TWRR vs IRR – What is the Difference, which is better, and why?

TWRR vs IRR – What is the Difference, which is better, and why?

TWRR (Time-Weighted Rate of Return) and IRR (Internal Rate of Return) are two commonly used methods to calculate investment returns. The difference between the two lies in the way they measure performance.

TWRR calculates returns based on the time-weighted average of each sub-period’s return, which is then compounded to determine the overall return. This method is commonly used for portfolio performance evaluation, where the investor has control over when they add or withdraw funds.

On the other hand, IRR calculates the rate of return that makes the net present value of all cash flows equal to zero. This method is commonly used for evaluating the performance of a single investment where the investor does not have control over when they add or withdraw funds.

Let’s consider an example to illustrate the difference between the two methods.

CASE 1:

Given the above data, the portfolio value at the end of 2023 would be Rs 123 Lakhs, and the IRR would be 8.45%.

Now, let’s take another scenario.

CASE 2:

Given the above data & same returns as in Case 1, the portfolio value at the end of 2023 would be Rs 125 Lakhs, and the IRR would be 6.62%.

Even though portfolio value is higher in Case 2 than in Case 1, the IRR is lower in Case 2.

Let’s take another scenario:

CASE 3:

Given the above data & same returns as in Case 1, the portfolio value at the end of 2023 would be Rs 117 Lakhs, and the IRR would be 4.94%.

The timing of an investor’s investment in a portfolio impacts its returns, leading to differences between the average investor returns and average fund returns.

It would be unfair to evaluate the Fund Manager’s performance based on this factor since Portfolio Managers have no control over the timing of the investor’s investment. Therefore, to assess the fund manager’s performance, the impact of the timing of cash flows must be removed by only considering the returns and calculating the geometric mean of those returns, which is known as Time Weighted Rate of Return (TWRR).

For instance, for the portfolio generating revenues as mentioned above, the TWRR calculated as the geometric mean of these returns, equals 8.11%.

Notably, the TWRR remains the same regardless of when an investor invests in the portfolio.

Hence, it is only fair to gauge the fund manager’s performance based on the TWRR of the portfolio, which factors in the returns generated by the manager without the influence of the timing of cash flows.

PMSs show performance on TWRR basis. This change was announced by SEBI on October 1, 2020, and was implemented from the quarter ending December 31, 2020.