Performance Calculations

101
Monday, October 19, 2009
Public Pension Financial Forum
John D. Simpson, CIPM
The Spaulding Group, Inc.
What well do today
Well cover a few basic formulas that are
used to calculate rates of return and risk

Nature is pleased with simplicity
Issac Newton, Principia
We will try to make this easy to comprehend
But, we have a fair amount to cover and
limited time
Feel free to ask questions
Rates of Return:
Time-weighting vs. Money-weighting
Time-weighted returns measure the
performance of the portfolio manager
Money-weighted returns measure the
performance of the fund or portfolio
Time-weighting
Time-weighting eliminates or reduces the
impact of cash flows
Because managers dont control the flows
Two general approaches:
Approximations, which approximate the exact,
true, time-weighted rate of return
Exact, true, time-weighted rate of return
Approximation methods
well discuss
Original Dietz
Modified Dietz
Modified BAI
(a.k.a. Modified IRR and Linked IRR)
What Are Cash Flows?
Two types:
External: impact the portfolio
Internal: impact securities, sectors
Specifics:
External: contributions/withdrawals of cash and/or
securities
Internal: buys/sells, interest/dividends, corporate actions
Visualizing Flows
Our Portfolio
Tech
Stocks
Bank
Stocks
Corporate
Bonds
Munis
Transfer
100 shares
Dell, Inc.
Withdraw
$1,000
Buy 100 shares BofA
External
Flows
GM Bond pays interest
Internal
Flows
The scenario we will use to
demonstrate the various formulas:
5/30 BMV 100,000
6/10 Cash Flow 20,000
6/30 EMV 123,000
Assumes constant rate of return on the portfolio
during the period
Very easy method to calculate
Provides approximation to the true rate of return
Returns can be distorted when large flows occur
Also, return doesnt take into account market
volatility, which further affects the accuracy
Weights each cash flow as if it occurred at the
middle of the time period
Original Dietz
Original Dietz
R
EMV BMV C
BMV C
OriginalDietz
=

+ 05 .
5/30 BMV 100,000
6/10 Cash Flow 20,000
6/30 EMV 123,000
R
OriginalDietz
=

+
=
123 000 100 000 20 000
100 000 05 20 000
273%
, , ,
, . ,
.
Modified Dietz Method
Assumes constant rate of return on the
portfolio during the period
Provides an improvement in the
approximation of true time-weighted rate of
return, versus the Original Dietz formula
Disadvantage greatest when: (a) 1 or more
large external cash flows; (b) cash flows
occur during periods of high market volatility
Weights each external cash flow by the
amount of time it is held in the portfolio
Modified Dietz Method
R
EMV BMV C
BMV W C
W
CD D
CD
W
CD D
CD
ModifiedDietz
EOD
SOD
=

+
=

=
+ 1
W
SOD
=
+
=
30 10 1
30
070 .
Modified Dietz Method
5/30 BMV 100,000
6/10 Cash Flow 20,000
6/30 EMV 123,000
R
EMV BMV C
BMV W C
ModifiedDietz
=

+
R
ModifiedDietz
=

+
=
123 000 100 000 20 000
100 000 070 20 000
263%
, , ,
, . ,
.
Determines internal rate of return for the period
Takes into account the exact timing of each
external cash flow
Market value at beginning of period is treated as
cash flow
Disadvantage: Requires iterative process solution
difficult to calculate manually
Modified BAI
(Modified IRR, Linked IRR)
Modified BAI Method
5/30 BMV 100,000
6/10 Cash Flow 20,000
6/30 EMV 123,000
( ) ( ) ( ) ( )
0
1 1 1 1
1 2
1 2
= +
+
+
+
+ +
+

+
InitialValue
CashFlow
r
CashFlow
r
CashFlow
r
Outflow
r
t t
n
t t
n end
...
( )
( )
0 100 000
20 000
1
123 000
1
0 30
= +
+

+
,
, ,
.
r
r
Modified BAI Method
( ) ( ) ( ) ( )
0
1 1 1 1
1 2
1 2
= +
+
+
+
+ +
+

