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Portfolio Construction And Analysis
Presented by
Pranav Bhagat(03)Darshit Desai(08)
Ratul Ghosh(12)
Sagar Ghutkude(13)
Aanchal Narula(30)
Madhur Sawant(43)
Khushbu Shah(46)
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Flow of Presentation
Introduction to Portfolio Construction
Portfolio Risk and Returns
Portfolio Optimization
Portfolio Management Strategies
Portfolio Performance Measurement
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Introduction
Traditional Investments
- Security Analysis
- Portfolio Management
Security Analysis involves estimating the merits of individual
investments
Portfolio Management deals with the construction and maintenanceof collection of investments
Aims at reducing risks rather than increasing returns
Portfolio construction is a part of portfolio management
Portfolio Construction is a disciplined personalized process In constructing a portfolio, the individual risk & return characteristic
of underlying investment must be considered along with clients
unique needs, goals and risk considered
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Brief History1952
-Publication ofHarry
Markowitzthesis, Portfolio
Selectiion
1964
- WilliamSharpe came
out withCAPM model
-IntroducedAlpha and Beta
1980
- AG Beckerintroducedconcept ofInvestment
Style
1986
- GaryBrinson
introducedDeterminants
of PortfolioPerformance
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Importance of Portfolio Construction
Planning investment with financial planner helps in
reaching the investment objectives
Individual investor focus more on right fund manager and
securities Portfolio constructions helps in attaining investment
objectives with minimum risk
2 types of investors- Private investors and Professional
investors They build their portfolio in 2 different ways
- Bottom Up Approach
- Top down Approach
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Investment Consulting Process
It formalizes investing just like an architect
Developing a blue print based on your needs and goals, investment
parameters
The Investment Consulting Process is as follows
Establishing of Goals and Objectives
Asset Allocation
Manager Search and Selection
Performance Monitoring
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Cash Flow needs
Risk Tolerance Performance Objectives
Time Horizon
Investments Restriction
Determine Investment Parameters
Formulating Policy Statements
Optimize Risk and Reward tradeoff
Determining Asset Allocation
Define Investment Strategies
Portfolio Construction
Evaluation of Investment Structure
Manager Selection
Implement Investment Strategy
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Determine Performance benchmark
Evaluate Relative and Absolute Returns
Measure Performance
Ongoing review of Objectives and Strategies
Changing Clients circumstances
Changing Financial market conditions
Provide Ongoing Review andAdjustment
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Major Blunders in Portfolio
Construction
One sided approach
Lumpy Risks
Liquidity Problem Home bias problem
Failure to monitor portfolio regularly
Portfolio drift Awkward issue of no loss control
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Important Terms
ValueInvesting
Deep Value
RelativeValue
GrowthInterest
GARP
Important Terms
CumulativeReturns
RollingPeriod Return
StandardDeviation
Beta
Alpha
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Value investingis the art of buying stocks which trade at asignificant discount to their intrinsic value. Value investorsachievethis by looking for companies on cheap valuation metrics, typically
low multiples of their profits or assets, for reasons which are notjustified over the longer term.
Deep value investing-means finding companies that are genuinebargains that can pay back phenomenally over the long term. Theyare firms so cheap that even if they were to close tomorrow theirassets would pay you out at a profit.
Relative Value-A method of determining an asset's value that takesinto account the value of similar assets. In contrast, absolute valuelooks only at an asset's intrinsic value and does not compare it toother assets. Calculations that are used to measure the relative valueof stocks include the enterprise ratio and price-to-earnings ratio.
Beta is a historical measure of volatility. Beta measures how anasset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark(i.e. an index).
Alphais a historical measure of an assets return on investmentcompared to the risk adjusted expected return.
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Growth At A Reasonable Price - GARP
An equity investment strategy that seeks to combine tenets of both growthinvesting and value investing to find individual stocks. GARP investorslook for companies that are showing consistent earnings growth above
broad market levels (a tenet of growth investing ) while excludingcompanies that have very high valuations (value investing
Cumulative Return
The aggregate amount that an investment has gained or lost over time,independent of the period of time involved. Presented as a percentage, thecumulative return is the raw mathematical return of the following
calculation Rolling Returns
The annualized average return for a period ending with the listed year.Rolling returns are useful for examining the behavior of returns for holding
periods similar to those actually experienced by investors.
Standard Deviation
A measure of the dispersion of a set of data from its mean. The morespread apart the data, the higher the deviation. Standard deviation iscalculated as the square root of variance.
