Inside The Return
Published on Aug 04, 2019.
In this series of inside the return, we first get familiar to the general terms related to return that as an investor you come across in investment literature frequently –
Absolute Return – The simplest form. It just tells you the total return an investment has generated. Say Rupees 100 invested 5 years back are 150 today. The absolute return is 50%.
Annualized Return – Almost all investment literature or fund fact sheets talk about this figure. A return over a period translated into compounded annual return. It’s also called in technical terms CAGR (Compounded Annual Growth Rate). In the above example, the investment every year has given 8.45% CAGR over 5 years.
Calendar Year Return – As the name suggest, return given by the fund in a calendar year. Only a very few Mutual Fund houses in the country reports calendar year return in their fact sheets however this is an important metric to understand the fund’s performance as it shows how volatile the journey has been. In the above example, the fund has given 10%, -15%, 40%, -5% and 21% calendar year return in it’s 5 years journey.
Internal Rate of Return – In the above, we have talked about how you see the return for a single investment. What if, in your journey you have moved money in and out many times, for every in you have an partial of complete out, for every such investment absolute and annualized returns can be calculated separately but what if you need a single number to calculate the return for the entire investment journey at any point of time, the Internal Rate of Return (IRR) solves this problem. The rate is internal because it depends only on cash flows of the investment and no extra data is needed. IRR essentially assumes that all cash flows take place at an equal interval say at the end of the year. For cash flows which occur at incongruous time period like anytime during the year, we need to use a variant of IRR called XIRR. XIRR is the most important number that you must look while seeing your investment report, it tells you the accurate return your overall portfolio has delivered on the date.
While reading the prospectus of a bond or fact sheet of a debt fund you must also have encounter a term called Yield to Maturity (YTM). YTM is nothing else but another term for IRR used in Fixed Income context.
Money-Weighted Rate of Return – In investment performance measurement IRR is also known as money-weighted rate of return because it accounts for the timing and Rupee flows into and out of the portfolio. Your overall return can be higher than the fund’s return if you have put a higher inflow before a favorable time period thus increased the money weight in a better performing period and vice versa is true during a higher money weight in unfavorable time period.
Time Weighted Rate of Return – Time Weighted Rate of return tells about the return averaged over time. It is not affected by addition or withdrawal of the funds in the portfolio. It simply tells about the growth of 1 Rupee invested in the portfolio over a stated measurement period. As the time weighted rate of return is insensitive to the portfolio investment and withdrawals, it tells the true performance of a portfolio manager.
To evaluate an adviser, one should thus use Money Weighted Rate of Return and to evaluate a portfolio manager one should thus use Time Weighted Rate of Return.
We will talk about more on the Money Weighted and Time Weighted rate of return and their uses for an investor in appraising performance of their advisers and portfolio managers in the next part of this series.
Sachin Kapoor, CFA