Returns on individual assets

Holding Period Return

Pt +1 - Pt + Payoffst +1
rt +1 =
Pt
where:
rt+1: Holding Period Return, HPR (over the period from t to t+1)
HP: Holding period (= time between t and t+1)
Pt+1: Ending price
Pt: Beginning price
Payoffst+1: Payments (e.g., coupons or dividends) made during the HP
 Returns on individual assets
Time aggregation of returns
Holding period returns are not time additive
The holding period return computed over many periods is not equal
to the sum of the holding period returns on each sub-period, that is
(assuming two periods and no dividends):
rt +2 ≠ rt +1 + rt +1,t +2
where: • rt+2 = holding period return over the period t, t+2
• rt+1 = holding period return over the period t, t+1
• rt+1,t+2 = holding period return over the period t+1, t+2

In fact, it can be written:

Pt +2 - Pt Pt +2 - Pt +1 Pt +1 Pt +1 - Pt Pt +1
rt +2 = = × + = rt +1,t +2 × + rt +1
Pt Pt +1 Pt Pt Pt
 Returns on individual assets
Returns on investments in foreign currencies
Cleaning asset returns from ForEx returns
Example: The asset is denominated in USD, the investor is European
USD €
Time iUSD/€ i€/USD
Asset price
t 1.3 0.769 10 7.69
t+1 1.2 0.833 13 10.83
rt 0.083 0.3 0.408
Which is the return for a European investor (r€) over the t, t+1 period?
(1+r€) = (1+ri€ /USD) × (1+rUSD) Note that this formula
involves the multiplication
of two gross returns

In the example: (1+r€) = (1+0.083) × (1+0.3) = 1.408

r€ = 1.408 -1 = 0.408
 From returns on individual assets to returns on portfolios and indices

Returns on portfolios
An important feature of these formulas is that they can be
extended from individual assets to portfolios
The following feature holds:
the return of a portfolio is equal to the “portfolio” of the
returns
A portfolio is defined as a set of weights (ωi) for each of its N assets,
N
with åω
i =1
i =1
Then, the return on a portfolio (rtP) of N assets with rti returns is
N
r = å rti ωi
t
P

i =1
 From returns on individual assets to returns on portfolios and indices

Returns on market indices

Market indices are a special case of portfolio
• Problem: You have a bunch of assets in your “universe”, how do you measure how
the entire group does?
Answer: Measure the performance of a portfolio of the assets
• Uses
– Tracking average returns (of market, sectors, industries, etc.)
– Comparing performance of managers (indices as benchmarks)
– Being the underlying reference of derivatives
• Three steps:
– Selection of assets (which assets in the index?)
– Definition of the relevant return components (price or total return?)
– Choice of the weighting scheme (how are assets weighted?)
 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Three steps
Formal definitions for the index return
1. Identification of the N assets in the index (i = 1, 2, … , N)
2. Definition of the relevant assets’ return
Pit1 - Pit0 + Payoffsit 1
Asset i return : ri = where Pit = price of asset i in time t
0
Pit Payoffsi = payoffs of asset i in time t
t

3. Definition of the assets’ weights ωi

N
Index return : rP = ∑i =1 ωi × ri
 From returns on individual assets to returns
on portfolios and indices
Constructing market indices
• Selection of assets
• Dow Jones Industrial Average (DJIA)

Also: Country-, Region-, Sector-,

Industry-, Currency-based, and
– Index of 30 largest US stocks
• S&P 500

Investment style Indices

– Index of 500 large US stocks (in term of market capitalization) selected by Standard and Poor’s
• NASDAQ Composite
indices
Stock

– Index of the stocks listed on the NASDAQ stock market (over 3,000 components)
• Russell 1000
– Index of 1.000 largest US stocks selected by FTSE-Russell
• MSCI US Investable Market 2500
– Index of 2,500 US stocks (98% of the capitalization of the US equity market) selected by MSCI
• CAC 40
– Index of 40 most significant stocks (in term of market capitalization) on the Paris Bourse
• Shanghai Stock Exchange (SSE) Composite Index
(…)

• Bloomberg Barclays Indices

indices

• Bank of America Merrill Lynch Indices

Bond

• Citigroup Fixed Income Index LLC (formerly known as Salomon Brothers Indices)
• Ibbotson and Associates Indices
• (…)
From returns on individual assets to returns
on portfolios and indices
Constructing market indices
• Definition of the relevant assets’ return:
Price indices vs Total return indices
• Price indices
• Consider changes in prices only and do not consider payoffs such as dividends or coupons
• Most of stock indices are typically price indices (some corrections, using adequate dividend yield
indices, would be necessary to get a truly rate of return)
Pit1 - Pit0
Asset i return : ri =
Pit0
• Total return indices
• Include intermediate payoffs as well as capital gains (by making some assumptions about the payoff
reinvestment)
• The major bond indices are total return indices

