Aurora Borealis
1 August 2017 CFA Institute Journal Review

The Case against Time-Weighted Return for Alternative Investments (Digest Summary)

  1. Servaas Houben, CFA
Despite the popularity of the time-weighted return (TWR) in both the GIPS® standards and the economic literature, it may not be ideal for use with alternative investments, which usually lack liquidity. The author argues that because of illiquidity and the infrequency of transactions, valuation is more challenging and TWR can be applied only in certain cases.

How Is This Research Useful to Practitioners?

The author concludes that the internal rate of return (IRR) is better suited than the time-weighted return (TWR) for alternative investments because IRR can be applied independently of an asset’s liquidity. Moreover, IRR indicates whether a minimum return requirement has been met, which is valuable management information. A possible drawback is that IRR does not allow for manager comparison.

The author shows that TWR is superior for liquid assets, which can be benchmarked. TWR also makes manager comparison possible. The capital inflows and outflows of the portfolio should be limited to make TWR a valuable information metric.

Most prior researchers (and authors of CFA Institute study materials) favor TWR and stress the drawbacks of IRR. One of those drawbacks is evident when cash flows change from positive to negative many times during the investment horizon; IRR can provide not one but several solutions, thus making its interpretation harder. Moreover, the surge in the popularity of indexes, for which benchmarking is essential, has resulted in a corresponding rise in TWR’s popularity. Especially in cases when the asset manager does not have control over cash flows (e.g., when investing in a benchmark), the use of TWR is preferred. When the manager does have control over cash flows (e.g., when additional capital injections are required), TWR has weaknesses. Because alternative assets require multiple investments, alternative valuation methods—for example, IRR—may be more pragmatic.

In addition, because the GIPS standards require the use of TWR in almost all cases (except private equity), TWR’s drawbacks are not always widely discussed. Other reporting standards also recommend the use of TWR.

Over the past decade, alternative assets have grown in both size and popularity. US pension funds allocate around 25% of their assets to alternative investments and US endowment funds allocate 50%. Although there is no exact definition of alternative assets, they usually consist of such assets as hedge funds, futures, private equity, and real estate. Their common characteristic is that they are hard to value. Part of the problem is that alternative investments may need to be done in phases (e.g., real estate). Development in phases may be required because one phase must be completed before the next phase can begin, and some investments may depend on the successful completion of a certain phase. Another reason behind the installment approach is that it allows for risk management: Losses are capped. Because alternative assets are illiquid and may encounter a high degree of concentration risk, limiting the invested capital may be the most practical approach to limiting risk.

The author also describes the drawbacks of TWR. One drawback is that TWR does not differentiate between an initial investment and a series of investments. Another is that stale pricing and inaccurate valuations reduce the practical applications of TWR to alternative investments.

With alternative investments becoming more popular, this topic is an important one for CFA® charterholders to become more comfortable with. Those working in the alternative assets industry and those working for funds that invest in alternative assets (e.g., insurance companies and pension funds) will find the author’s results interesting.

How Did the Author Conduct This Research?

An alternative method to TWR is the Modified Dietz Method, which works well when capital flows are limited and no extreme leverage or portfolio volatility occurs. But because alternative assets have volatility characteristics, Modified Dietz is a less suitable approximation for that asset class. In real estate, for example, valuation depends on a subjective assessment, resulting in four generally applied appraisal methods. Further, the values of completed and partly completed projects cannot be easily compared: A half-built house does not have 50% of the value of a completed house. In the world of alternative assets, asset overvaluation is not uncommon. Lack of transparency allows managers to manipulate the value of assets by using markups or exaggerating returns. Especially during times of fund marketing, valuations are prone to misspecification.

To allow for more frequent reporting of illiquid assets, the technique of return smoothing is applied. Multiple sources are used for estimating prices, and both positive and negative outliers are mitigated. Managers can thus discard certain price information and improve both the risk and the return of the asset.

The author concludes that TWR is not the best tool for valuating illiquid assets. TWR performs best for liquid assets with reliable valuations, which do not require reinvestment during the investment process. Because alternative assets usually have such characteristics, TWR is not an appropriate performance standard.

Abstractor’s Viewpoint

Although alternative investments are part of the CFA Program curriculum, their valuation does not play a major role in the curriculum itself. Bond and equity valuation are the basis; for alternative assets, the focus is more on their characteristics than their pricing. Thus, the author offers an interesting point of view that many investors may be unaware of. His examples of performance overvaluation are very clear, and the strength-and-weakness analyses of IRR and TWR are quite insightful. The example about calculating the return on US oil should have been simplified so readers could more easily navigate the calculations and understand the differences between TWR and the money-weighted return. Nevertheless, the author is concise, providing an interesting read for investment professionals.

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