+
InitialValue
CashFlow
r
CashFlow
r
CashFlow
r
Outflow
r
t t
n
t t
n end
...
2.63% (1.40)
2.62% (14.25)
2.64% 7.94
Solving for r through
iteration (trial & error)
R
ModifiedBAI
= 2 63% .
Value portfolio every time external flows occur
Advantage: calculates true time-weighted rate
of return
Disadvantage: requires precise valuation of the
portfolio on each day of external cash flow
True, exact TWRR
True, exact TWRR
5/30 BMV 100,000
6/9 EMV 101,000
6/10 Cash Flow 20,000
6/30 EMV 123,000
ROR
EMV
BMV
EMV
BMV
EMV
BMV
EMV
BMV
True
i
i
i
n
n
n
= =
=
[
1
1
1
2
2
1 1 ...
R
Exact
= =
101 000
100 000
123 000
121 000
1 2 67%
,
,
,
,
.
Money-weighted returns
Internal Rate of Return (IRR)
Takes cash flows into consideration
Cash flows will impact the return
Only uses cash flows and the closing market
value in calculation (dont revalue during
period)
Produces the return that equates the present
value of all invested capital
Its an iterative process


We solve for r, by trial-and error
The general rule is to use the Modified Dietz return
as the first order approximation to the IRR
( ) ( ) ( ) ( )
0
1 1 1 1
1 2
1 2
= +
+
+
+
+ +
+

+
InitialValue
CashFlow
r
CashFlow
r
CashFlow
r
Outflow
r
t t
n
t t
n end
...
Solving for the IRR
5/30 BMV 100,000
6/10 Cash Flow 20,000
6/30 EMV 123,000
( ) ( ) ( ) ( )
0
1 1 1 1
1 2
1 2
= +
+
+
+
+ +
+

+
InitialValue
CashFlow
r
CashFlow
r
CashFlow
r
Outflow
r
t t
n
t t
n end
...
( )
( )
0 100 000
20 000
1
123 000
1
0 30
= +
+

+
,
, ,
.
r
r
IRR Method
( ) ( ) ( ) ( )
0
1 1 1 1
1 2
1 2
= +
+
+
+
+ +
+

+
InitialValue
CashFlow
r
CashFlow
r
CashFlow
r
Outflow
r
t t
n
t t
n end
...
2.63% (1.40)
2.62% (14.25)
2.64% 7.94
Solving for r through
iteration (trial & error)
IRR= 263% .
IRR Method
Why did the Modified BAI and IRR yield the same
returns (2.63%)?
Calculation Question
Contrasting IRR
with time-weighting
Exact
w
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h
t
w
e
i
g
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t
w
e
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t
R
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e
Internal Rate of Return
Inception
Mostt
Recent
Period
Cash
Flow
Cash
Flow
Cash
Flow
V
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M/E M/E M/E M/E
M/E M/E
M/E
M/E
V
a
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e
Modified Dietz, Modified BAI
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D
a
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W
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D
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W
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D
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IRR values portfolio at the beginning and end of the period
TWRR values at various times throughout the period
Our investment is a mutual fund
Where two investors begin with 100 shares
And both make two additional purchases during
the year of 100 shares each
But at different times
And at different prices
Well use an example to
compare TWRR and MWRR
10
10.5
11
8
14
9
11
15
9
10
9
11
12
7
8
9
10
11
12
13
14
15
16
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Our funds end-of-month NAVs
Investor #2
Purchases
Investor #1
Purchases
BMV for both
Investors
10
10.5
11
8
14
9
11
15
9
10
9
11
12
7
8
9
10
11
12
13
14
15
16
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Believes
Buy low/
Sell high
Believes
Buy high/
Sell low
Our investors purchases
Month NAV Investor #1 Investor #2
Dec 10 1,000 1,000
Jan 10.5
Feb 11
Mar 12
Apr 8 800
May 14 1,400
Jun 9
Jul 11
Aug 15 1,500
Sep 9 900
Oct 10
Nov 9
Dec 11
3,900 2,700
3,300 3,300
(600) 600
Total Investment
EMV =
Gain/Loss
Paper gain
of
$600!
Paper loss
of
$600!
The investments unrealized
gains/losses
The funds return (using an exact TWRR method):