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Sharpe Ratio & Information Ratio
While selecting funds most simple approach would be
performance that is returns
But reliabilty of scheme is also important that is volatility
A scheme giving good returns but extremely volatile may notfavor large number of investors
Sharpe Ratio expresses this measure
The ratio will be high if returns are high and volatility is low
A good fund will have a high ratio This can be explained with the help of drawing an analogy
with cricket
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Analogy
Imagine a cricket series just got over and we areanalyzing the score of Sehwag, Dhoni and Sreesanth
1.Sehwag (0, 0, 120, 160) Average- 70, StandardDeviation- 71.41
2.Dhoni (60, 60, 70, 70) Average- 65, StandardDeviation- 10
3.Sreeasnth (0, 0, 5, 20) Average- 6.25, StandardDeviation- 8.19
Here Sharpe Ratio will be
Sehwag - 70-6.25/71.41= 0.9
Dhoni - 65-6.25/10 = 5.8
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Mathematically, Sharpe Ratio= (Rp-r)/Sp
Where, Rp = Return of the fund or the portfolio, r
= Risf free rate,
Sp = Volatility of the the funds
Higher the Sharpe Ratio better is the fund
While calculating Sharpe Ratio we compared theaverage of batsman with that of bowler
In the world of finance the bowler is the risk free
investment ie government bonds
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Hence we should compare average of batsman with another
batsman who could be treated as benchmark
Similarly in funds we compare the performance with
benchmark funds performance both for return as well as
volatility
This is called Information Ratio
Now lets assume Dravid is the benchmark batsman for India in
this series
In our example Information Ratio would compare performance
of batsman (Sehwag and Dhoni ) with Dravid
Dravid (80, 75, 85, 70) Average-77.5 Standard Deviation-
5.59
Both average and s.d are better and hence he is the benchmark
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Thus, Information Ratio =
Difference in average of players compared to
benchmark/ Difference in standard deviation ofplayer compared with benchmark
Thus IR of Dhoni is 0.34
IR measures the excess return of an investmentmanager divided by the amount of risk the manager
takes relative to a bencmark
Whereas SR compares the performance of an asset
against the return of a risk free instrument
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Qualitative Risk Parameters
Qualitative Risk Analysisis concerned with
discovering the probability of a risk event occurring
& the impact the risk will have if it does occur.
All risks have both probability & impact. Probabilityis the likelihood that a risk event will occur, and
impact is the significance of the consequences of the
risk event.
Impact typically affects the following project
elements: Schedule, Budget, Resources, Deliverables,
Costs, Quality, Scope, Performance.
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Market Sentiments
Market sentimentis the general prevailing attitude
of investors as to anticipated price development in a
market.
This attitude is the accumulation of a varietyof fundamental and technical factors, including price
history, economic reports, seasonal factors, and
national and world events.
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For example, if investors expect upward price
movement in the stock market, the sentiment is said
to bebullish
. On the contrary, if the market sentiment is bearish,
most investors expect downward price movement.
Market sentiment is usually considered as
a contrarian indicator: what most people expect is a
good thing to bet against.
Market sentiment is used because it is believed to be
a good predictor of market moves, especially when itis more extreme.
Very bearish sentiment is usually followed by the
market going up more than normal, and vice versa.
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Accounting scandals
Accounting scandals are political and/or businessscandals which arise with the disclosure of financialmisdeeds by trusted executives of corporations orgovernments.
Such misdeeds typically involve complex methods for
misusing or misdirecting funds, overstating revenues,understating expenses, overstating the value of corporateassets or underreporting the existence of liabilities,sometimes with the cooperation of officials in othercorporations or affiliates.
In public companies, this type of creativeaccounting" canamount to fraud, and investigations are typically launched bygovernment oversight agencies, such as the Securities andExchange Board of India (SEBI).
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Satyam scandal
The Satyam Computer Services scandal was a corporate
scandal that occurred in India in 2009 where chairman Ramalinga
Raju confessed that the company's accounts had been falsified.
The Global corporate community was shocked and scandalized
when the chairman of Satyam, Ramalinga Raju resigned on 7
January 2009 and confessed that he had manipulated the accountsby US$1.47-Billion.
The Indian arm of PwC was fined $6 million by the SEC (US
Securities and Exchange Commission) for not following the code of
conduct and auditing standards in the performance of its dutiesrelated to the auditing of the accounts of Satyam Computer
Services.
