Tuesday, August 28, 2012

Money- versus time-weighitng: let me be very clear

It's election time here in the United Staes, so it's appropriate to cite a few of our presidents. America's 37th president (Richard Nixon) is often recalled for his "let me make this perfectly clear" line. Our 42nd president (Bill Clinton) didn't use the term "clear," though it was implied when he denied "having sexual relations with that woman." And our current president (Barack Obama) frequently uses the term "make it clear" in his speeches. Sometimes, when trying to make something "clear," we end up making it muddier; obfuscating rather than elucidating, so to speak.

Over the recent past I have attempted to make the differences between time- and money-weighting clear, and to some degree have met with success, but not to the extent I would like.

I recently received the following note from a long time friend and colleague:
"I am working with some financial institutions and they use XIRR to measure the return of even stock and mutual funds. I am trying to convince them to adopt GIPS standard and use Modified Dietz and Time Weighted Rate of Return to calculate rates of return. Since I have never used XIRR, I wanted to see if there was anything you might have or be able to share to help me convince this client - ideally a white paper comparing the two methods and which one is most appropriate."

First, the XIRR is a form of the internal rate of return, and therefore it's a money-weighted method. Second, and more important, we have to understand the reason behind their use of performance / returns. Is it (a) to tell clients how THEY did, or (b) tell them how their MANAGERS did? This is critical in order to decide the way to proceed.

If the answer is "to tell our clients how they performed," XIRR is perfectly fine.

If, however, it's "to tell our clients how those who manage their money have done," then TWRR is probably the right formula, unless their managers control the cash flows, in which case XIRR is the way to proceed.

More and more folks are seeing the wisdom behind this. And while I may sound like a broken record, I (along with several of my colleagues who feel the same way) believe it's important to keep pressing this point. Disagree or, have other thoughts? Please chime  in!

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