IRR, or the Internal Rate of Return, is the gold standard for measuring fund performance.
In a nutshell, IRR is the annualized and dollar-weighted return that a fund generates on all of its investments. In contrast, a time-weighted return simply tallies up a fund's total return over a given period without considering the amount of capital invested at different points in time.
What is the value of IRR over a purely time-weighted return?
As mentioned, IRR is a dollar-weighted return, which considers the timing of cash flows in and out of a fund. This is important because it gives a more accurate picture of the fund's performance rather than just looking at the total return over a given period.
Since an absolute return doesn't normalize to an annual figure, it can be misleading. You need to annualize both returns to compare two funds with different investment horizons.
How to calculate IRR?
The easiest way to calculate IRR is with a financial calculator or spreadsheet software. You can also estimate IRR by using the following formula:
IRR = (Ending Value / Beginning Value)^(1/n) - 1
where n is the number of years in the investment period.
For example, you invested $10,000 in a fund five years ago, now worth $15,000. The time-weighted return would simply be (15,000 / 10,000) - 1 = 0.5, or 50%.
To calculate the IRR of this same investment, we would plug the numbers into the formula above:
IRR = (15,000 / 10,000)^(1/5) - 1 = 8.4%
This lets us compare the performance of this fund to other investments since we're now dealing with annualized returns.
What are the limitations of IRR?
While IRR is a helpful metric, it does have its limitations. It's important to remember that IRR is a backward-looking measure. That is, it only tells you how a fund has performed in the past, not how it will perform in the future.
Second, IRR can be manipulated. Consider capital calls or demands for payment of the committed but uninvested portion of a fund's capital. Suppose a fund manager does not call significant amounts of capital during a year in which the fund has strong performance. In that case, the denominator in the IRR equation will be artificially low, leading to a higher calculated IRR.
Finally, two investments with the same IRR won't necessarily generate the same return on capital. This is because IRR doesn't consider an investment's effective hold period. For example, a fund that generates a 20% IRR over seven years will have a different return on capital than a fund that generates the same 20% IRR over ten years.
Despite these limitations, IRR remains a crucial measure for assessing fund performance. You can use IRR to make more informed investment decisions by understanding how it works and its limitations.
What are other fund performance metrics?
Return multiples are another popular metric for measuring fund performance. Different multiples calculations use different numerators (realizing, unrealized, or total proceeds) and denominators (referring to the amount of capital invested, committed, or called).
The TVPI, or Total Value to Paid-in Capital, measures the value of the realized and unrealized investment. In comparison, DPI, or Distributions to Paid-in Capital, only includes realized proceeds distributions. In contrast, the Residual Value to Paid-in Capital (RVPI) includes unrealized proceeds. Each of these three return multiples can provide different insights into how a fund performs.
If you're looking to measure fund performance, IRR is the metric. It's a dollar-weighted return that considers the timing of cash flows, and it can be easily annualized to compare different investments. Remember that IRR is a backward-looking metric, and capital calls can manipulate it.