During an investment period, there are capital inflows (including external cash inflows and security deposits) and capital outflows (including external cash outflows and security withdrawals) on the account. The size and timing of capital flows have an impact on the investment’s rate of return. These capital inflows and outflows can distort the return on the account, by either overstating or understating the return as a result of the effects of the capital inflows or outflows.
Consider an account with a 7% return at the end of an investment period. If 3% is attributable to a cash inflow that was made on the last day of the investment period, then the return presented does not give a complete picture. The 3% return resulting from the capital inflow, distorts the return on the account.
To give a clearer picture of the rate of return, an investment period is broken down into sub-periods. Each sub-period reflects a capital inflow or outflow occurrence, where capital flow effects are incorporated in calculating return, within the sub-period that the capital flow is relevant. Saxo breaks down sub-periods into trading days so that capital flows are the sum of capital flows on a given trading day.
To calculate the time-weighted rate of return, consideration is made for the time (sub-period in which the capital flow occurred) and the size (capital flow amount).
The example below depicts an investment period with two sub-periods. The investment has a value of USD 1000 at the beginning-of-day 2nd May and grows in value to USD 1250, by 2nd May end-of-day. On 3rd May a cash inflow of USD 200 is received on the account, bringing the account value to USD 1450. The investment has a value of USD 1650 on 3rd May end-of-day. The investment period is broken down into two sub-periods: 2nd May where the account grows in value to USD 1250 and a second sub-period, 3rd May where there is a cash inflow of USD 200 and growth in the account value. The time-weighted rate of return is then calculated by first calculating the rate of return in each sub-period:
And then the time-weighted return is the accumulated rate of return of all the sub-periods, where the sub-periods are multiplied together and presented as a percentage:
Read more on how daily Percentage Returns are calculated taking into account whether the sum of capital flows on a given trading day is negative or positive.