Pit1 - Pit0 + Payoffsit1

Asset i return : ri =
Pit0
 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Choice of the weighting scheme
Formal definitions for the index return
1. Identification of the N assets in the index (i = 1, 2, … , N)
2. Definition of the relevant assets’ return
Pit1 - Pit0 + Payoffsit0
Asset i return : ri = where Pit = price of asset i in time t
0
Pit Payoffsi = payoffs of asset i in time t
t

3. Definition of the assets’ weights ωi

N
Index return : rP = ∑i =1 ωi × ri

Price-weighted Value-weighted Equally-weighted

P Market Capi 1
ωi = Ni ωi = N ωi =
N
∑j=1 Pj ∑j=1Market Cap j
 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Price-weighted indices
The first step requires the construction of the index series (i.e., a number that represents the value of the index at any point of time)

Here the index series is the average of the stocks’ prices in the index
It is calculated by adding together each stock price and dividing the total by the number of stocks in the series*

The second step consists into the index return computation over a certain period t, t+1:

Price-weighted series = Sum of stock prices

# of stocks in the index

Index seriest+1 - Index seriest

Index return =
Index seriest

* Note that dividing by the number of stocks, at the very first step, it is not strictly necessary. The index return would be the same even
without a denominator. The denominator, however, becomes necessary to adjust the numerator in case of stock splits
 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Price-weighted indices
Example:
Given the following series data, calculate the return over the Dec 31, 2020-Dec 31, 2021
As of Dec 31, 2020 As of Dec 31, 2021
Stock Share price Shares O/S Market cap Share price Shares O/S Market cap
A €15 2,000 30,000 €10 2,000 20,000
B €25 5,000 125,000 €30 5,000 150,000
C €40 3,000 120,000 €40 3,000 120,000
D €80 1,000 80,000 €100 1,000 120,000
Total €160 11,000 355,000 €180 11,000 390,000

Price-weighted index31dec20 = 15+25+40+80

= 40
4
10+30+40+100
Price-weighted index31dec21 = = 45
4

Price-weighted return2021 = 12.5%

 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Value-weighted (or capitalization- or cap-weighted) indices
The first step requires the construction of the index series (i.e., a number that represents the
value of the index at any point of time)

Here, the index series is the market value (stock price multiplied by shares outstanding) of
all the companies in the index
As this number would be very big, it is usually normalized to a Base index value (e.g., to
100) when the index is created
In this case, the market value the day of the creation of the index is said Base market cap

Therefore, the index series at any other point of time t will be equal to
Mkt capt
Value-weighted Index seriest = × Base index value
Base Mkt cap

The second step consists into the index return computation over a certain period t, t+1:
Index seriest+1 - Index seriest
Index return =
Index seriest
 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Value-weighted (or capitalization- or cap-weighted) indices
Example:
Given the following series data, calculate the return over the Dec 31, 2020-Dec 31, 2021
As of Dec 31, 2020 As of Dec 31, 2021
Stock Share price Shares O/S Market cap Share price Shares O/S Market cap
A €15 2,000 30,000 €10 2,000 20,000
B €25 5,000 125,000 €30 5,000 150,000
C €40 3,000 120,000 €40 3,000 120,000
D €80 1,000 80,000 €100 1,000 120,000
Total €160 11,000 355,000 €180 11,000 390,000

Base period = 31dec2020; Base index value =100 (= Value-weighted index31dec18)

Note that the choice of the base index

Base mkt cap = 355,000; Current mkt cap = 390,000 value is just a convention and serves to
make easier comparisons with previous
390,000 index values
Value-weighted index31dec21 =
355,000 ×100 = 109.85 In fact, the index return can be computed
by comparing the mkt cap of the stocks in
two subsequent periods
Value-weighted return2021 = (109.85/100)-1 = 9.85% In this example: [(390th-355th)/355th]
 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Equally-weighted indices
It requires the computation of the returns of all the assets in the index and the index return
is their arithmetic average
Example:
Given the following series data, calculate the return over the Dec 31, 2020-Dec 31, 2021
As of Dec 31, 2020 As of Dec 31, 2021
Stock Share price Shares O/S Market cap Share price Shares O/S Market cap
A €15 2,000 30,000 €10 2,000 20,000
B €25 5,000 125,000 €30 5,000 150,000
C €40 3,000 120,000 €40 3,000 120,000
D €80 1,000 80,000 €100 1,000 120,000
Total €160 11,000 355,000 €180 11,000 390,000
10-15 30-25
StockA return2021 = StockB return2021 =
15 = -0.33 25 = 0.20
40-40 100-80
StockC return2021 = StockD return2021 = = 0.25
40 = 0.00 80
-0.33+0.2+0+0.25
Equally-weighted return2019 (arithmetic average)= = 2.91%
4
From returns on individual assets to returns
on portfolios and indices
Constructing market indices
• Choice of the weighting scheme
• Price-weighted
• DJIA
• Nikkei 225

