Performance Measurement and Evaluation 7 1

PERFORMANCE MEASUREMENT AND

EVALUATION

Calculating Returns: Different Rate of Return

Formulae = Different Results
David Spaulding
Journal of Performance Measurement
vol. 5, no. 4 (Summer 2001):2531
The author shows why different methods of calculating returns
produce dramatically different results. He identifies several
formulas that are considered approximation methods and
other formulas that are believed to provide more accurate
results. He compares and contrasts these methods and
describes why the industry is moving to daily returns.

Since the mid-1980s, multiple ways of calculating rate of return have

emerged. Some of the methods are classified as approximation
methods, which are convenient and simple to use but can produce
sizable rate-of-return differences compared with other methods in the
presence of portfolio cash flows. In the past, the only choice was the
approximation formulas because technology did not allow for frequent valuations of the portfolio at each cash flow.
The author uses an example to illustrate the results of the various
approximation methods. The first method discussed is the midpoint
Dietz method. This method assumes that all the cash flows occur at
the midpoint of the period. The advantage is that the calculations for
this method are simple; the disadvantage is that it is most appropriate
for periods of a month or less and when cash flows are relatively small.
A cash flow that is less than 10 percent of the starting market value
is considered small in this context.

David Spaulding is with the Spaulding Group, Inc. The summary was prepared
by Frederick J. Cornelius, CFA, Burt Associates, Inc.
a i m rp u b s .org

72 The CFA Digest M a y 2 0 0 2

A slightly improved version of this method is the day-weighted, or

modified Dietz, method. This method adjusts the cash flow by a
factor that corresponds to the amount of time between the cash flow
and the beginning of the period. Peter O. Dietz, the developer of both
the midpoint and day-weighted methods, believes the day-weighted
method to be a more accurate gauge of performance.
In order to further improve accuracy, the market value at the time of
each cash flow must be calculated. Revaluing the portfolio for each
cash flow provides the most accurate measure, known as the true timeweighted return (TWR). The TWR methodology is considered to be
the most appropriate measure to evaluate the performance of a
portfolio manager because it is based on the level of assets under his
or her control. Indeed, AIMR and the Global Investment Performance Standards (GIPS) recommend revaluing portfolios each
time a cash flow occurs. But even the TWR method can provide
distortions depending on the assumption of when the cash flow was
received (i.e., start, middle, or end of the day). The author illustrates
the problem by varying only the timing of a very large cash flow (five
times the original portfolio value, received on the fifth of the month).
The resulting return calculation under the three assumptions produces results that vary from a low of 7.11 percent to a high of 32.47
percent. The author concludes that the same methodology can produce distorted results, depending on the cash flow convention used.
Prompted by AIMR GIPS standards, the industry will be required
to use daily returns in 2005. The author states that firms should make
sure their software is flexible, allowing for both start- and end-of-day
methods. The author concludes that the key is to select an appropriate
method and apply this method consistently unless specific circumstances dictate otherwise.
Keywords: Performance Measurement and Evaluation: performance measurement

2002, A I M R