100 = 1.5%

Now we can calculate the annual time-weighted rate of return using the formula below:

[(1.065 × 1.057 × 1.025 × 1.015) – 1.00] × 100 = 17.1%

In this example portfolio, the time-weighted rate of return is 17.1%.⁶

Advantages of time-weighted rate of return

The time-weighted rate of return excludes the timing influence of the cash flows, so it’s particularly useful when large additions or withdrawals are made. Cash coming in and out of your portfolio at different times can skew your returns because of the constantly fluctuating stock market.

This way of assessing portfolio performance also helps to compare the decision-making abilities of whoever is managing the portfolio’s assets. Time-weighted rate of return is used by J.P. Morgan in our performance dashboard, and it works as a measurement tool for managed portfolios as well as clients investing on their own.

For instance, assume you start out the year with $100,000 in a portfolio of stocks, and you add $5,000 to this portfolio during the year. If you add the money at the beginning of the year, your end-of-year amount would be different than if you added it later in the year, and it would depend on returns over different time periods. The difference in the year-end amounts can’t be attributed to your stock-picking ability, but rather to the timing of the infusion of funds.⁷

Disadvantages of time-weighted rate of return

If you’re trying to calculate the returns of a portfolio that has many inflows and outflows, the time-weighted rate of return can be a cumbersome way to do that and may be cumbersome to calculate, requiring daily calculations.

If you’re simply looking for the return on a particular investment, the rate of return, which calculates the return on a particular investment using the initial investment and the total profit or loss from the investment, may be a more useful calculation.⁸ However, the rate of return calculation does not account for the cash flow differences in the portfolio, whereas the time-weighted rate of return does account for deposits and withdrawals.

The bottom line

Time-weighted rate of return is one way to measure the performance of an investment portfolio. Since it removes the effects of cash flows coming in and out of a portfolio – which can distort returns – it’s considered a more accurate way to assess and compare the performance of investment portfolios. It’s especially useful for investors tracking the long-term performance of their portfolios, taking into account market fluctuations and their own risk tolerance.