The AIRR paradigm is a comprehensive approach to investment evaluation. It is invaluable for ex-ante applications, where assessment of future economic profitability is of paramount importance to investors and their managers. When used ex-post, AIRR provides performance measurement professionals with a methodology that is both theoretically rigorous and practically easy-to-use.
AIRR is a better MWRR metric than IRR because, unlike IRR:
- AIRR forces the analyst to choose a cost of capital, a thoughtful important exercise which should, of course, be mandatory whenever one computes a money-weighted rate of return, so as to know if the result was (ex-post)/or is expected to be (ex-ante) good enough.
- AIRR uses actual, or your best estimates of, periodic values of the investment, to produce an average of variable, periodic rates of return. Unknown to most practitioners, IRR’s rate of return is earned on implied, beginning-of-period values that could only be correct if the rate of return were constant across every period – the latter being a scenario which is unrealistic.
(a) Using IRR as one’s MWRR adds an unintended difference between TWRR and MWRR, i.e., differences in these beginning-of-period values. AIRR allows you to use the same interim beginning-of-period values for MWRR as you are using for TWRR so that, as intended, the only difference between TWRR and MWRR is how the periodic rates of returns are combined.
(b) AIRR thereby allows for risk analysis of its variable rates of return, whereas such is impossible with IRR’s constant rate of return assumption.
- AIRR always produces a unique solution, whereas IRR may have hidden solutions (or no solution).
- AIRR is computed using simple arithmetic and does not require some sort of computer-based optimization routine to try to solve it.
Dean Altshuler, Ph.D., CFA
Bard Consulting LLC