ROR
EMV
BMV
Fund
= = = 1
11
10
1 10%
Whats our return?
How about our investors?
ROR
EMV
BMV
i
i
i
n
#
,
,
,
,
,
,
1
1
1
1400
1000
3 000
2 800
3 300
4 500
1 10% = = =
=
[
ROR
EMV
BMV
i
i
i
n
#
,
,
,
,
,
2
1
1
800
1000
1800
1600
3 300
2 700
1 10% = = =
=
[
But this investor lost $600
And this investor made $600
Because time weighting eliminates the
effect of cash flows!
Investor #1s IRR = -24.86%
Investor #2s IRR = +35.16%
How about money-weighting?
As a Plan Sponsor
Which returns make more sense to you?
Which are more meaningful?
Investor #1 Investor #2
P&L -$600 +$600
TWRR 10% 10%
MWRR -24.86% +35.16%
TWRR judges
portfolio manager
MWRR
judges the
portfolio
Multi-period rates of return
We dont just want to report returns for a
month
We want to link our returns to form
quarterly, annual, since inception, etc.
returns
How do we do this?
The process used to link sub-period returns to
create returns for extended periods:
e.g., We want to take January, February, and March
returns to create a return for 1Q
We geometrically link in order to compound our
returns
Geometric linking
Step-by-step process:
1. Convert the returns to a decimal
2. Add 1
3. Multiply these numbers
4. Subtract 1
5. Convert the number to a percent
Geometric linking
Jan 1.10%
Feb 0.89%
Mar 0.60%
Step 1 Convert to a decimal 0.0110
0.0089
0.0060
Step 2 Add 1 1.0110
1.0089
1.0060
Step 3 Multiply 1.0261
Step 4 Subtract 1 0.0261
Step 5 Convert to a percent 2.61%
Geometric linking
Before we move to risk, are
there any questions?
Risk measures
Two categories
Formulas that measure risk
Well look at standard deviation and tracking error
Formulas that adjust the return per unit of risk
Well look at Sharpe Ratio and Information Ratio
Standard Deviation
Measures volatility of returns over time
The most common and most criticized
measure to describe the risk of a security or
portfolio.
Used not only in finance, but also statistics,
sciences, and social sciences.
Provides a precise measure of the amount of
variation in any group of numbers.
Standard Deviation; based on the
Bell-shaped (normal) curve
Standard Deviation Formulas
| |
o =

R R
n
i
2
Note: This is represented in Excel as the STDEVP Function
| |
o =

R R
n
i
2
1
Note: This is represented in Excel as the STDEV Function
An example of
standard deviation
A B C D E F G
1 Portfolio
2 Month Return
3 1 6.02%
4 2 4.43%
5 3 -3.34%
6 4 4.22%
7 5 3.69%
8 6 -2.58%
9 7 6.47%
10 8 0.18%
11 9 1.42%
12 10 -2.45%
13 11 2.53%
14 12 2.82%
15 13 5.78%
16
17 2.25% =AVERAGE(C3..C15)
18 3.25% =STDEVP(C3..C15)
Average ROR =
Standard Deviation =
Tracking Error
The difference between the performance of
the benchmark and the replicating portfolio
Measures active risk; the risk the manager
took relative to the benchmark
Measured as annualized standard deviation
Standard deviation of excess returns
Standard deviation of the difference in
historical returns of a portfolio and its
benchmark
Tracking Formula: Volatility of
Past Returns vs. Benchmark
Tracking error measures how closely the
portfolio follows the index and is measured
as the standard deviation of the difference
between the portfolio and index returns.
( )
TrackingError StdDev Rp Rb
A i i
=
An example of
Tracking Error
A B C D E F
1
2
3 Month Portfolio Index
4 1 6.02% 5.81% 0.21%
5 2 4.43% 4.23% 0.20%
6 3 -3.34% -3.24% -0.10%
7 4 4.22% 4.15% 0.07%
8 5 3.69% 3.65% 0.04%
9 6 -2.58% -2.55% -0.03%
10 7 6.47% 6.35% 0.12%
11 8 0.18% 0.13% 0.05%
12 9 1.42% 1.20% 0.22%
13 10 -2.45% -2.55% 0.10%
14 11 2.53% 2.50% 0.03%
15 12 2.82% 2.78% 0.04%
16 13 5.78% 5.74% 0.04%
17 0.09% =STDEVP(D4..D16)
18 0.31% =D17*SQRT(12)
Excess
ROR
Tracking Error
Annualized Tracking Error
To annualize,
multiply by
square root of
12
The Sharpe Ratio
Also known as
Reward-to-Variability Ratio
Developed by Bill Sharpe
Nobel Prize Winner
Equity Risk Premium (Return) / Standard
Deviation (Risk)
Sharpe Ratio Formula
Equity Risk Premium divided by
standard deviation of portfolio returns
SharpeRatio
R R
p f
p
=

