Why Is It Important to Know the Difference Between "Time-Weighted" and “Money-Weighted" Returns?

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This is the latest installment of our “Ask Wealthsimple" series, where our financial guru Dave Nugent helps you navigate the world of investing.

Dave, it’s time to have a very sexy conversation. Apparently there’s a lot of confusion out there about the difference between something called time-weighted returns and another thing, called money-weighted returns. Are you stoked for some financial talk?

Yeah.

Sounds it! Well, my first question is why do the bosses want us to talk about this particular thing right now?

It’s actually a timely conversation. For the last number of years, it has been standard for Canadian investment professionals to show their returns as time-weighted. But, in case you haven’t heard, there’s been some regulatory reform in the industry. So come January, all investment firms must begin showing their returns as money-weighted. Which means people are wise to know what the heck that means.

Before we get into the nitty-gritty, let’s start with basics. What’s a return?

A return is the amount of money earned or lost on an investment. Annual returns are usually shown as a percentage on your statements. Let’s say you start the year with $100, and at the end you have $110; that would mean you have a 10% return on your money.

OK, I’m with you so far. But what are time-weighted and money-weighted returns? I Googled the terms, and it spit out a lot of really scary equations. I fear what I was looking at was calculus. Maybe we could come up with something I’ll understand better. Like maybe my account can be the Hunger Games lottery. I’ll be Katniss, and you can be Peeta, and the return models will be the districts of Panem.

That sounds fun, but I haven’t seen the movies! Here’s how to think about it in real terms. Time-weighted returns are simply the performance of an account over a certain period of time. Let’s take that same account. If you started the year with $100 in it, and you didn’t touch it, and at the end of the year had $110, that would be a 10% time-weighted return. But here’s the hitch: People don’t often just leave accounts alone. They make deposits and withdrawals over the year. Money-weighted returns take this into account and reflect the actual money you made or lost over the year.

Let’s go back to our example. Say you have your account with $100 in it, and over the course of the year you earn another $10. But now let’s say you deposited $100,000 into the account on December 30, and the market stayed flat? The time-weighted annual return could still be 10%, while the money-weighted return would be 2.7%.

If you want to see this in action, check out your Wealthsimple account page—we show you both types of returns. If you simply deposited money on one occasion and left it there, those two graphs will be identical. But if you have made a lot of deposits and/or a lot of withdrawals, your money-weighted and time-weighted returns probably look extremely different. Now you know why.

Are there benefits to looking at your returns one way or the other?

If what you’re interested in is comparing the performance of different investments or money managers, time-weighted return is the relevant number. It clears out the noise made by deposits and withdrawals. But it’s not good for helping you understand how much money you actually made or lost. Take our example in which you deposited $100,000 on December 30, only pretend that the market went down that day. Your time-weighted return could still be 10% for the year, even though you actually lost money. So in that case, time-weighted returns don’t really provide you with information that’s all that relevant.

Here’s something I’m wondering but kind of afraid to ask: How are money-weighted returns actually computed? No math please.

OK. Back to our example. An investor has $100 in her account and doesn’t make any additional deposits or withdrawals for 364 days of the year, and invests $100,000 on the last day of the year. To come up with money-weighted return, the propeller heads will use a mathematical formula that puts a smaller weight on the longer time period when you had less money in your account and a heavier weight on the one day when you had more. If the market is flat on the one day when you have a lot of money in your account, your annual money-weighted rate of return is going to be 2.7%, a lot lower than 10% time-weighted rate of return.

I think I get it. I’m going to quit while I’m ahead.

That’s your call, Andrew. But I support it!

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