• Value-weighted
• S&P500
• NASDAQ Composite
• Russell 1000
• MSCI US Investable Market 2500
• CAC 40
• Shanghai Stock Exchange (SSE) Composite Index
• Merrill Lynch Indices
• Salomon Brothers Indices

• Equally-weighted
• Value Line Composite Index
 From returns on individual assets to returns on
portfolios and indices
Constructing market indices
• Choice of the weighting scheme
• Price-weighted
It gives higher priced stocks more weight
The denominator of the price weighted series is the number of stocks with the sum of the stock prices as the numerator
Problems occur when a stock split takes place: the numerator changes to reflect the new stock price and the denominator
needs to be adjusted to reflect the stock change

• Value-weighted
Large market cap stocks have a greater effect on the market weighted series relative to small market cap stocks

• Equally-weighted
Such an index (computed as a simple average of returns) assumes that the portfolio of assets is continuously rebalanced:
changes in the value of the invested assets will change their weights in the portfolio, therefore, you need to have
rebalancing to have equal investments in each asset
 Performance returns on an investment fund

Investor’s vs manager’s perspective

Calculating returns for an asset or a portfolio is simple, but it becomes more complex
when it involves investment funds (e.g., open-end mutual funds) with variable capital,
where investors can enter (with cash inflows or contributions) or leave (with cash
outflows or withdrawals) throughout the investment period
In such a case, one might be interested in the returns that measure the performance
of the investment fund from the perspective of the investor or the portfolio manager’s
which do not necessarily coincide
In fact,
• returns measuring the performance of the investment fund from the investor’s
perspective would depend also on the investor’s decisions to invest/divest in the
fund
• returns measuring the performance of the portfolio manager should not account for
investors’ decisions (i.e., external cash flows), as that are out of the control of the
portfolio manager
 Performance returns on an investment fund

Investor’s vs manager’s perspective

Consequently, there are different methods of measuring the returns on an investment
fund
Among them:

The Money-Weighted Rate of Return (MWRoR) [or Dollar-Weighted RoR] measures the
performance of individual investor as it depends (also) on her decisions to
invest/divest in the fund

The Time-Weighted Rate of Return (TWRoR) measures the performance of the

portfolio manager as it excludes the impact of the individual investors’ decisions since
they are out of the control of the portfolio manager
 Performance returns on an investment fund

MWRoR vs TWRoR
Example
On December 2020 two investors, Mr Grey and Ms Green, bought 100 units of the
NOCS mutual fund
They both made two additional purchases during the year of 100 units each
but at different times (Mr Grey did it in May and Aug and Ms Green in Apr and Sept)
and at different prices (the fund’s NAVs at these periods)
NOCS mutual fund’s end-of-month NAVs in 2021 where the following
Mr Grey purchases
16 additional 100 units
15
15
14
14
Both purchase
13 100 units
12 12

11 11
11 11 10
10 10,5 9
10
9
9 9
8 Ms Green purchases
8 additional 100 units
7
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
 Performance returns on an investment fund

MWRoR vs TWRoR
Example In spite they bought the same number (300) of units of NOCS
Month
Fund’s Mr Grey’s Ms Green’s mutual fund, Mr Grey’s and Ms Green’s total investments
NAV CFs CFs
Dec 10 1000 1000
were different
Jan 10.5
Feb 11 The final market value of their investments is the same (as
Mar 12 they hold the same number of units)
Apr 8 800
May 14 1400
Jun 9 Because of the different timing of their investments, Mr Grey
Jul 11 reported a paper loss of € 600, while Ms Green a paper gain of
Aug 15 1500 € 600
Sep 9 900
Oct 10
Nov 9
Dec 11 They invested in the same mutual fund, managed by the same
investment management company, that operated the same
Total investment 3900 2700
Final Market Value (FMV) 3300 3300
way for all its investors
Gain/Loss -600 600
We may want two different measures of return that capture
the two performances: investors’ and portfolio manager’s
 Performance returns on an investment fund

