How can you determine if your portfolio manager is doing a good enough job with your money? It’s time to learn about time weighted versus money weighted ways of calculating returns. Not an easy concept, but one we’re going to delve into today to make sure you understand how your money is working for you.
Historically, mutual fund managers and portfolio managers generally refer to their performance in a time weighted return number. Time weighted effectively measures performance over time. A month by month, week by week, day by day, measure of how the performance has been, irrespective of if there are inflows or outflows into their funds their performance.
It’s used to compare one portfolio manager to another. The idea is that you don’t want to penalize a portfolio manager if a ton of money came in midway through the year, or if a ton of money moved out of their fund halfway through the year.
It’s effectively the sum of the performance of all the days for the year. How much did you return in January, how much did you return in February, in March, etc., all the way to December. That’s effectively your number.
Money Weighted Returns
The time weighted approach is one that was used historically. Now, most institutions have started reporting both time and money weighted returns. Money weighted is the concept that I was referring to that we’re trying to avoid.
With a time weighted approach, if money enters the portfolio at a later date, or if money comes out of the portfolio at a later date, that is factored in.
Your money weighted average for an individual will generally be much different than time weighted if there is significant money in or out of your portfolio. If there’s no money movement of any kind, the two are going to be largely similar.
More importantly, as the money is being added to an account, if the performance is strong in the later months, you’ve not performed the same as in a time weighted.
Making the Choice
As a simple example: You have a dollar in your investment account, and you’re up 50% in the first half of the year. You pull the dollar out of your investment account and now you’re flat. The rest of the year you’re going to have a very strong money weighted return because your full dollar performed during the first half of the year while you had an invested, and you had no investment that lost money or was flat for the second half of the year.
Now, the time weighted average wouldn’t care that you had no money invested in the second half of the year. It would recognize every single month, every single day throughout the year as a portion that is equally important, and therefore your returns would be much lower in that case.
People often ask me, which one’s more important for me? What matters more for me? Well, I’ll say this. If you’re measuring your portfolio manager or if you’re trying to measure your funds straight up to compare them, I would be using a time weighted average.
Most of the time it’s going to come to something accurate and the manager’s not penalized if funds are moving out. If you want to know personally how your money did during that year and there was a significant movement of funds, I would consult the money weighted average during that time.
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