Internal Rate of Return (IRR) is the single rate of return at which the beginning market value plus additions grows to equal the ending market value minus withdrawals.
In my opinion IRR is most useful as a measurement of an individual holding. If you want to know how a particular position did during a particular time period in a particular portfolio, IRR is the “go-to” number.
IRR can also be useful in measuring how close you are to reaching a specific goal, since it is the hypothetical straight line between the beginning value and ending value of the time period.
But sometimes the IRR produces strange or counter-intuitive results — usually due to the size and timing of cash flows.
The 4 main situations that can skew the IRR are:
- a cash flow that is large relative to the total position which occurs on either the first or last day of the month (or reporting period).
- a cash flow that is large in comparison to other cash flows in the month which occurs near the last day of the month.
- large cash flows which occur during a period of market volatility.
- reporting on a short time period that included a volatile market swing.
If you see an usually high or low IRR, check for one of the above conditions and re-run the intervals without breaking around large cash flows. This will typically resolve the issue. If it doesn’t you may have one of those “strange but true” performance numbers, but hopefully you can explain to the client what caused it because you recognize one of the 4 conditions above.