How we calculate Performance
IRR – Internal Rate of Return
Beginning in July 2016, all investment dealers are required by the Canadian Securities Administrators (CSA) to show your account’s return is a prescribed manner. The CSA has determined that a Dollar-Weighted Rate of Return is the method of choice.
What is a Dollar Weighted Rate of Return?
Internal Rate of Return (IRR) is an example of a Dollar-Weighted Rate of Return. IRR factors in the impact of deposits to and withdrawals from your account. The IRR is an annualized rate of return that is calculated in the following way:
- The IRR is applied to the starting balance from the beginning of the period to the end of the period.
- The IRR is applied to any transactions from the date of the transaction to the end of the period.
What does this all mean for me?
- IRR measures your actual account performance and can vary widely from the performance of underlying assets based on the timing of transactions
- IRR should be used when talking about how your account has performed. For instance, if you made a large purchase at a market low, which then appreciated with the upswing, IRR would show an increased return because of the timing of your investment. Conversely, if the purchase was at a market peak, IRR could be negative.
- IRR should not be used when talking about the performance of fund managers as the timing of when the client bought into the fund can have a major effect on the performance(for better or worse) that is not controlled by the fund manager
- IRR has a tendency to favor periods with more money invested over periods with less money invested
- IRR more closely matches the net invested and gain/loss of the account in dollar value. For example, a positive gain loss will always show a positive IRR)
What other rate of returns were being used?
DVM – Daily Valuation Method
A very common methodology in use today is Daily Valuation Method (DVM) and an example of a Time-Weighted Rate of Return. When calculating a return using DVM, the effects of the Investor’s transactions into or out of the account will be negated. One interpretation of this is that DVM always represents the return of the underlying fund or the performance of the Fund Manager.
What is the difference?
The main difference between IRR and DVM is how they take into account the effect of transactions. If there were very few transactions in the period, these returns would be very similar. Conversely, if there were many transactions in the period, it is also possible for these numbers to be drastically different.
If the account had a major downturn(lost 30% of its value), and at the market bottom the investor put in significantly more money. Over a number of years the account steadily increased in value(28%). The DVM return would be negative for this period since the account still hadn’t increased in value by the original 30% that was lost. In this situation the IRR return could actually be positive since with a large investment at the bottom the period with steady positive growth would be weighted more heavily than the period with the large loss but a smaller overall account value.