Time weighted return (TWR) as the name suggests, calculates the return over a given period irrespective of the timing of your contributions or withdrawals from the portfolio. Returns for longer periods are the result of compounded returns from shorter timeframes.
Time-weighted return is also called the geometric return.
Dollar weighted return (DWR) on the other hand, calculates an internal rate of return by taking into account both the size and timing of cash inflows/outflows. In other words, large investments at the right time when returns are highest can lead to higher dollar weighted returns compared to time weighted returns.
Example:
Consider an asset that currently sells for $50. You purchase the stock today, record performance of 10% in the first year (Y1), -5% in the second year (Y2) and 15% in the third year (Y3). You invest a further $50 in Y2 then sell the asset at the end of Y3.
Time Weighted Return
The time-weighted return is calculated by finding the rates of return on asset at the end of Y1, Y2 and Y3, and then finding the geometric mean for those rates.
TWR=[(1+10%)*(1-5%)*(1+15%)]-1
=20.18% or 6.32% per annum
As you can see, the timing of investment inflows and outflows do not have an impact from a time-weighted perspective.
Dollar weighted return
In the same example above, the total cash outlays and inflows would be:
Outlay
Y0: Initial investment of $50 for purchase of the asset
Y2: Additional $50 investment
Inlay
Y1: $5 return
Y2: $5 loss
Y3: sale of asset for $115 (includes return of $15)
The dollar weighted rate of return can be calculated using the discounted cash flow (DCF) approach:
NPV=0
DWR = 7.03% per annum
Unlike time weighted returns, the dollar weighted return is impacted by the size of the cash inflows and outflows.
Many Fund managers will display the time weighted return because they have no control over the cashflows that come in and out of the funds from investors. Also, they want to ensure consistency with benchmark returns which are calculated using a time weighted approach.
However, the dollar weighted return is regarded as a more accurate reflection of the true performance of your portfolio because it takes into account how your inflows and outflows have contributed to your portfolio returns.
Note also that the time weighted and dollar weighted return are identical when there have not been any contributions or distributions from a portfolio during the measured period.
If you have any further queries on the differences between time and dollar weighted returns please contact our office on 1300 676 333 or support@lincolnindicators.com.au