We think it is most appropriate to evaluate Wealthfront like an index fund, therefore we recommend using the Time-weighted return shown on your dashboard to measure account performance. Your dashboard also displays a Money-weighted return that takes into account the deposits and withdrawals you make over time. We do not display and do not recommend using Simple return to measure performance, as explained below.
Time-Weighted Return (TWR)
TWR compounds the daily returns of your account from the time it was initially funded until present. It is the best way to evaluate the performance of an investment manager because it does not consider when a client deposits or withdraws cash from her account. TWR is also the method used by index funds to measure performance. It is a true reflection of how we have managed your money, not a reflection of how your contributions and withdrawals affected your performance.
Money-Weighted Return (MWR)
MWR is the rate of return that will cause the net present value of your portfolio’s cash flows (deposits and withdrawals) and terminal value to equal the value of your initial investment. It is analogous to a fixed rate on a daily-interest savings account. While TWR compounds your account’s unique pattern of daily returns, MWR is calculated as the constant rate of return that would have to be paid for you to obtain the account’s ending value, given your deposits and withdrawals. The annualized version of Money-weighted return is known as Internal Rate of Return (IRR).
MWR is often a better measure of how you manage your contributions and withdrawals than how your investment manager performs. Because it transforms a varied set of daily returns into a fixed rate, it is highly sensitive to when you deposit and withdraw cash. For example, if you initially deposit $10,000 in your account and it doubles in one month and then you deposit $100,000 and the market drops 25% in the following month then your TWR will be positive 50% and your MWR will be negative 31% (and your IRR would be negative 89%). In this example your investment manager invested well, but you timed the market poorly.
If you make frequent deposits, MWR and TWR will converge over time.
We do not recommend using Simple return as a performance measure. The Simple return is your portfolio’s total net gain divided by net contributions. In effect, this weights all cash flows to the beginning of your account’s life and therefore is not a very appropriate way of evaluating an investment manager’s performance.
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.