Last updated: 15 Sep, 2020 | 07:29 am
What is the right measure of investment performance and what is it telling us? We break down the jargon and answer this question.
The simplest and most intuitive measure is an absolute return.
Absolute Return (%) = (EndingValue - BeginningValue) / BeginningValue
It does not capture time. It is difficult to say if this return is good or bad without knowing over what duration of time it has been earned. For investments that pay periodic cash flows (dividends, interest, coupon payments), it does not capture your total return. It represents only the price return.
XIRR vs TWRR
Extended internal rate of return (XIRR) and Time-weighted rate of return (TWRR) are two measures that seek to address these drawbacks. Let’s understand what they tell us using an example and three scenarios:
This is the base case, the investor simply holds his investment through the assessment period. In the absence of any buy/ sell transactions, both XIRR and TWRR will give a similar measure of performance.
In this case, we have an additional cash flow to consider and it happens at a time when the price was down (1 April). Hence, this cash flow would earn a higher return for the investor. This is captured in the higher XIRR under this scenario.
Similarly, XIRR would be higher if a Sell was made with good timing, say around the 1st Nov peak.
However, what would happen if a Buy happens on 1st November, that is our next scenario.
In this case, the additional cash flow happens when the price peaked on 1st November. Hence, this cash flow would earn a lower return for the investor. This is captured in the lower XIRR under this scenario.
Understand how TWRR remains unaffected under the three scenarios. It is agnostic of the timing and size of any interim buy/ sell decisions. It simply reports the performance of the basket of assets in your portfolio. It tells us that INR 100 at the beginning, would have become INR 119 at the end of the period.
Similarly, benchmark TWRR reports the performance of the basket of benchmark indices (blended benchmark) appropriate for your portfolio. Assuming a benchmark TWRR of 15%, it implies your portfolio performance was better than the benchmark by 4% (19-15%).
The answer is they both measure different but equally important things.
Both skills are essential for good long term wealth creation.
XIRR is also a better measure of performance on a cash basis. Meaning: in scenario 3 above, assume that the Buy on 1st November was INR 5 lacs, instead of INR 1 Lac. In that case, the investor would be at a net cash loss and XIRR would be negative to reflect this correctly. However, TWRR would still be unchanged. This can be unintuitive, as TWRR would be a positive number even though the investor made a cash loss.
We now know:
XIRR: Measures the performance of your cash flows. Timing is important.
TWRR: Measures the performance of your portfolio. Timing does not matter.
XIRR > TWRR implies you have been successful at timing the market with your cash flows.
XIRR < TWRR implies you would be better off dollar-cost averaging your contributions.
Over the long term, for a SIP investor, the XIRR and TWRR should be very similar since the SIP approach evens out the impact of cash flow timings with market up-down movements over time.
The investment performance engine of the INDmoney platform reports both XIRR (annualized) and TWRR (un-annualized) at all grouping levels of an investor’s portfolio facilitating a complete analysis of the portfolio performance vs. the benchmark under different time periods.
The platform risk monitoring engine aims to identify and alert investors on bad exposures, hence improving overall asset allocation, boosting long term TWRR. The dynamic asset allocation engine keeps a hawk-eye on market fundamentals to improve timing on your market entry and exit points, improving XIRR.
In the next post, we dig deeper into the concept of return contributions. Allowing an investor to put a finger on what contributed and what has detracted from investment performance over any time period.