Money-Weighted Return: what is it?

3 December 2021
Money-Weigthed Return, Exirio

The money-weighted return is a value that a wealth tracker calculates to assess the performance of an investment. It is called money-weighted, because it takes into account the timing and size of all cash flows (money) relating to the investment.

It is the same as the internal rate of return (IRR), and it tells investors the average annual return from an investment either realized or expected. (Although, in Exirio, we favor the term MWR because it’s more descriptive of the meaning).But why is it called internal? And what does it mean to take into account timing and size of cash flows?

Time value of money

It is called internal because it is the rate which – when used to discount the present and future cash flows related to an investment – will make their present value (their sum) equal to zero. In other words, it is the rate internal to that investment.

But if what you just read makes little sense, it is because you may not be familiar with the fact that money has a different value based on time. This is to say that $100 today is worth more than $100 a year from now. Why? Because if I give you $100 today, you have it. If I promise to give it to you in a year you cannot be 100% sure that I will actually do it. There is essentially a risk that I will fail on my promise, and this risk grows larger the longer you have to wait. A lot of things can happen in one year, but a lot more in five or ten. Moreover, I could put $100 in a safe investment and keep the returns.

This means that while $100 today is worth $100, the same amount in one year will be worth a little less today, making it preferable to have it now than at a later day. Consequently, $100 today will need to be worth more a year from now for you to be indifferent between now and next year. 

And this difference is the MWR (or IRR). I will accept to part with my $100 today if I receive $100 + return a year from now. Which in mathematical terms is $100 times (1+MWR). And that is the most important metric a portfolio tracker must give you.

Money-weighted

It is called money-weighted return because it is based on when and how much you invest. It does not measure the return of an asset in absolute terms, but in relation to your own decisions. This is better understood with an example. If you read in the news that the S&P500 generated a return of 10% in the past year, is this a MWR? No, it is not. It only tells you that if you had invested 1 dollar at the beginning of the year, it would be worth 1.1 dollar now. The MWR would be specific to your investment, to your own decisions in relation to how much and when to invest or divest. If you only invested in the S&P500 half-way through the year, your MWR would in all likelihood be different from 10%.

Advantages & disadvantages

The most valuable aspect of MWR as a metric is that it is universal. It can be calculated for any investment, and it then allows investors a true comparison among their assets. 

It is also complete, as it takes into accounts all cash flows.

Conversely, exactly because it takes into account the timing and the magnitude of movements in and out of an investment, it is not useful to quantify the intrinsic performance of an asset. The 10% in our previous S&P example is the intrinsic performance of the index: while anyone who invested or divested the index during the year will have a different MWR, the one true return for the S&P is 10%. This 10% is actually the TWR of the investment, or time-weighted return.

Lastly, if you have not sold your investment your MWR is actually somewhat incomplete (it may also be called provisional IRR). Since you still own the asset, the last and possibly most important cash flow (the one coming from the sale of the asset) is assumed to be the asset current value, i.e. what you would get for it if you were to sell it, net of the costs associated with the sale. But while this approximation is more than acceptable for very liquid investments (if the price of share X is 100 right now, it is acceptable to assume that I will get 100 for it, if I sell it now), it is not that obvious for less liquid assets. If I own a property, I can have a good sense of its value today but I cannot be sure of what I will precisely get for it unless I go through a real sale process. And what if I cannot actually sell that asset at all? Other return metrics may then be used to complement MWR.

Conclusions

There is little doubt that if you have to pick one return metric you want a wealth tracker to give you to assess your investments, MWR is the one to choose. It is the one value that calculates what gets back in your pocket from an investment and can be easily compared against all other investments. And that is why it is the most prominent metric that Exirio provides for all your positions, holdings and overall wealth.

Related Posts