Measuring Investment Returns With Cashflows
Trustees of charities need to regularly monitor the returns of their investment portfolios. Returns can be affected by cashflows, and it is important that Trustees understand what is being presented to them.
A previous article discussed the difference between arithmetic-mean returns and geometric-mean returns. We assumed all money was invested into a fund at once, and left untouched. This article now considers the measurement of returns when an investor is regularly taking money in and out of a fund. We explain with an example the difference between a time-weighted return and a money-weighted return.
Let’s assume an investment at the start of year 1 of $1000.
Year 1 produces a 50% return, which increases the investment’s value to $1500.
Suppose an additional investment of $1000 is made at the start of year 2.
Year 2 produces a -20% return, which reduces the investment’s value from $2500 to $2000.
Over the 2-year period, the money-weighted return on the fund is 0%. This is because the investor contributed $2000, and the final value of their investment is also $2000.
However the time-weighted return is +20%. This is the return that would have been produced had there been no additional cash flows after the initial investment. The original $1000 would have become $1500 by the end of year 1, and then reduced to $1200 by the end of year 2.
This example highlights that an investor can have a positive (arithmetic mean) 2 year return but not make any money. Despite the Fund delivering strong overall returns, the investor did not make money because they invested most heavily after the strong return had already happened.
When evaluating an investment manager, a time-weighted return provides the fairest evaluation, as the manager doesn’t control cash flows. When evaluating the performance of an investment portfolio, it is important to take cash flows into account as they may have a significant impact on the portfolio’s return.
When reporting to clients, Trust Management presents time-weighted returns for individual managers. Trust Management also presents portfolio level returns that take into account asset allocation decisions and cash flows. Both measures of investment returns serve a useful purpose.
Want to know more?
Trust Management can provide advice to charities about measuring the returns on their investment portfolios and achieving their investment objectives.
If you have any questions, or would like to know more about measuring your investment returns, please do not hesitate to contact John Williams on (09) 550 4046.
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