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Money Weighted Return (MWR) metrics are used to establish investment performance for a portfolio and are ideally suited to comparing investment performance.
Money Weighted Returns metrics such as Internal Rate of Return enable investors to determine financial performance based on series of cash flows such as money deposited, varying investment returns and money withdrawn over a defined period of time. ie, Money Weighted Return metrics enable you to determine your rate or return relative to the length of time you have invested your capital. Money Weighted Return metrics are primarily focused on the timing of when your money was invested or withdrawn.
When developing an understanding of how Internal Rate of Return values are calculated, the easiest thing to do is to consider what would be the equivalent rate of interest that your bank would have to pay you every year, for your bank account to be worth the same as your investment portfolio. In doing so assume that you deposit and withdraw equal amounts of capital on the same dates in your bank account as your broker account. The Internal Rate of Return, gives you a 'best fit' equivalent interest rate, based on the timing of when capital was deposited or withdrawn and the amount of time your capital has been invested.
Let us review the investment performance using the Internal Rate of Return as a Money Weighted Rate of Return metric - for comparison we will use the same example as used in the previous Time Weighted Returns article:
- on the 1st of April 2007, you invest £10,000 in a portfolio of shares. Using the Internal Rate of Return, as no time has elapsed, the Monthly Internal Rate of Return is 0% i.e. if you had put the equivalent capital in a bank account, you would not yet generated any interest.
- on the 1st of May 2007 your portfolio is still worth £10,000 i.e. it has not increased or decreased in value. As the portfolio value has not changed, the Internal Rate of Return when compared to the 1st of April is 0%, i.e. the equivalent interest rate that your bank account would have to pay you to achieve the current value of your investments is 0%. You now decide to increase your investment in your portfolio by depositing another £5,000 into your trading account, and in doing so you increase your portfolio value to £15,000.
- on the 1st of June 2007 your portfolio has doubled in value and is now worth £30,000. Using a Monthly Internal Rate of Return, i.e. the equivalent rate of interest that your bank would have to pay you each month, then the Monthly Internal Rate of Return on the capital invested since the 1st of April is 50%. If you calculate the Monthly Internal Rate of Return on the capital invested since the 1st of May 2007, then the Monthly Internal Rate of Return on the 1st of June is 100%.
If you had put £10,000 in a bank account on the 1st of April 2007 at an interest rate of 50% per month, one month later, on the 1st of May 2007, your bank account would have increased in value by £5,000 and be worth £15,000. Considering that you deposited another £5,000 on the 1st of May, then your total bank account would be worth £20,000 on the 1st of May. The £20,000 invested at a monthly interest rate of 50%, would result in your bank account generating a further £10,000 in interest, therefore on the 1st of June 2007, your bank account would be worth £30,000. It is important to note that the timing of when cash is deposited or withdrawn and the period of time that you had your money invested, determines the rate of return generated by Money Weighted Return Metrics.
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