In a recently published whitepaper, SS&C provided insight into the increased popularity of open-end funds. There may be nuances asset managers are not familiar with given their closed-end fund focus—especially their comfort with the prevailing performance measurement tool, Time Weighted Returns (TWRs). This blog explores the differences between TWR and Internal Rate of Return (IRR) and some of those particular nuances with TWR’s this author has personally experienced during his nearly 20-year career working with open-end funds. Much of the technical language was sourced from the NCREIF PREA Reporting Standards Manual. NCREIF and PREA encourage the distribution of these standards among all professionals interested in institutional real estate investments. Copies are available for download at www.reportingstandards.info.
Use of TWRs vs IRRs
Typically, TWRs are the preferred performance measure to use in open-end funds. By removing the timing effect of cash flows from the formulas TWRs provide a good measure of the performance of the advisor. In addition, TWRs are preferred when valuation frequency is high and returns are linear. Conversely, when an advisor does control the cash flows of the entity, as is the case in a closed-end fund, the preferred metric is the Internal Rate of Return (IRR). The use of TWRs allows investors and advisors to benchmark performance against other funds and across industries.
TWR Components and Composite Returns
Industry practice is to separate the total return into two components: income return and appreciation return. Regulations also require the disclosure of before and after fee returns. When calculating after fee returns at the fund level, only consider advisory fees and incentive fees (including carried interest paid to the advisor). Fees such as management fees, acquisition fees, disposition fees, etc. are not a factor. Further common segregation is the calculation of levered and unlevered fees. In order to facilitate these calculations, the advisor will need the ability to track all these inputs. This is best served by maintaining detailed books and records with a robust chart of accounts.
TWR composites can be created to measure the performance of more than one entity. The common practice is to publish composite returns by property type (Office, Retail, etc.) and region (East, West, etc.).
Fund Level, Investment Level and Property Level Returns
TWRs are calculated at three levels: Fund Level, Investment Level and Property Level. While the TWRs of each level all follow the same basic principles, the financial inputs that are used in the numerators and denominators of each differ.
Property level TWRs reflect the performance of a property or group of properties. The property level relates strictly to property operations and attempts to strip out all ownership level activity, usually including advisory fees, use of working capital, and owner income and expenses. Property level TWRs do not represent investors’ earnings from those properties, but rather the earnings that are generated by the property.
Investment level TWRs reflect the performance of a single investment or group of investments, at the fund’s ownership percentage. Investment level TWRs differ from property level in that the full scope of the investment, including ownership level activity, is included in the calculation.
A fund level TWR is the aggregation of all the amounts earned by the investments and fund level activity. This activity would include audit and appraisal fees, interest income and portfolio borrowings. This return measures the performance of the advisor.
Items to note:
Income and Appreciation Will Not Equal the Total
When component returns are presented for any full individual quarter, the sum of the income return plus the appreciation return will generally equal the total return. When component returns are geometrically linked to create cumulative compounded returns, the simple addition of the cumulative compounded income return plus the cumulative compounded appreciation return will not usually equal the cumulative compounded total return; the sum of the parts not equaling the total is normal and acceptable. The total return is precise, and the income and appreciation components are approximations. These approximations are deemed acceptable because applying the more precise cross compounding formula to the income and appreciation component returns would make the formulas very complex and approximated results are not materially different.
In the financial industry, investors and advisors tend to think in terms of annual rates of return. The industry standard for TWRs is to annualize all cumulative returns that contain four or more full quarters.
Partial Period Returns
If an asset is acquired on a date other than the first day of a quarter or sold on a date other than the last, the resulting measurement period is said to be a “partial period” because the asset does not have a full quarter’s worth of activity.
These partial periods can create distortions in the TWR calculations. Various factors play a role in the distortion including the nature of the return (single entity calculation versus group calculation), component of the return (income versus appreciation) and time-period covered (current quarter versus annualized return).
There are a number of different methods currently being used to deal with partial periods. It is up to each advisor to decide which method to adopt as there are pros and cons to each, and the methods that are currently used for the various NCREIF indices or recommended by the GIPS standards for composites may not always meet the needs of the end uses. The method chosen should be applied consistently and properly documented in the firm’s performance measurement disclosures.
The three most commonly used methods are summarized below, though other methods may also be acceptable so long as they are applied consistently and do not materially misstate the return results:
- Method I – Start and end dates used for TWR Calculations will match the start and end dates for the entity’s actual life (i.e. keep partial periods).
- Method II – For TWR purposes, an entity will begin on the first day of the first full quarter following acquisition and end on the last day of the last full quarter prior to disposition (i.e. drop partial periods).
- Method III – A hybrid of Methods I and II where the start date begins on the first day of the first full quarter following acquisition and the end date matches the actual disposition date (i.e. drop acquisition partial period but keep disposition partial period).
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