You have likely already received your investment statements for the period of December 2016. Included with those statements are new reports. The financial regulators have mandated that most financial firms send two new reports, one providing an overview of some of the costs clients have paid, the other providing a rate of return for their account. Additional regulations state that the rate of return on the second report must be calculated using a money weighted formula. Up until now most firms have calculated rates of return using a time weighted formula. In fact time weighted rates of return have become the industry standard. Many financial firms are adjusting to these new rules by including both money weighted and time weighted rates of return on the reports.
Seeing multiple rates of return for the same account can be confusing. Many folks have already asked me, “So which rate of return is the right one?” I like to think about money weighted returns and time weighted returns as tools in a tool box. Depending on the job we might need a hammer or a screwdriver. It is not that one is better than the other, we have different tools for different jobs. Money weighted rates of return are specific to your account and are best used to measure your progress towards your specific goals. For example, if you have a retirement plan and the plan has a 5% target rate of return, you can use a money weighted return to measure your progress towards that goal. Money weighted returns are specific to your account so they should not be used for comparison. Time weighted rates of return, on the other hand, are best used for comparison or evaluation. If you want to compare your portfolio’s performance against a benchmark or compare with your neighbour a time weighted rate of return is the proper tool for the job. Also, for example, if you are considering buying a mutual fund and want to evaluate the fund manager’s past performance, time weighted rates of return would be appropriate.
Without getting into the complex mathematics the basic difference between time weighted rates of return and money weighted rates of return is how they treat deposits and withdrawals. If you are trying to calculate your rate of return for 2016 and are using a time weighted formula, it will ignore any deposits and withdrawals. The formula will minimize their impact. Money weighted rates of return, however, include all deposits and withdrawals. So if you added a significant lump to your account in September 2016, a time weighted formula would essentially ignore it. In calculating the 2016 return the time weighted formula would treat the month of September the same as every other month. However the money weighted formula will include the deposit in its calculation. In calculating the 2016 rate of return the money weighted formula will give more significance to the month of September. So that large deposit will have no influence on a time weighted return but it will impact the money weighted rate of return. If there are few deposits or withdrawals the time and money weighted returns will be similar. However if there are large cash flows the returns can be very different.
Multiple rates of return can create confusion. Your financial professional should be able to help you determine which tool best suits your needs.
This information transmitted is intended to provide general guidance on matters of interest for the personal use of the reader who accepts full responsibility for its use, and is not to be considered a definitive analysis of the law and factual situation of any particular individual or entity. As such, it should not be used as a substitute for consultation with a professional accounting, tax, legal or other professional advisor. This commentary reflects my opinions alone, and may not reflect the views of National Bank Financial Group.