The Difference Between Time-Weighted and Internal Rates of Return
Time-Weighted Rate of Return
The time-weighted rate of return is a measure of the compound rate of growth in a portfolio. Because this method significantly reduces the distorting effects created by inflows of new money, it is used to compare the returns of investment managers.
When calculating the time-weighted ROR, the effect of varying cash inflows is eliminated by assuming a single investment at the beginning of a period and measuring the growth or loss of market value to the end of that period.
Internal Rate of Return
The internal rate of return is the average rate earned by each and every dollar invested during the period. This rate is influenced not only by the movements in financial markets and decisions made by portfolio managers, but also by the timing and size of the cash inflows and outflows and the beginning and ending book or market values.
Since the internal rate of return weights the final overall return by the size of the investment and the timing and size of cash flows in each subperiod, the method produces inappropriate results if the purpose is to compare the performance of two investment funds. For that purpose, the investment industry standard is to use time-weighted rates of return.