Still in India, but I have access to a computer ever now and then so it thought I would keep writing! Unfortunately, Fiona has been a bit ill – I think we both got a bit of food-poisoning, but it’s hit her harder than me. The rest of the family are off to Ranthambore on a tiger safari, but Fiona and I are still in Jaipur – not to worry though, as I’m getting some quality time with my aunts! :)
Time Weighted Returns
When you see the return of mutual funds, it’s important to make a distinction between the time weighted return which is similar to what is reported on performance charts and the dollar-weighted returns, which represents what the average investor actually earned – the two can be dramatically different. If we have a fund that has an average annual return of 20% for three years, it can attract a lot of new investors (performance chasers). Let’s suppose that the fund had $100 million invested at the beginning of this spectacular three year run. Now let’s further suppose that $1 billion of new money gets added to the fund due to the great performance, but that the NEXT three year period results in a flat performance of 0% each year. The time-weighted average return over the 6 years is 10% – still sounds great.
Dollar Weighted Returns
The dollar weighted returns tells you what the average investor experienced since it links the performance to the amount invested in the fund at the time. From above we see that only $100 million earned a great rate of return, but the $1 billion that followed after the first three years earned nothing. On a dollar weighted basis the average investor earned less than 2% – a far cry from the 6 year average of 10%.
But why does that matter? Aren’t time-weighted returns more relevant? If I’m choosing a fund, I don’t particularly care that other investors had unlucky timing.
@Patrick – It’s another piece of the puzzle for investors to consider, and if you are invested from day one of the time period you are looking at then you are correct in that time-weighted returns is more relevant. But dollar weighted returns reflect the actual experience of investors – the next post will highlight some data that shows the significance of this point.
Greetings from Bogota, Colombia.
Get well soon Preet, I heard that ‘Bombay Runs’ are a pain in the arse.
I miss the Friday vids, so I thought I might post one.
Hope you all like it:
http://www.youtube.com/watch?v=Lbwp0OTk0Hs
Merry Christmas from my family to yours
Preet,
Good explanation. However, I would disagree on the overall tone of the article. If you are invested in a fund then you will want YOUR rate of return calculated on a dollar weighted average, since that is what you recieved. However, if you are a NEW investor, then the time weighted is generally much better indicator of performance since it is not biased by cash flows and are more representative of what you would have recieved if you started and where invested in the fund since inception.
@Justin – fair, but in my mind I was framing it from a behavioural finance slant. It is specifically the better time-weighted return which can attract an investor to a fund in the first place, which can lead to a poor dollar weighted return (which is what you will use to judge your initial decision and perhaps attract you to dumping the fund, and perhaps at the wrong time.)
@Preet – interesting. There’s a paradoxical aspect to this. If you look at time-weighted averages, you may chase the best performers, causing your own return to look more like the dollar-weighted average. However, if you look at dollar-weighted averages, you’re less likely to shift your money around, making your returns look like the time-weighted ones.
In short, whichever average you choose to compare your options, your returns will always look more like the other one!
@Patrick – sounds like the contrarian would prosper… :)
This just reminded me of another paradox, so I’ve described it here.