Every year, the Brown Brothers Harriman (BBH) investment team speaks with hundreds of investment managers, ranging from take-public activists who focus on Israeli military startups to hyperconcentrated mega-cap investors who own just three companies. Given the immense diversity of background, philosophy and personality across this spectrum, it is tempting to think we have heard it all. However, one recent manager meeting concluded with something we do not often encounter: a bet.
The manager in question – a grizzled, successful emerging markets veteran – pointed to his two-pronged track record, which exhibited both time-weighted and capital-weighted returns. Notably, his fund’s average capital-weighted return since inception had beaten its time-weighted return by 1 or 2 basis points. Few other managers could claim that kind of parity, he said. In fact, he doubted whether more than one in five would even disclose such numbers, if they kept them at all. If we could prove him wrong, he promised, he would buy us dinner at a New York restaurant of our choice.
Why All the Fuss About a Simple Return Calculation?
Capital-weighted returns – also called money-weighted, dollar-weighted or investor returns – are significant for the added insight they offer into a manager’s performance, but also for the broader discussion about capacity and investor behavior they tend to provoke. Put simply, capital-weighted returns are a form of internal rate of return (IRR): They measure the dollar return generated on each dollar invested in a portfolio.
By contrast, the majority of investment managers prefer to quote their total time-weighted return, which reflects the average compound rate of return of the portfolio as a whole – that is, the position-weighted appreciation of a portfolio’s underlying holdings – regardless of when or how much capital has been invested or redeemed over the life of the portfolio.
This distinction is best portrayed using an example. Imagine an individual investor who invests $100 in a fund at time (t) zero. The fund returns 20% in its first year, increasing the value of the investor’s original investment to $120 at t=1. Encouraged by these early results, the investor allocates another $500 to the fund. In year two, however, the fund loses 10%, bringing the dollar value of the investor’s total cumulative investment to $558 at t=2.1 The investor then liquidates her investment.