Time Weighted Return Explained for Crypto Traders

Time Weighted Return Explained for Crypto Traders

Definition: Time-Weighted Return (TWR) is a method used to measure the performance of an investment portfolio over a specific period, such as a month, a quarter, or a year. It's designed to eliminate the impact of external cash flows (money coming into or out of the portfolio) on the calculation, allowing you to assess the manager's skill in generating returns.

Key Takeaway: TWR provides a pure measure of investment performance by isolating it from the effects of deposits and withdrawals.

Mechanics: How Time-Weighted Return Works

Imagine you're running a race. Your speed (investment returns) is what we want to measure. Now, imagine people can enter or leave the race at any point (cash flows). TWR is like measuring your speed without considering when others enter or leave the race. It focuses solely on how fast you ran during the time you were running.

The TWR calculation involves these key steps:

1. Break Down the Period: Divide the total investment period into sub-periods, typically whenever there's a cash flow event (deposit or withdrawal). Each sub-period starts with the beginning value and ends with the value just before the next cash flow.

2. Calculate the Return for Each Sub-Period: For each sub-period, calculate the return using the following formula:

   Sub-period Return = ((Ending Value - Beginning Value - Cash Flow) / (Beginning Value + Cash Flow))

   If there are no cash flows, the formula simplifies to:

   Sub-period Return = (Ending Value - Beginning Value) / Beginning Value

   • Beginning Value: The portfolio's value at the start of the sub-period.
   • Ending Value: The portfolio's value at the end of the sub-period.
   • Cash Flow: The amount of money added to the portfolio (positive) or withdrawn from the portfolio (negative) during the sub-period. Remember to account for the timing of the cash flow. If a cash flow occurs mid-period, you may need to adjust the beginning or ending values accordingly.

3. Link the Returns: Calculate the Time-Weighted Return for the entire period by compounding the returns of each sub-period. This is done using the following formula:

   TWR = [(1 + Return Sub-period 1) * (1 + Return Sub-period 2) * ... * (1 + Return Sub-period n)] - 1

   This formula multiplies the individual returns, adding 1 to each return to represent the total value at the end of the period. Finally, subtract 1 to express the result as a percentage.

   • This formula effectively chains together the performance of each sub-period to give you the overall performance. The TWR is the product of all the returns for each time period.

Example: Let's say you start with $1,000 in a crypto portfolio. After a month, the value is $1,100, and you deposit an additional $500. Then, after another month, the portfolio value is $1,800. We'll break this down:

• Sub-period 1: Beginning Value: $1,000, Ending Value: $1,100. Cash Flow: $0. Return = ($1,100 - $1,000) / $1,000 = 10%.

• Sub-period 2: Beginning Value: $1,100, Ending Value: $1,800. Cash Flow: $500. Return = ($1,800 - $1,100 - $500) / ($1,100 + $500) = 12.5%.

• TWR = (1 + 0.10) * (1 + 0.125) - 1 = 23.75%.

Trading Relevance: Why TWR Matters

In crypto trading, TWR is essential for several reasons:

• Performance Evaluation: It allows you to objectively evaluate your trading performance, regardless of when you added or removed funds.

• Comparing Strategies: TWR enables you to compare the performance of different trading strategies or portfolios fairly, even if they have different cash flow patterns.

• Managerial Skill: For professional traders, TWR is the standard metric used to assess their ability to generate returns independently of contributions and withdrawals.

• Portfolio Analysis: Helps understand how your portfolio's value has changed over time, by analyzing the individual sub-period returns, which will show you the highest performing time periods and the lowest. This can help you to understand how market conditions or your trading decisions have influenced your portfolio.

Risks and Limitations

While TWR is a powerful tool, it's not without limitations:

• Market Timing: TWR doesn't account for your ability to time market entries and exits. If you consistently deposit funds before a market rally and withdraw before a crash, your TWR might not reflect the full benefit of your timing skills.

• Data Accuracy: Accurate calculations require precise data on portfolio values and cash flows. Errors in data entry can lead to inaccurate results.

• Short-Term Focus: TWR is most informative when calculated over longer time horizons. Short-term TWR calculations can be volatile and less representative of your true trading skill.

History and Examples

The concept of TWR has been around for decades, originating in traditional finance. It became crucial as institutional investors needed a way to compare the performance of fund managers without being skewed by the timing of investor contributions and withdrawals.

• Early Adoption: In the 1970s and 80s, TWR became a standard in the mutual fund industry. This allowed investors to compare funds more effectively, as they could focus on the manager's ability to generate returns, not how the fund's size changed over time.

• Crypto Applications: With the rise of crypto, TWR is becoming increasingly important. Early Bitcoin investors in 2009, for example, benefited from massive price increases, but their returns would vary depending on when they bought and sold. Using TWR allows us to isolate the performance of the investment itself from the timing of the buys and sells.

• Modern Day: Today, many crypto exchanges and portfolio trackers provide TWR calculations, helping traders and investors gain a clearer understanding of their performance.