How to determine the return on your portfolio?

on Jan 27, 2013 in Home, Portfolio ad hoc | 2,579 comments

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In an ideal world, you would be updated semi-annually or annually with your portfolio’s performance, enabling you to compare it to the appropriate benchmarks. In reality, some asset managers may not provide you with the accurate figure! As a matter of fact, deciding on which return measurements should be used is a key element to evaluate the true performance of your portfolio.

Below are two of the most commonly calculated return methodologies, which will be discussed in detail. If you want to measure your asset manager success as a decision-maker, meaning how well did his selection of assets perform relative to a benchmark portfolio, use the time-weighted return methodology. On the other hand, if you want to determine how well your invested assets performed, meaning how much your money earned for you during the year, I would suggest you to use the money-weighted return methodology.

An investment fund for instance uses the money-weighted return methodology. Mainly because the timing of cash flows into and out of the fund will have an impact on fund performance. Asset managers, on the other hand, are required to use time-weighted return when reporting their performance. Simply because a prospective client or yourself need a measure of the decision-making ability of the manager that excludes the effect of cash inflows and outflows that are beyond the manager’s control.

The money-weighted return can differ substantially from the time-weighted return largely on a combination of the following three variables: The timing of the cash flows, the size of the cash flows and the volatility of the portfolio’s market value. The main difference between the two is that time-weighted return ignores the effect of cash inflows and outflows, whereas money-weighted return incorporates the size and timing of cash flows.

The money-weighted return internalizes both the timing and size of external cash flows (such as deposits and withdrawals), whereas time-weighted return allows different sub-periods to have different returns. In most cases at portfolio level the time-weighted return methodology is the most appropriate to measure portfolio performance. Primarily to allow comparison between asset managers with different cash flow history. Ask yourself the question, would the investment decisions, asset allocation and investment selections been different, had a different amount of money been available. Almost certainly not!