MWRoR
It captures the individual investor’s performance
It is similar to an internal rate of return (IRR), in fact it is the discount rate on which
the NPV = 0 (or: present value of inflows = present value of outflows)
In an investment portfolio (from the investor’s point of view):

Outflows: 1. Final market value

2. Investor’s withdrawals
Inflows: 1. Beginning market value
2. Investor’s contributions
 Performance returns on an investment fund

MWRoR
Example
In our example:
Outflows: • Final market value (3,300 for both the investors)

Inflows: • Beginning market value (1,000 for both the investors)

• Investor’s contributions (1,400 and 1,500 for Mr Gray; 800 and 900 for Ms
Green)
If these cash flows are adequately discounted, the following IRRs can be obtained :

Investor MWRoR
Mr Grey -24,86%
Ms Green +35,16%
 Performance returns on an investment fund

TWRoR
It captures the portfolio manager’s performance
It should be driven by the fund’s NAV (as it is not affected by redemptions or additions
of units – see Section 01), or – if based on the fund value – the effects of
redemptions/additions of units should be “cleaned”
It is essentially a geometric mean of a number of holding-period returns that are
linked together or compounded over time (thus, time-weighted), with each holding-
period return (HPRt) being computed using this formula:
MVt - MVt -1 - CFt -1
HPRt =
MVt -1 + CFt -1
where: MVt-1 = beginning market value; MVt = ending market value
CFt = investors’ cash flows (positive if contributions, negative is withdrawals)
The total period of length T during which capital movements occur on dates t is broken into many sub-
periods, with a sub-period ending (and portfolio priced) on any date t with significant contribution or
withdrawal activity, or at the end of the month/quarter/etc. (i.e., whenever the market value of the fund is
disclosed)
Sub-periods can cover any length of time chosen by the manager and need not be uniform
 Performance returns on an investment fund

TWRoR
Compounded TWRoR, for n holding periods is then computed using the formula:

Compounded TWRoR = [(1 + HPR1)×(1 + HPR2) ×(1 + HPR3) × ... ×(1 + HPRn)] - 1

The compounded rate of return can refer to any period (depending on the length of
the n holding periods used to compute it)
The annualized TWRoR takes the compounded rate and standardizes it using an
Effective Annual Return-like rule, i.e.:

Annualized TWRoR = (1 + Compounded TWRoR)1/T – 1

where: T = total time in years

 Performance returns on an investment fund

TWRoR
Example
Looking at the investment fund’s NAV: The holding period (here: one year)
Month NAV HP return Gross return
return looking at the mutual fund’s
Dec 10 - - NAV is 10% = (11-10)/10
Jan 10.5 5.00% 1.0500
Feb 11 4.76% 1.0476
Mar 12 9.09% 1.0909
Apr 8 -33.33% 0.6667
May 14 75.00% 1.7500
Jun 9 -35.71% 0.6429
Jul 11 22.22% 1.2222
Aug 15 36.36% 1.3636
Sep 9 -40.00% 0.6000
Oct 10 11.11% 1.1111
Nov 9 -10.00% 0.9000
Dec 11 22.22% 1.2222
Same result if monthly holding period
Equivalent return 10%
NAV-based returns are compounded
over time
 Performance returns on an investment fund

TWRoR
Example
Looking at the investment fund’s values:
Mr GREY Ms GREEN
MVt CFt HPRt 1 + HPRt MVt CFt HPRt 1 + HPRt Similarly, the TWRoR for
Dec 1000
0.05 1.05
1000
0.05 1.05
the two investors is 10%
Jan 1050 1050
0.047619 1.047619 0.047619 1.047619
Feb 1100 1100
0.0909091 1.0909091 0.0909091 1.0909091
Mar 1200 1200
-0.333333 0.6666667 -0.333333 0.6666667
Apr 800 800 800
0.75 1.75 0.75 1.75
May 1400 1400 2800
-0.357143 0.6428571 -0.357143 0.6428571
Jun 1800 1800
0.2222222 1.2222222 0.2222222 1.2222222
Jul 2200 2200
0.3636364 1.3636364 0.3636364 1.3636364
Aug 3000 1500 3000
-0.4 0.6 -0.4 0.6
Sep 2700 1800 900
0.1111111 1.1111111 0.1111111 1.1111111
Oct 3000 3000
-0.1 0.9 -0.1 0.9
Nov 2700 2700
0.2222222 1.2222222 0.2222222 1.2222222
Dec 3300 3300
Product 1.1 Product 1.1

TWRoR = 1,1-1=10%