The Money-Weighted Rate of Return (MWRR) is a powerful metric that captures the true performance of an investment by considering the size and timing of all cash flows. This inclusive measure aligns the present values (PV) of all cash flows to the initial investment, reflecting the authentic rate of return.
Similar to the Internal Rate of Return (IRR), the MWRR can be weighed against the Time-Weighted Rate of Return (TWRR), which nullifies the influence of cash in- and outflows.
Key Takeaways
- The MWRR evaluates investment performance by accounting for the size and timing of deposits or withdrawals.
- It sets the initial investment’s value equal to the future cash flows including dividends added, withdrawals, deposits, and sale proceeds.
- The MWRR equals the IRR and demands equivalent annual interest rates for the present values of all cash flows and the initial investment to align.
Understanding the Money-Weighted Rate of Return
With various methods available for measuring asset returns, it’s crucial to use the appropriate one. By factoring the size and timing of cash flows, the MWRR effectively measures portfolio returns. It sets the initial value of an investment equal to the future cash flows, adjusting for all changes during the investment period, including sale proceeds.
Calculating the MWRR
The MWRR is calculated using the IRR methodology:
PVO = PVI = CF0 + CF1 / (1 + IRR) + CF2 / (1 + IRR)^2 + ... + CFn / (1 + IRR)^n
Where:
- PVO: PV of Outflows
- PVI: PV of Inflows
- CF0: Initial cash outlay or investment
- CF1, CF2, CF3,… CFn: Cash flows for individual periods
- n: Each period indexed
- IRR: Internal Rate of Return, also representing the MWRR
Using a Spreadsheet
Given the complexity requiring iterative guesses, spreadsheets simplify MWRR calculations. Suppose you purchase a share for $50, earn annual $2 dividends, and sell it for $65 after three years. Here is how the computation appears in a spreadsheet:
| A | B | C | |
|---|---|---|---|
| 1 | Outlay and Cash Flow | MWRR | |
| 2 | Year 1 | ($50) | |
| 3 | Year 2 | $2 | |
| 4 | Year 3 | $2 | |
| 5 | Year 3 sale price | $65 | = IRR(B2:B5) = 11.73% |
The IRR function easily calculates the MWRR from given cash flows, enhancing efficiency and accuracy.
Cash Flows and MWRR
The MWRR context deems it identical to IRR: identifying the discount rate to where NPV equals zero. This requires tracking cash flows within a portfolio, including proceeds from sold assets. Cash flows include:
Outflows
- The cost of purchased investments.
- Reinvested dividends or interest.
- Withdrawals.
Inflows
- Proceeds from investments sold.
- Dividends or interest received.
- Contributions.
##Comparing MWRR with Time-Weighted Rate of Return
Though the MWRR and TWRR often juxtapose, each brings unique attributes:
-
TWRR: Calculates portfolio’s compound growth rate. Useful for comparing managers’ performances by eliminating cash flows’ distortion.
-
MWRR: Considers fund inflows/outflows, factored by size and timing. Undistorted by internal cash flows, it faithfully tracks investor behavior not segmenting cash flow occurrences.
If absent additional cash flows, both methods deliver similar outcomes.
Limitations of MWRR
As an investment spans quarters, MWRR applies heavier weights to periods wherein maximum funds reside. This weighting, albeit informative, hazards penalizing managers for cash flows they can’t control. Reductions prior to performance spikes confer negative perceptions, conversely enhancements ascertain perceived positives.
##Advantages of MWRR
MWRR charts your investments’ journey reflecting whether yield is a steady rate of interest. Deviations in rates flag incongruences indicating altering ROI pathways.
Applying MWRR and TWRR: Choose Wisely
To evaluate changes effecting investments, rely on MWRR cherishing temporal cash impact resonance or, for static return magnitudes resistant to contributions/disbursements, reap TWRR’s specificity.
The Bottom Line Knowing the Money-Weighted Rate of Return bequeaths genuine insight into investment performance, equipping comprehension over how investing decisions reshape returns trajectory analyzing each epoch’s participative cash flows.
Related Terms: Time-Weighted Rate of Return, Internal Rate of Return, Net Present Value, Cash Flow, Dividends, Discount Rate, Portfolio Management.
