Can I get some intuition on: Why is it called time weighted? Why is it better for performance evaluation? Thx!
It is better for performance evaluation when evaluating managers in situations where the portfolio manager does not control cash flow magnitude or timing. The TWRR eliminates the affect that a cash flow has on the performance calculation. It does this by breaking down the return into different segments, with a new segment starting at the date of each cash flow. Each segment is implicitly weighted by its length of time relative to the entire performance period. For example, if a cash flow occurs after 10 days, the compounding of sub-period returns is as follows: Monthly return = (1+R1)*(1+R2) BUT, the return for period 1 is actually the product of (1+Mean Daily Return1)^10 and the return for period 1 is actually the product of (1+Mean Daily Return2)^21. So the mean daily return for period 1 is given a weight of 10/31 and the return for period 2 is given a weight of 21/31 days.
What kind of Cash Flow? I do not understand the formula. what is R1?
R1 is the return for the first period (End MV - Beg MV- CF) / Beg MV. You need to calculate a return for a sub-period every time there is a cash flow (contribution or withdrawal). For example: You have $100 on day 1, $20 contribution on day 10 (for a total of 140) and on day 31 you have $150. The return for the first 10 days is (140 - 100 - 20) / 100 = 20% The return for the last 21 days is (150 - 140 - 0) / 140 = 7.14% The TWRR for the month is (1.20)*(1.0714) -1 = 28.57% Don’t worry about the explanation about “why” it is called time-weighted, that doesn’t matter as far as the exam goes. Just know what the return is and when to use it.
Does CF include dividend, interest income? How about capital distribution?
Cash flows = contributions and withdrawals. Dividends and interest = income.