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by PANAGIOTIS AVRAMIDIS
P1 CF P2
P0
P1
P2
P0
(1)
CF
1
.
P1
(2)
P2 0.5 CF
.
P0 + 0.5 CF
1 0.5 Z 2 1
,
1 + 0.5 Z 0 1 Z1
(3)
= 0.
(4)
= 0.
Property 4 implies that the distance between the approximated and the actual geometric mean eventually shrinks
to zero, while Property 5 shows that Property 4 holds
even if the impact of the error takes infinitely large values.
This result signifies that using an approximation for a single period does not affect the measure of mean return rate
as long as a sufficient number of periods are considered.
Nonetheless, firms rarely use an approximation for
only a single period. Moreover, for such an approximation
to be valid, a large number of periods may be required.
For a fixed term, increasing n is equivalent to adopting
smaller time intervals (periods), which essentially means
that the analyst is calculating portfolio returns at the time
of every cash flow, so an approximation method is no longer needed. Property 4 could be useful, however, in evaluating the long-term mean of portfolios with frequent
intraday cash transactions (and several multiple periods).
Lets now assume that k represents the number of
periods that are approximated by using the original Dietz
method and that the margin of error is fixed and equal
to the factor 1 + b. The actual position of the approximated period is irrelevant to the final outcome, and for
1 0.5 Z 2 1 (7)
= GX
1 .
1 + 0.5 Z 0 1 Z1
Equation 7 implies that the distance of the approximated from the actual mean return rate is proportional
to the weights of the cash flow relative to the initial value
(Z0), intermediate value (Z1), and end value (Z2) of the
portfolio, factored by the actual geometric mean value.
Table 1 summarizes the theoretical values of the approximation error when GX = 1 as calculated from Equation 7 for
cash flow weights Zs and grid points 1%, 5%, and 10%.
The lowest error, 0.01%, is produced when each of
the three relative cash flow weights equals 1%, and the
highest error, 10%, is produced when the cash flow is
10% of the portfolio value right after its occurrence and
1% of the beginning and end values. Furthermore, when
all cash flow weights are equal, the error is minimized
even for large cash flow weights. In general, the higher
the distance of relative weight Z1 from weights Z0 and
Z2, the larger the approximation error.
Table 1: Theoretical Values of G X G X Based on Equation 7 for a Range of Cash Flow Weights
Z0
1%
5
10
1
5
10
1
5
10
Z1
1%
1
1
5
5
5
10
10
10
Z2
1%
1
1
1
1
1
1
1
1
Approx. Error
0.01%
1.95
4.28
4.22
2.18
0.25
10.01
7.86
5.29
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Z0
1%
5
10
1
5
10
1
5
10
Z1
1%
1
1
5
5
5
10
10
10
Z2
5%
5
5
5
5
5
5
5
5
Approx. Error
2.01%
3.92
6.20
2.12
0.13
2.26
7.79
5.69
3.17
Z0
1%
5
10
1
5
10
1
5
10
Z1
1%
1
1
5
5
5
10
10
10
Z2
10%
10
10
10
10
10
10
10
10
Approx. Error
4.52%
6.38
8.61
0.50
2.44
4.76
5.03
2.98
0.53
So, we can conclude that the original Dietz approximation may produce sufficiently accurate mean estimates
for performance measurement if cash flows are relatively
small (<1%) in relation to portfolio value or if the portfolio value is fairly stable (low portfolio volatility), which
will ensure that the relative weights of the cash flow will
be close. In either of these circumstances, firms could use
the approximation instead of evaluating the portfolio at
the time of each cash flow without jeopardizing mean
performance representation. In contrast, the higher the
portfolio volatility, the more likely that the approximation error will be large because of the deviation of weight
Z1 from weights Z0 and Z2.
NUMERICAL APPLICATIONS
To see how the approximation method might be applied,
we will let 1 Ri < denote daily portfolio returns, and
we define Yi = ln(1 + Ri). Then, < Yi < . Through the
restriction in Ri, we assume that the maximum amount
that can be lost is the entire capital. Thus, the minimum
return is 100%. (This restriction exempts from our
analysis leveraged portfolios, for which the total loss may
exceed the initial capital.) If we assume that Yi follows a
normal distribution, with mean and standard deviation
, then the transformed Xi = exp(Yi) = 1 + Ri follows a lognormal distribution, with X = e+2/2 and X = X (e2 1).
Initially, we will simulate the daily return rates of an
equity portfolio, so according to Brown and Warner (1985),
we assume that is 0 and is 2%. Because the geometric
mean of the lognormal distribution of X is e (see Limpert,
Stahel, and Abbt 2001), we conclude that GX = 1. The weights
of the cash flows Z0, Z1 and Z2 range over five grid points (1%,
5%, 10%, 15%, and 20%), yielding a total of 125 scenarios.
Table 2 shows that for a single approximated period,
k = 1, and total periods n = 10, the average approximation error is 0.78% with a standard deviation of 0.529%.
