Brinson attribution can be used to reconcile the differences between time-weighted returns and money-weighted returns. Both methods can be used together to determine the return rate of a given investment. If a discrepancy between the two is detected, an appropriate reconciliation should be added. A report template can be used for such a reconciliation.
How Is This Research Useful to Practitioners?
Time-weighted returns (TWR) and money-weighted returns (internal rate of return, or IRR)
may produce divergent or even conflicting results from time to time. The IRR method weights
the investment return against the cash flow inputs and outputs. The TWR method focuses on
specific time intervals, compounding them geometrically. Practically, the IRR method works
better for such investments with unpredictable cash flows as private equity. In contrast,
the TWR method is more appropriate for benchmark comparisons of liquid investments—for
example, bonds and stocks.
The problem with the TWR method is that the ultimate return rate is a geometric total of
partial rates; it ignores the influence of the investment’s underlying amounts. The
time-weighted return on the investment may have a positive sign even though its
money-weighted counterpart has a negative sign. The IRR method is not free from drawbacks
either. For instance, it imputes a reinvestment rate equal to the internal rate of return,
which is an unlikely occurrence. Moreover, investment managers seldom have discretion over
the timing and sizes of cash flows. All this strengthens the position of the TWR method,
which is recommended by the Global Investment Performance Standards
(GIPS®).
Using the Brinson attribution model, the author presents a quantitative decomposition of
the discrepancy between the two methods. Given the pros and cons of the TWR and IRR methods,
it seems reasonable to proclaim both methods an industry standard for estimating rates of
return. Both rates should be presented to investors, accompanied by an obligatory
reconciliation. The author argues that presenting the two return measures will not confuse
investors if a proper disclosure is made. He also suggests a report template for making such
disclosures.
The author’s research might be of interest to various market participants, including
regulatory bodies, investment managers, and investors. Investors face the challenge of
picking the “right” investment managers for their savings. The methodology and
background the author outlines might prove helpful to these participants.
How Did the Author Conduct This Research?
The author presents several theoretical examples of performance attribution, with
particular attention paid to the Brinson model introduced by Brinson, Hood, and Beebower
(Financial Analysts Journal® 1986). In general, investment performance
attribution is a set of techniques that can be used to analyze the difference between
portfolio returns and benchmark returns. As presented by the author, the attribution
analysis focuses on two potential sources of portfolio returns (selection and allocation of
securities), although it may include such other factors as currency. The Brinson model
decomposes the portfolio return into three components: selection, allocation, and the
interaction between the two. The author finds that the key difference between the TWR and
IRR methods is that the TWR method equally weights variable reinvestment rates and the IRR
method takes a fixed reinvestment rate and applies the different weights resulting from the
portfolio’s cash flows.
Theoretical examples are used to illustrate the author’s viewpoint. Therefore, it is
difficult to quote particular numbers. The methodology presented nevertheless allows one to
simultaneously zero out the impact of the different weights on the return estimation and
isolate both timing- and selection-related effects. Thus, the factor that is not within
management’s discretion is effectively removed.
Abstractor’s Viewpoint
The author’s conclusion implies that both the discussion of the differences between
the two methods and the attempts to justify the superiority of one method over the other are
not important needs of the investment industry. The real need can be addressed by
understanding the actual reasons for the discrepancy between portfolio and benchmark
returns. The author presents a quantitative methodology that enables a concise and coherent
analysis of that discrepancy. The ultimate goal is to help investors pick the best
investment managers and measure their effectiveness. Thus, the author makes an important
contribution. Although the author’s research probably has limited academic value, it
can be applied immediately to real-life situations.
This paper joins a substantial block of literature and a multilayered discussion on the
industry standard for investment return estimation and presentation. This discussion has
powered the investment world for many years and offers a voice of common sense in this
important matter.