What is an internal rate of return?

The other money-weighted return figure displayed in your account is the internal rate of return, or IRR for short. It is certainly more useful than the simple earnings figure. But, it is also not the best figure to use to understand how well Betterment is managing your money (TWR is), because it includes the impact of your deposits and withdrawals.

IRR does a better job of answering the question, “What are the average returns on the dollars I personally deposited into Betterment?” as opposed to “How well does Betterment design and manage the portfolios I have with them?”

In other words, the time-weighted return tells you about the performance of the underlying portfolio itself, while the IRR tells you about the degree to which you benefited from the performance of that portfolio based on the time frame in which you were invested in it.

Here’s an example to help explain how IRR is affected by your cash flows, versus the underlying portfolio itself:

Let’s say there’s a statistic that says Denver, Colorado is sunny for 250 days a year on average. That’s about 70% of the days in a year. But you went on a trip to Denver for five days, and it was overcast for four of the days you were there. In your personal experience of Denver, it was only sunny 20% of the time, in contrast with its average rate of 70% sunny days.

If you wanted to describe the general weather in Denver, it would make more sense to describe it using the 70% sunny days statistic, not your personal 20% sunny days experience. If you were to describe your experience with Denver on your trip, you would say Denver was only sunny 20% of the time, which was largely based on luck around when you were there.

In this weather example, the average of 70% sunny days in Denver is analogous to the time-weighted return. The 20% sunny days that you experienced during your five-day trip is similar to your IRR for a given time period. It’s personalized, and it matters to you, but it doesn’t fully describe the weather in Denver, and it shouldn’t inform what you should expect weather in Denver to be like in the future.

The date you traveled to Denver is similar to when you decided to make a large deposit into your investment portfolio. The IRR figure is affected by your deposits and withdrawals. Your simple earnings are also affected by your deposits and withdrawals, but IRR does a better job of describing your returns than simple earnings, because it’s sensitive to the amount of time that your dollars were invested. IRR gives more weight to returns on dollars that have been invested for longer. IRR can be useful, especially in comparison to TWR. But, for most investors at Betterment, IRR is not the return figure that answers the question they are trying to answer.

IRR tends to be more relevant for investors if their portfolio manager is not only choosing what they’re invested in, but also when securities are bought and sold. We don’t do this at Betterment, because we buy and hold ETFs when you deposit. Our investing philosophy is a passive, long-term investing strategy, which has been shown in research to generally outperform most active portfolio management strategies. At Betterment, you control the timing of your deposits and withdrawals, not us, so your IRR will tell you more about the luck you had regarding when you made your largest deposits and withdrawals.

Another example of IRR and when it can be helpful:

An example of when IRR might be the most relevant measure of performance can be found in the hedge fund depicted in The Big Short, a film about the 2008 financial crisis and the investors who predicted it would happen.

If you’re not familiar with the story, here’s a quick rundown: The creator of the hedge fund, Dr. Michael Burry, believed a large amount of individual mortgage loans were going to start defaulting in about two years, and that the bonds backed by those loans would therefore also fail. He chose a specific point in history to buy securities for his investors that would increase drastically in value if his effective “bet” against those mortgage-backed bonds was correct. In buying these securities, he effectively bet against the mortgage bonds when everyone else still thought the bonds were safe.

Once it became apparent years later that the bonds were not safe, the value of the securities he bought for his investors drastically increased. For years, he sat in cash and his investors had a low IRR. Then, in just a few months, the IRR changed drastically. When comparing fund managers like Dr. Michael Burry’s hedge fund company, IRR becomes a lot more relevant.

Most Betterment investors are not comparing investment managers that have this level of control over their assets, so the time-weighted return continues to be the most useful figure in understanding how well Betterment is managing your portfolio.

If Your Money Is Growing, Time Weighted Return Usually Grows Faster

One more note on IRR versus TWR: Suppose you are auto-depositing on a regular basis while the market is going up—what would you expect your IRR and TWR to be?

Your IRR will be lower than your TWR because each new auto-deposit hasn’t grown as much as the previous ones. It can be frustrating to continuously feel like you are underperforming over time as you auto-deposit, but it’s actually a sign you’re doing things right.

In the graph below, the darker line representing time-weighted return is an estimate of what a portfolio would have returned if all future deposits were invested into an account on day one. Notice how greatly the line varies from the lighter colored line, which depicts simple earnings.

Graph: Time Weighted Return and Simple Earnings Comparison

Source: Time-weighted returns and earnings for a hypothetical portfolio with $10 monthly deposits into U.S. Total Market fund (VTSMX). Data from Xignite, analysis by Betterment.