This paper discusses the merits and shortfalls of the two most popular metrics; the Internal Rate of Return (IRR) and the Time-Weighted Rate of Return (TWR), and the Money-Weighted Rate of Return (MWR).

IRR, TWR, and MWR Defined

IRR measures the return between two dates, factoring in the timing of each and every capital inflow and outflow in an investment. It is defined as the discount rate at which the net present value (NPV) of capital inflows and outflows would be 0. Since IRR is affected by the size and timing of cash flows, it gives a heavier weighting to larger capital flows and may overlook performance on smaller amounts.

TWR calculates the return on a $1 investment over successive time periods without considering the quantum of capital flows, as it eliminates the effects of additions and withdrawals to the portfolio.

MWR, which is mathematically equivalent to IRR when applied to a portfolio, measures the investor’s actual return by factoring in the timing and size of all cash flows. It is influenced by the investor’s decisions to add or withdraw capital and shows the real experience of the investor, not just the portfolio’s performance in isolation.

For example, assume that you invested $10,000 in a portfolio which grew 5% to $10,500 a year later. Then you added $100,000 to your portfolio which fell 5% from $110,500 to $104,975 at the end of the second year. In short, you have invested $110,000 in a portfolio that was worth $104,975 after two years. Now let us calculate the returns using IRR, TWR, and MWR.

In the above example, Annualized TWR is only slightly negative at ‑0.125%, offsetting the 5% gain in Year 1 against the 5% loss in Year 2 (-1).

The IRR, however, is -4.19%, giving far more weight to the negative returns on the larger investment in year 2 than the positive returns on the smaller investment in year 1.

Since MWR reflects the investor's experience by considering both the amount and timing of capital flows, its value in this case would match the IRR, i.e., -4.19%. This is because MWR, like IRR, is sensitive to the impact of when and how much was invested.

Now assume that you invested $100,000 in the same portfolio and added $10,000 a year later. Your portfolio would be worth $109,250 after two years following the positive returns in the first year.

Although the portfolio in the second example is worth more than in the first, Annualized TWR remains unchanged as it measures the portfolio returns rather than the amounts invested during each period. Meanwhile, IRR improved to -0.36% since most of the investment benefited from the positive returns during the first period.

Again, MWR would also reflect -0.36% in this scenario, because it tracks the actual return based on the investor’s contribution schedule. In cases where the timing of capital flows significantly affects returns, MWR provides a more personalized performance picture than TWR.

In the above examples, the IRR (and thus MWR) differentiated between the different ending values of the portfolio more accurately than did TWR. However, it is possible to have more than one IRR value if the invested capital is staggered in stages and income is received in the interim. When measuring the performance of a portfolio into which capital is added and withdrawn from time to time, the IRR will produce multiple results that render it meaningless. The IRR and MWR are thus best suited to measure the return of a single investment or the investor’s own cash flow-weighted performance.

TWR, meanwhile, is better suited to measure the performance of a portfolio of investments using relatively simple calculations based on portfolio changes between two consecutive dates. It therefore reflects the choices made by the investment manager undistorted by capricious portfolio additions and withdrawals by investors over time.

How The Family Office Measures Performance

The Family Office uses all three metrics. TWR is used to compute the performance of each bespoke client portfolio, IRR is used to gauge the performance of individual investments, and MWR helps assess the actual return experienced by the investor, especially when capital flows vary over time. All metrics are made available to clients and updated regularly along with a host of qualitative information.

The Family Office offers bespoke solutions tailored specifically for the unique circumstances, lifestyle and goals of each client.