o
An example of
Sharpe Ratio
Month R
p
R
Fr ee
1 6.02% 0.32%
2 4.43% 0.31%
3 -3.34% 0.33%
4 4.22% 0.35%
5 3.69% 0.40%
6 -2.58% 0.39%
7 6.47% 0.37%
8 0.18% 0.29%
9 1.42% 0.34%
10 -2.45% 0.35%
11 2.53% 0.41%
12 2.82% 0.38%
13 5.78% 0.39%
Ave 2.25% 0.36%
3.25%
0.36%
1.89%
0.58
2.01 Annualized Sharpe =
Standard Deviation =
Ave Risk Free ROR
Av ROR - Av Risk Free
Sharpe Ratio =
To annualize,
multiply by
square root of
12
Information Ratio
The Information Ratio measures the excess
return of an investment manager divided by
the amount of risk the manager takes
relative to the benchmark
Its the Excess Return (Active Return) divided
by the Tracking Error (Active Risk)
IR is a variation of the Sharpe Ratio, where
the Return is the Excess Return and the Risk
is the Excess or Active Risk
Information Ratio
IR serves as a measure of the special
information an active portfolio manager has
Value Added (excess return) / Tracking Error



Typically annualize
IR
Excess turn
TrackingError
=
Re
( )
IR
Avg R Avg R
R R
=

( ) ( )
o
Information Ratio
Active Return
on the account
Accounts
Active Risk
( )
IR
Avg R Avg R
R R
=

( ) ( )
o
An example of
Information Ratio
A B C D E F
1
2
3 Month Portfolio Index
4 1 6.02% 5.81% 0.21%
5 2 4.43% 4.23% 0.20%
6 3 -3.34% -3.24% -0.10%
7 4 4.22% 4.15% 0.07%
8 5 3.69% 3.65% 0.04%
9 6 -2.58% -2.55% -0.03%
10 7 6.47% 6.35% 0.12%
11 8 0.18% 0.13% 0.05%
12 9 1.42% 1.20% 0.22%
13 10 -2.45% -2.55% 0.10%
14 11 2.53% 2.50% 0.03%
15 12 2.82% 2.78% 0.04%
16 13 5.78% 5.74% 0.04%
17 0.09% =STDEVP(D4..D16)
18 0.31% =D17*SQRT(12)
19 0.99%
20 0.08% =D19/13
21 0.85 =D20/D17
22 2.93 =D21*SQRT(12) Annualized IR =
=SUM(D4..D16) Sum of Excess Returns =
Average Excess Return =
Excess
ROR
Tracking Error =
Annualized Tracking Error =
Information Ratio =
What have we covered today
Hopefully youll agree a lot in a short time
Return measures
TWRR approximation measues
Original Dietz
Modified Dietz
Modified BAI
TWRR exact measure
True daily
Geometric Linking
What have we covered today
Risk measures
Measurements of risk
Standard deviation
Tracking error
Measurements of risk-adjusted returns
Sharpe ratio
Information ratio
Questions?




John D. Simpson
jsimpson@spauldinggrp.com
1.310.500.9640
www.spauldinggrp.com