Investors often gauge the success of their investments by looking at returns. However, not all returns are calculated the same way, and understanding the differences can be crucial for making informed financial decisions. Hence, it is important to understand which returns are to be used for gauging your investment performance.

If the time period for which the investment is being analysed is less than or equal to one year, we can use absolute returns to gauge investment performance or to compare performances of different portfolios. However, if the time period is greater than one year, the best practise is to annualise the returns for better comprehension and comparison of investment performance.

There are two methods to do this annualisation of returns - Time-weighted returns (CAGR) and Money-weighted returns (IRR), each serving a distinct purpose depending on the context. Let us understand these two concepts in more detail and the context in which they are to be used.

1. Time-Weighted Returns (CAGR)

Time-weighted returns, also known as Compounded Annual Growth Rate (CAGR), measure the compound rate of growth in a portfolio over a specific period, unaffected by external cash flows such as deposits or withdrawals. This method is particularly useful for assessing the performance of a portfolio manager or comparing the performance of different investment strategies over time.

When to use CAGR?

CAGR is used to assess investment performance when you are not in control of the timing and magnitude of the cash flow into the portfolio but you are in control of the stock/asset selection.

Ideal For:

Fund Managers – as they are not in control of timing and magnitude of cash flow into the mutual fund they manage but they are the ones who do stock selection for the fund. This metric provides a standardized, unbiased measure of investment success, unaffected by investor behavior.

Formula:

CAGR is a metric that provides a smoothed annual growth rate of an investment over a specified period. It’s the rate at which an investment would grow if it grew at the same rate every year, compounding annually:

CAGR = [(Ending Value/Beginning Value) ^ (1/No. of Periods)] – 1.

Example:

A mutual fund has total Asset Under Management (AUM) of INR 1 Lakh on 1 Jan 2020 and 100 issued mutual fund units. On 1 Jan 2024, the AUM increases to INR 10 Lakh and the number of issued mutual fund units increases to 500. Now, in order to gauge the fund manager’s performance, we first need to calculate the Net Asset Value per unit (NAV).

NAV on 1 Jan 2020 = AUM / No. of units = 1,00,000 / 100 = INR 1,000
NAV on 1 Jan 2024 = AUM / No. of units = 10,00,000 / 500 = INR 2,000

Calculating the NAV gets rid of the effects of magnitude and timing of cash flows into the mutual fund which are beyond the fund manager’s control.

Now, to arrive at CAGR over 4 years:
CAGR = [(2,000 / 1,000) ^ (1/4)] – 1 = 18.92%

Hence, the fund manager delivered a CAGR of 18.92% over the 4 years.

Pros and Cons:

• Pros: Provides a clear benchmark for evaluating fund managers’ performance over time.
• Cons: Does not take into consideration the timing and magnitude of cash flows into the portfolio.

2. Money-Weighted Returns (IRR)

Money-weighted returns, also known as internal rate of return (IRR), cater to individual investors seeking to evaluate their personal investment performance. This metric factors in the timing and magnitude of cash flows—such as contributions and withdrawals—offering a personalized view of actual returns experienced by the investor.

Ideal For:

Individual investors analyzing personal investment decisions and portfolio performance. This metric offers insights into how personal cash flows and timing decisions influence overall investment returns, enabling informed decision-making aligned with financial goals.

Formula:

Money-Weighted Return, or Internal Rate of Return (IRR), considers the timing and size of cash flows into and out of the portfolio, reflecting the actual return experienced by the investor.
Internal Rate of Return is the percentage value at which Net Present Value (NPV) of cash flows becomes 0.
Because of the nature of the formula, IRR cannot be easily calculated manually and instead must be calculated iteratively through trial and error or by using software programmed to calculate IRR (e.g., using Excel).

Example:

An investor invests INR 5,000 in stocks on 1 Jan 2022, adds INR 2,000 six months later, and withdraws INR 1,000 after one year. If the portfolio grows to INR 10,000 by 31 Dec 2033, calculating the money-weighted return provides insights into how these cash flows affected overall returns. We then calculate the XIRR [modified version of IRR when cash flows are not distributed over equal periods of time] using Excel as follows:

We now use the XIRR formula in MS Excel to calculate the Internal Rate of Return for this investment. XIRR stands for eXtended Internal Rate of Return and is used to calculate the internal rate of return when the time periods between cashflows is not constant.

In MS Excel type "= XIRR (<Select Cashflow Column> , <Select Date Column>)"
We get XIRR = 28.30%.

Hence, the investor earned an Internal Rate of Return (IRR) of 28.30% over the time period 1 Jan 2022 to 31 Dec 2023.

Pros and Cons:

• Pros: Reflects the impact of timing and magnitude of cash flows on portfolio performance.
• Cons: Can be sensitive to irregular cash flows, potentially skewing interpretation of investment success.

Conclusion

Understanding the differences between time-weighted and money-weighted returns helps investors evaluate their portfolio performance and make better decisions. Whether you’re judging fund managers or analyzing your own investments, picking the right metric ensures accurate measurement of success.