The Difference Between IRR and TWR

There are two main performance calculations: IRR, or Internal Rate of Return, and TWR, or Time Weighted Rate
of Return. This document is designed to explain the difference between these returns and help you select the right
kind of return to report to your clients.

IRR Explained
The IRR measures how the portfolios investments did overall. It is a single rate of return that makes the value of
everything added to the portfolio equal to everything taken out of the portfolio, or a constant rate of return that
makes the present value of the portfolios ending value and all withdrawals precisely equal to the present value of
the portfolios initial value and all contributions.

Characteristics

Reflects all changes in value, including fluctuating prices and the decision of the investor and/or money
market manager to add or remove value from the portfolio.

The IRR return is affected by the size and timing of capital flows larger flows affect the performance more
than smaller flows.

Return fluctuations are relative to portfolio size: larger portfolios have greater fluctuations in portfolio returns
than smaller portfolios.

The IRR provides a measure of the growth of a portfolio in absolute terms, so it is useful for determining if a
portfolio is growing fast enough to meet a future need or goal.

IRR is not suitable for determining the relative skill of an account manager or to be compared to a market
index, as it is greatly affected by the size and timing of flows an investor decides to add to the portfolio.

Calculation
The IRR cannot be computed directly. The IRR must be computed using a trial and error procedure in which you
guess an answer, plug the guess into the equation, then modify the guess depending on the results. The new
guess is plugged back into the equation, and the process is repeated until a satisfactory degree of precision is
achieved. The initial guess made by Base Estimation Method, and the final number calculated through this
iterative process.

DocumentID: spt010221
Last Updated: August 13, 2008

TWR Explained
The TWR measures how the manager performs. It removes the effect of the clients decisions to deposit or
withdraw money in the account. It measures investment performance (income and price changes) as a percentage
of capital at work, effectively eliminating the effects of additions and withdrawals of capital and their timing
that alter IRR accounting.(1) Stated another way, TWR is designed to remove the effects of capital flows into and
out of the portfolio.
(1) Dictionary of Finance and Investment Terms, Fourth Edition, p. 607.

Characteristics

Reflects effects of the market and the managers choices over which investments to select for the portfolio.

Eliminates effects of the size and timing of capital flows that alter IRR return numbers

Weights returns from each period equally no matter how much value is in the portfolio at the time

Calculation
The TWR is a set of smaller returns that are linked together using the geometric linking formula. In
PortfolioCenter, these smaller returns are typically IRR calculations for sub-period of one month, usually called
intervals.

Sub Period Return Formula =

Linking Formula:

When to use each calculation:

So, when should you use IRR and when should you use TWR? Review the chart below for tips on when to use
each calculation:
Use IRR when

Use TWR when

Comparing the portfolios return to an overall goal.

For example use an IRR if you want to see if the
portfolio is growing at least 10% in one year.

Comparing the growth of the portfolio to the

markets growth. For example, how did the
portfolio perform as compared to a market index
like the S&P 500?

Seeing the overall growth of the portfolio.

Comparing the performance of one portfolio

manager to another. For example, if the investor
moved assets under your management, but wanted
to compare your performance to your predecessor.

The Difference Between IRR and TWR

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