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The Mathematics of Portfolio Return

The document discusses various methods for calculating portfolio returns, including: 1) Simple return, which expresses the change in wealth as a ratio of the end value to start value. 2) Money-weighted returns, which accounts for external cash flows and assumes each dollar invested achieves the same effective return. 3) Modified internal rate of return (IRR), which is a money-weighted method that calculates the "annual" internal rate of return for a given time period using a formula that applies a time-weighting factor to external cash flows.

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65 views

The Mathematics of Portfolio Return

The document discusses various methods for calculating portfolio returns, including: 1) Simple return, which expresses the change in wealth as a ratio of the end value to start value. 2) Money-weighted returns, which accounts for external cash flows and assumes each dollar invested achieves the same effective return. 3) Modified internal rate of return (IRR), which is a money-weighted method that calculates the "annual" internal rate of return for a given time period using a formula that applies a time-weighting factor to external cash flows.

Uploaded by

Vu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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2.

The Mathematics of Portfolio Return


2.1 Simple return :

- This change in wealth can be expressed either as a wealth ratio or a rate of return. The wealth
ratio describes the ratio of the end value of the portfolio relative to the start value, mathematically:

- Money weighted returns : Unfortunately, in the event of external cash flows we cannot continue
to use the ratio of market values to calculate wealth ratios and hence rates of return.

2.2 Modified internal rate of return


- IRR is an example of a money-weighted return methodology; each amount or dollar invested
is assumed to achieve the same effective rate of return irrespective of when it was invested. In
the US the term dollar-weighted rather than money-weighted is more often used.

To calculate the annual internal rate of return rather than the cumulative rate of return for the
entire period we need to solve for r the using following formula:

where:
Y = length of time period to be measured in years
Wty = factor to be applied to external cash flow on day t.
This factor is the time available for investment after the cash flow given by:

V d: assume cash flow occurs on the 236th day of the 3rd year for a total measurement period of 5
years. Then:

2.3 Simple Dietz

2.4 ICAA method

However, from the portfolio mangers viewpoint if this income is not available for reinvestment it should
be treated as a negative cash flow as follows:
2.4 Modified Dietz

2.5 Time weighted returns

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