Page 322 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 13: Portfolio Performance Evaluation

Step 3: Portfolio Return Notes
v 1 v 0
=
v
0
6,000 50,000
= = 52%
50,000
Performance measurement becomes different when a client adds or withdraws money from the
portfolio. The percentage change in the market value of the portfolio as computed above may
not be an accurate measurement of the portfolio’s return in that case. For example, if the beginning
value of the portfolio is 50,000 and the value at the end of October is 70,000 and the client
deposits 30,000 in cash in early November, the value at the end of the year would be
1,00,000. The portfolio return in this case will be:
(1,00,000 – 50,000)/50,000 = 100%
However, the entire return was not due to the actions of the investment manager. A more
accurate measure would be:
(1,00,000 – 30,000) – 50,000/50,000 = 40%
In the event of a deposit or a withdrawal occurring just after the start of the period, the return on
the portfolio should be calculated by adjusting the beginning market value of the portfolio.
In the case of a deposit, the beginning value would be increased by the deposit amount and in
the case of withdrawal, the beginning value would be decreased by the amount.
When deposits or withdrawals occur in the middle of the period, either the dollar-weighted
return (rupee-weighted return) or the time-weighted return should be used. The choice of method
will depend on the performance evaluation objectives. If the performance of the fund is being
evaluated, dollar-weighted return would be appropriate as it provides the return from the
perspective of the client, if the investment manager’s decisions are being evaluated, the time-
weighted return would be appropriate as it would exclude the effect of the client’s cash flow
decisions. Let us explain these methods now.
The calculation of portfolio return becomes complicated when there exist certain additions or
withdrawals into the funds during the specific evaluating period. Further, when there exist
intermediate cash flows that may be due to dividend declarations by some companies and when
such cash flows are reinvested into the units of the given mutual fund, the calculation of portfolio
return becomes complicated. The following methods are used to calculate the portfolio return
during such situations.
1. Dollar-Weighted Rate of Return
2. Time-Weighted Rate of Return
3. Unit-Value Rate of Return

Dollar-Weight Rate of Return

The internal rate of return that equates the initial contribution and the cash flows that occur
during the period with the ending value of the fund is the dollar-weighted rate of return.
Mathematically, this measure of return is the dollar-weighted average of sub-period returns
with the dollar weights equal to the sum of the initial contribution and all the cash flows up to
the time of the sub-period return.

Example: A portfolio has a market value of 100 lakh. In the middle of the quarter, the
client deposits 5 lakh and at the end of the quarter the value of the portfolio is 103 lakh. What
is the dollar weighted return?

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