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Improving Our Investment Performance Reporting

Man Calculating ChartsWe recently changed the way we calculate the rate of return on your investments. Previously, our default performance reporting calculation method was the Internal Rate of Return (IRR). We will now use the Time Weighted Return (TWR) going forward on all reports in the Orion Portal.

The main reasons for the switch are:

  • Now that we have the ability to compare specific client portfolios to a blended benchmark using Orion, it made sense to use the TWR method as it provides a more “apples to apples” comparison.
  • Since we largely have no control over when money goes in and out of a portfolio (as this is a client decision), it made sense to use the method that eliminates the effects of the size and timing of capital flows. As referenced in more detail below, the TWR method eliminates the effects of the size and timing of capital flows, while the IRR includes them.
  • The Global Investment Performance Standards (GIPS) is a worldwide industry standard that recommends the use of TWR when the advisor does not control the cash flow decisions.

For those of you who are still reading here is some additional background information.

The IRR measures the return on the portfolio from manager performance as well as the impact of incoming (contributions) and outgoing (distributions) cash flows. It is the rate of return that makes the present value of the portfolio’s initial value and all contributions precisely equal to the present value of the portfolio’s ending value and all withdrawals. In simpler terms, it is the rate that makes the value of everything added to the portfolio equal to everything taken out of the portfolio. IRR is affected by the size and timing of cash flows. Larger cash flows as a percentage of the total portfolio affect the performance calculation more than smaller flows. In a similar manner, cash flows that occur before a significant market up or down movement affect the return more than during times when the market is stable.

It makes sense to use IRR when comparing the portfolio’s return to an overall goal and to see the overall growth of the portfolio including the effects of the timing and size of contributions and distributions.

The TWR measures how the portfolio grows solely as a result of mutual fund manager performance. It removes the effect of the client’s decisions of when and how much money to deposit or withdraw in the account. It reflects the effects of the market and the manager’s choices of which investments to select for the portfolio.

It makes the most sense to use TWR when comparing the growth of the portfolio to a benchmark or the overall market, comparing the performance of one portfolio manager to another, and when the portfolio cash flows are not intentionally timed based on predicted market movements.

Most of the time, the TWR and the IRR will be very similar as the majority of the return will be due to mutual fund performance. However, the two calculations may diverge under two circumstances: when the cash flow is a relatively large percentage of the overall portfolio or when the market is very volatile. When money is contributed to an account prior to a market upturn, the IRR will be greater than the TWR. When money is contributed prior to a market downturn, the IRR will be less than the TWR. Likewise, when money is withdrawn prior to a market upturn, the IRR will be less than the TWR and when money is withdrawn prior to a market downturn, the IRR will be greater than the TWR.

Both calculations are important and convey different information, and we rely on both calculations at KFG.  If you would like to compare the TWR to the IRR return, there are reports in the portal that allow you to calculate the IRR.

 

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