Time weighted rate of return and IRR (internal rate of return) are identical where there have not been any contributions or distributions from a portfolio during the measurement period. Differences between time weighted rate of return and IRR (also known as “money weighted rate of return” and “dollar weighted rate of return”) arise when there have been contributions or distributions during a period.
Each of these calculations serves a different purpose. The best way to describe the different uses for the two calculations is to say IRR is your rate of return while the time weighted rate of return is the money manager’s rate of return. The time weighted rate of return assumes that you had a constant investment every day during the measurement period. The internal rate of return looks at the return based on how much you have invested each day during the period.
How should you evaluate a money manager? Even though the IRR accurately calculates your rate of return, it may not be a good measure of the performance of your money manager. Since the money manager has no control over when you invest or how much you contribute or withdraw, you should not evaluate the money manager using the dollar weighted rate of return.
Let me pose an exaggerated theoretical example of why you should evaluate managers using the time weighted rate of return rather than the IRR. Let’s say you have two managers, A and B. In the first year each manager earned 100% , and then loses 50% in the year. At the end of the two years, they both broke even. Now let us say you invest $100 with manager A and $1,000 with manager B. At the end of the first year, manager A had doubled your investment to $200 and manager B had also doubled your investment (to $2000). Now you decide to transfer $1,800 from manager B to manager A. Manager A now has $2,000 which falls to $1,000 and manager B has $200 which falls to $100. You started and ended with the same amount of money and each manager had the exact same performance. This is the time weighted rate of return calculation. The IRR shows a completely different and incorrect evaluation of the two managers. Manager A made $100 in the first year and lost $1000 in the second year for a net loss of $900. Manager B made $1,000 in the first year and lost only $100 in the second year for a net profit of $900. Your annual internal rate of return was with manager A was negative (more than 40%). Your annual IRR for manager B was more than 85% . In evaluating the performance of the two managers, you must ignore which one did better due to timing of investments that was not in their control.
When you want to compare the performance of your money managers to an index or other managers, you should use the time weighted rate of return, rather than the IRR. If, however, you wish to see your performance, you should look at the IRR.