Thursday, July 2, 2009

Multiple solutions for the IRR

We were recently contacted by a client who had a scenario where the IRR produced multiple solutions. This isn't rare, but also isn't that common an occurrence in investing. Multiple solutions can arise when we have a series of in- and outflows. There is no guaranteed way to know that you have multiple solutions, but when you do have them the challenge is to know which of the solutions is the correct one. (Note that you can know that you don't have multiple solutions, and know when you might have them, but there isn't a way to know when you do have them).

Some time ago we formed an IRR Working Group to develop guidance on the IRR, as we're finding more firms realizing that it's usually the superior measure to employ. Multiple solutions is one of the topics we're tackling.

As I explained to our client, today there are no rules whatsoever regarding this topic. The easiest case to address, though, occurs when there are just two solutions, one positive and one negative. Here, you simply determine if you made or lost money during the period to decide which return to use: if you made money, you use the positive return; if you lost money, you use the negative return. (This is one of the advantages of IRR (money-weighting) over TWRR (time-weighted rates of return): with TWRR, you can legitimately have a positive return and lose money; something many find odd and counter intuitive. This doesn't happen with the IRR).

There may also be non-real (imaginary?) solutions, which would be discarded. But if you have multiple real solutions and they aren't in the form of the simple case noted above, further guidance is needed...we're working on it! [Note that we're having a meeting later this month and are hoping to make progress towards our eventual white paper].

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