Back-to-Basics: Measuring Portfolio Performance

Teri Geske
Senior Vice President, Product Development

Imagine you have $100,000 to invest. You place 50% of the money in Fund A and 50% in Fund B. Over the next three months, the Fund A account returns 10% and Fund B returns 5%, so your wealth at the end of the period is ($50,000 x 1.10) + ($50,000 x 1.05) = $107,500, for a 7.50% return. Since Fund A did so well relative to Fund B, you decide to reallocate your wealth. You withdraw $41,750 from Fund B (leaving only $10,750), invest $20,250 of this amount in Fund A and keep the remainder in cash. Over the next three months, Fund A returns 7% and Fund B returns 12%, so the sum of the value of the two funds at the end of the six months is: ($75,250 x 1.07) + ($10,750 x 1.12) = $92,557. How do you evaluate your total return for the entire 6 month period?

Two methods are commonly used to calculate returns, referred to as the Dollar-Weighted return and Time-Weighted return methods. Deciding which is more appropriate depends in part upon your perspective. The Dollar-Weighted return is the internal rate of return that equates the present value of the cash flows (inflows minus outflows) from all of the individual periods plus the ending market value of the portfolio to the portfolio's beginning market value. As an investor evaluating your overall return for a period of time, you would probably want to incorporate the effect of your asset allocation decisions, plus contributions and withdrawals, on the total return calculation; this is done using the Dollar-Weighted method. In this example, the Dollar-Weighted return is 7.55%, i.e. the internal rate of return which equates the present value of receiving $21,500 (the cash withdrawal) after the first period and $92,557 (the ending wealth) at the end of the second period, based on an initial investment of $100,000.

However, when you want to evaluate different investment managers relative to each other, the Time-Weighted technique must be used to avoid penalizing individual managers for the timing of cash inflows and outflows that are beyond their control. A Time-Weighted return measures the compounded rate of growth of the portfolio market value during the period and is also referred to as the geometric return, since it is computed by taking the geometric average of the individual period returns. AIMR presentation standards require the use of the Time-Weighted return method, with valuation on at least a quarterly basis. In this example, Fund A had a Time-Weighted return of (1.10)(1.07)^1/2 - 1 = 8.49%, and Fund B had a time-weighted return of (1.05)(1.12)^1/2 - 1 = 8.44% - only 5 bps apart. Using the Dollar-Weighted approach, Fund A would show a return of 4.14, while Fund B's return would be 6.18%, causing us to conclude that Fund B was much better than Fund A over the entire period, when in fact the change in allocation and withdrawals caused the difference in the return numbers.

The Performance Measurement system in BondEdge computes Time-Weighted portfolio returns, geometrically linking monthly returns to compute performance over the selected period of time (e.g. a quarter, a year, or many years). Each time a Daily Database Update is done, BondEdge will record performance information for the portfolios you select, computing the total return from the previous date (e.g. a few days ago). Intra-month return calculations are most accurate if your portfolio positions are updated regularly (at least once a week). We also provide returns for each sector in your portfolio, and supply performance statistics on a variety of benchmark indices. If you would like more information on how to use Performance Measurement in BondEdge, please contact your Interactive Data Fixed Income Analytics representative.