Satyam's shares fell to 11.50 rupees on 10 January 2009, their
lowest level since March 1998, compared to a high of 544 rupees in
2008
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Minority Shareholder Rights
(Companies Act 2013)
The Companies Act 2013, expected to be fully operational by April2014, goes a long way in protecting shareholders' interests andremoves administrative burden in several areas.
The Act would protect minority shareholders, investor protection
and better framework for insolvency regulation, besides institutionalstructure.
Provisions such as class action suit, approval of auditors byshareholders will bring in more transparency.
Small investors who at present are not able to get compensation incases of fraud due to the absence of any such law will be able to
fight for justice with such suits. This suit is brought by one party on behalf of a group of individuals
to file for claims against erring companies in a court.
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Systematic Risk
The risk inherent to the entire market or an entire market segment.This type of risk is both unpredictable and impossible to completelyavoid.
Putting some assets in bonds and other assets in STOCKS canmitigate systematic risk because an interest rate shift that makes
bonds less valuable will tend to make stocks more valuable, and viceversa, thus limiting the overall change in the portfoliosvalue fromsystematic changes.
Systematic risk underlies all other investment risks.
The Great Recession provides a prime example of systematic risk.Anyone who was invested in the market in 2008 saw the values of
their investments change because of this market-wide economicevent, regardless of what types of securities they held.
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Returns Benchmarking
A benchmark is a feasible alternative to a portfolio againstwhich performance is measured.
Investors look to broad indexes as benchmarks to help
them gauge not only how well the markets are performing, but
also how well they, as investors, are performing. For those who own stocks, they look to indexes like the S&P
500, the Dow Jones Industrial Average (DJIA) and the Nasdaq
100 to tell them "where the market is".
Most investors hope to meet or exceed the returns of theseindexes over time.
The problem with this expectation is that they immediately put
themselves at a disadvantage because they are not comparing
apples to apples.
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How it works
Let's assume you compare the returns of
your stock portfolio, which is a broadly diversified
collection of small-cap stocks and is managed by
Company XYZ, with the Russell 2000 index, whichyou feel is an accurate universe of feasible
alternative investments.
If Company XYZ's portfolio returns 5.5% in a year
but the Russell 2000 (the benchmark) returns 5.0%,then we would say that your portfolio beat its
benchmark.
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Portfolio Optimization
Definition
Portfolio optimizationis the process of choosing the
proportions of various assets to be held in a portfolio,
in such a way as to the portfolio better than any other
according to some criterion.
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Modern Portfolio Theory
Modern portfolio theory has had a marked impact on
how investors perceive risk, return and portfolio
management.
The theory demonstrates that portfolio diversificationcan reduce investment risk.
MTP has Shortcomings in the real world
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The Efficient Frontier
How to identify the best level of diversification?
For every level of return, there is one portfolio that
offers the lowest possible risk, and for every level ofrisk, there is a portfolio that offers the highest return.
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CML (Capital Market Line)
A line used in the capital asset pricing model to
illustrate the rates of return for efficient portfolios
depending on the risk-free rate of return and the level
of risk (standard deviation) for a particular portfolio. CML is considered to be superior to the efficient
frontier
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Risk Free rate
It is the market off which other assets are priced;
companies pay an extra spread over the risk-free rate,
equities offer a "risk premium" in the form of a
higher long-term return to compensate for theirhigher short-term volatility.
Local government bond that constitutes the risk-free
rate
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Methods of portfolio optimization
Traditional measure
standard deviation
Sortino ratio
CVaR (Conditional Value at Risk)
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Optimization constraints
Regulation and taxes
Transaction costs
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Mathematical tools used in portfolio
optimization
Quadratic programming
Nonlinear programming
Mixed integer programming
Meta-Heuristic Methods
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Issues with portfolio optimization
Investment is a forward looking activity
Financial crises are characterized by a significant
increase in correlation of stock price movements
which may seriously degrade the benefits ofdiversification.
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4 Steps To Building A Profitable
Portfolio
Determining the Appropriate Asset Allocation for You
Achieving the Portfolio Designed in Step 1
Reassessing Portfolio Weightings Rebalancing Strategically
B d O i f I t t
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Broad Overview of Investment
Strategies
Active Management Strategies
Fundamental Analysis
TopDown(asset class rotation, sector rotation)
Bottom Up(stock undervaluation/overvaluation)
Technical Analysis
Contrarian (e.g. overreaction)
Continuation (e.g. price momentum)
Passive Management Strategies
Efficient Markets Hypothesis
Buy and Hold
Indexing
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Portfolio Management Strategies refer to the approaches that
are applied for the efficient portfolio management in order to
generate the highest possible returns at lowest possible risks.