As expected, the error shrinks to zero when the number
of periods increases. If we use an approximation for multiple periods, k = 5, the error continues to shrink to zero
as we increase n (although at a lower rate than for a single
period). If all periods are approximated, k = n, the average approximation rises to 7.65%, the 25% largest errors
exceed 11.44%, and the approximation error remains
almost unaffected by the number of periods.
Individual scenarios in Table 3 (for n = 10) are more
conclusive as to the effect of cash flow size on the approximation. The most influential factor is the size of the cash
flow relative to the value of the portfolio right after the
time of cash flow occurrence, Z1. Overall, higher approximation errors are linked to greater distance between the
cash flow weight, Z1, and the cash flow weights relative to
the beginning and ending portfolio values. Inversely, low
or moderate but equal cash flow weights (Z0 = Z1 = Z2)
yield lower approximation errors. The rank in Table 3 is
robust to the number of approximated periods, k, as well
as the number of periods, n.
Next, we consider the impact on the approximation
error of an increase in the duration of the period from
daily to annual. Table 4 summarizes the average numerical approximation errors for = 0% and = 2% (daily
return rates) and = 15% and 30% (annual return rates).2
As Table 4 shows, the average error for a single period,
k = 1, increases from 0.78% for daily return rates to 0.95%
for annual return rates. When approximation is applied
over all periods, k = n, the average error increases from
7.65% to 9.75% as the duration of the period changes
from daily to annual.
Consequently, higher expected returns yield larger
approximation errors, which is consistent with the
theoretical findings (the approximation error is exponentially dependent on expected return , GX = e). The
impact of volatility on error is not significant. Overall,
the conclusion is that longer durations of the underlying
periods yield, on average, higher approximation errors.
Multiple Periods (k = 5)
All Periods (k = n)
Statistic
n = 10
n = 100
n = 1,000
n = 10
n = 100
n = 1,000
n = 10
n = 100
n = 1,000
Mean
0.780%
0.078%
0.008%
3.82%
0.40%
0.04%
7.65%
7.98%
7.99%
St dev
0.529
0.053
0.005
2.61
0.27
0.03
5.32
5.55
5.56
Q3
1.199
0.121
0.012
5.76
0.61
0.06
11.44
11.93
11.95
Max
2.259
0.224
0.022
11.54
1.15
0.11
24.31
25.36
25.41
Table 3: Relative Cash Flow Weights That Yield the Top Five and Lowest Five Errors for n = 10
G X G X
Single Period (k = 1)
Z0
Z1
Z2
G X G X
All Periods (k = n)
Z0
Z1
Z2
2.26%
1%
20%
1%
24.31%
1%
20%
1%
2.01
20
21.38
20
2.00
20
21.28
20
1.76
20
20
18.60
10
20
1.75
10
20
18.43
20
10%
10%
10%
0.001
10
20
104
10
106
0.005
0.028%
0.013
10%
10%
10%
0.059
10
20
0.030
10
0.619%
0.178
0%
15%
Single Period (k = 1)
Multiple Periods(k = 5)
All Periods (k = n)
= 2%
= 30%
= 2%
= 30%
= 2%
= 30%
0.78%
0.79%
3.82%
3.80%
7.65%
7.59%
0.91%
0.95%
4.33%
4.15%
9.26%
9.75%
CONCLUSION
Numerical and theoretical findings seem to back the recommendation for evaluation of actual rates of return at the time
of every external cash flow. For a small number of periods
and external cash flows of the magnitude of >1% of the portfolio value, approximation entails a high chance of significant
misrepresentation of mean performanceespecially when
all the periods are approximated. The conditions in which
the requirement that actual rates of return be evaluated upon
every external cash flow can be waived are as follows: low
external cash flow (<1% of portfolio value) or low portfolio
volatility. In both cases, however, a sufficient number of periods must exist. A large number of periods and low portfolio
volatility create a high frequency of evaluations, which effectively annuls the usefulness of approximation. Furthermore,
increasing the duration of the periods being examined yields
higher approximation errors via higher mean portfolio values.
4 WWW.CFAINSTITUTE.ORG
END NOTES
1. Contributions to the portfolio are positive flows, CF > 0, and withdrawals or distributions are negative flows, CF < 0.
2. Following Brown and Warner (1985), the annual mean rate is 250
0.06% = 15% and the annual volatility (using the number of traded
days per year) is
250 2% 30% .
REFERENCES
Brown, Stephen J., and Jerold B. Warner. 1985.
Using Daily Stock Returns: The Case of Event
Studies. Journal of Financial Economics, vol. 14, no. 1
(March):331.
CFA Institute. 2012. Global Investment Performance
Standards Handbook, 3rd ed. Charlottesville, VA:
CFA Institute.
Limpert, Eckhard, Werner A. Stahel, and Markus
Abbt. 2001. Log-Normal Distributions across the
Sciences: Keys and Clues. Bioscience, vol. 51, no. 5
(May):341352.
Panagiotis Avramidis is adjunct assistant professor of finance and
quantitative methods at ALBA Graduate Business School at the
American College of Greece.