The information set forth below was written by Financial Computer Support, Inc., vendors for DbCAMS, the asset management software system used by Financial Planning Associates, Inc. It is reproduced here by permission.
Common Misconceptions Regarding the Internal Rate of Return (IRR)
It is extremely important to remember that the calculation of an accurate Internal Rate of Return requires taking the timing and size of each individual cash flow into account. This has many very important implications and can lead to misinterpretations of IRR results. Listed below are some common misconceptions surrounding the calculation of an Internal Rate of Return.
The IRR can be calculated as: (End Value - Begin Value) / Begin Value
This is true IF AND ONLY IF there are absolutely no cash flow transactions between the begin and end dates specified. If there are any transactions which change the amount of money put into an asset (or group of assets), the IRR will not equal the result of the above equation. When there are transactions, the IRR can be approximated by dividing the total return (TR) by the average daily investment (ADI) as in the following equation: (TR/ADI)*100 = IRR%.
There is a substantial period of time when the investment in the asset is zero, or nearly so. This time period should be ignored during the IRR calculation.
This fallacy is best proven wrong by an example:
Suppose $100,000 is invested from January 1 to January 31 of a certain year. During this period of time, the investment increases in value by $1,000. It is sold for $101,000 at the close of business on January 31. On December 1 of the same year, $100,000 is again invested in the same asset. On December 31 at midnight, the investment is again worth $101,000.
What is the IRR for this asset for the year? Many people would say 2% (the total gain, $2,000, divided by the money invested, $100,000). This, however, is wrong. In both January and December, you earned 1%. If this is all the information you had, would your best guess for what could have been earned in February through November be zero? Doubtfully. However, that is exactly what an annual IRR of 2% would imply. Lacking any other information, you'd probably guess you could have made about 1% per month during the other ten months of the year also. Earning 1% per month for a full year would give a compound annual return of 12.68%. The actual IRR calculation performed is much more complicated, but yields a similar result - 12.63%.
I'm being charged interest on my margin account. It's costing me money… so the IRR should be negative.
The balance on your margin account is negative. You're right - it is costing you money. Therefore, the total return on the margin account is also negative. Since the average daily investment is negative and the total return is negative, the IRR must be positive ((-TR/-ADI)>0). This is similar to a credit card account. If you have a debit balance, you owe the credit card company money. They charge you interest. It is costing you but the interest rate is positive.
When the margin account is included with the rest of the client's assets, the IRR should decrease.
False, if the overall rate of return is greater than the cost of the borrowed funds. True, if it is lower. Leverage, borrowing to buy additional investments, causes the rate of return to be larger/smaller than it otherwise would have been if the (all cash) rate of return is greater than/less than the interest rate charged on the borrowed funds, respectively.
Let's look at a simple example:
Suppose, on an all cash basis, we have $100,000 invested and gain $10,000. The period rate of return is 10%. Simple, right? Now, suppose we borrowed $25,000 to buy those investments and the cost of that borrowed money was 5%, or $1,250. The cost of the borrowed money reduces our absolute gain to $8,750 but we only have $75,000 of our money invested. The IRR is $8,750/$75,000, or 11.67%. Even though it cost you to borrow the money, you've got even less at risk so your return is greater.
Intuitively, this makes sense. After all, you wouldn't borrow money to invest unless you expected to make more money on the investment than is required to pay the costs of the loan.
A group rate of return should lie between the rates of return earned on the individual assets comprising the group.
Not necessarily. While this is true if all the individual asset rates of return are calculated for the same time period, it is not necessarily true if they aren't. It is 'standard practice' to report period rates of return for time periods of less than a year, but annualized, or average annual, rates of return for time periods of greater than a year. The combined option in dbCAMS+ automatically does this for you. Unfortunately, this means that individual assets and groups can be for many different lengths of time. The determinants of the time periods are the report period chosen and buying into/selling out of individual assets or groups of assets during this time period. You must be very careful when comparing rates of return under these conditions.