There are two basic approaches for portfolio management
including Active Portfolio Management Strategy and Passive
Portfolio Management Strategy.
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The Active portfolio management relies on the fact that particular
style of analysis or management can generate returns that can beat
the market. It involves higher than average costs and it stresses on
taking advantage of market inefficiencies. It is implemented by the
advices of analysts and managers who analyze and evaluate market
for the presence of inefficiencies.
The active management approach of the portfolio management
involves the following styles of the stock selection.
Active Portfolio Management Strategy
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Fundamental Strategies
Tactical Asset Allocation
- Asset Class Rotation: Shifts funds between stocks, bonds andother securities depending on market forecasts and estimatedreturns.
Sector, Industry or Style Rotation Strategy- Shifts funds between different equity sectors and industries(financial stocks, technology stocks, consumer cyclicals,durable goods) or among investment styles (e.g., largecapitalization, small capitalization, value growth)
Individual Stock Selection
- Buy low, Sell High
44
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Technical Strategies
Contrarian investment strategy
- Best time to buy a stock is when the majority of other
investors are selling.
- Buy low, sell high. Hope asset prices are meanreverting.
- Overreaction hypothesis.
Price momentum strategy Earnings momentum strategy
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A financial strategy in which an investor invests in accordance with a pre-determined
strategy that doesn't entail any forecasting.
The idea is to minimize investing fees and to avoid the adverse consequences of failing
to correctly anticipate the future.
Passive management is most common on the equity market, where index funds track
a stock market index
One of the largest equity mutual funds, the Vanguard 500, is a passive management
fund.
The two firms with the largest amounts of money under management, Barclays Global
Investors and State Street Corp., primarily engage in passive management strategies.
Passive Portfolio Management Strategy
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Passive asset management is based on the belief that: Markets are efficient.
Market returns cannot be surpassed regularly over
time. Low-cost investments held for the long-term will
provide the best returns
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Efficient market theory: This theory relies on the fact that theinformation that affects the markets is immediately available and
processed by all investors. Thus, such information is always considered
in evaluation of the market prices. The portfolio managers who follows
this theory, firmly believes that market averages cannot be beaten
consistently.
Indexing: It is done by retail investors by buying one or more index
funds. An investment portfolio tracks an index and achieves low
turnover, very low management fees and good diversification.The low management fees enable the investor to receive higher returns in
comparison to similar fund investments with higher management fees or
transaction costs. Passive management is widely used in the equity
market and involves tracking of stock market index by index funds.
METHODS
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Patient Portfolio:This type of portfolio involves making investments in well-
known stocks. The investors buy and hold stocks for longer periods. In this
portfolio, the majority of the stocks represent companies that have classic growth
and those expected to generate higher earnings on a regular basis irrespective of
financial conditions.
Aggressive Portfolio: This type of portfolio involves making investments in
expensivestocksthat provide good returns and big rewards along with carrying
big risks. This portfolio is a collection of stocks of companies of different sizes
that are rapidly growing and expected to generate rapid annual earnings growth
over the next few years.
Conservative Portfolio:This type of portfolio involves the collection of stocks
after carefully observing the market returns, earnings growth and consistent
dividend history.
I l t ti f P i tf li
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Implementation of Passive portfolio
management strategy
Index funds refer to the collective investment
schemes that utilize passive investment strategies for
tracking the performance of a stock market index.
An index fund can be implemented by buyingsecurities in the similar proportion as present in the
stock market index.
The sampling involves purchasing each type of stocksfrom various sectors in the index but do not include
some quantity of stocks of every individual stock.
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Advantages
Low cost: Provides meaningful and specificincremental advantage.
Reduced uncertainty of decision errors: By makinginvestments, investors are exposed to market risks and
passive investment strategy reduces the uncertainty ofdecision errors.
Style consistency: Indexing enables the investors tocontrol their overall allocation by selecting theappropriate indexes.
Tax efficiency: Indexing is considered as more taxefficient especially in cases of larger-cap indexes thatinvolve less trading and which are fairly stable.
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Portfolio Performance Measurement
Performance evaluation is a critical aspect of
portfolio management
Proper performance evaluation should involve a
recognition of both the return and the riskiness of the
investment
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Risk : It is the amount of volatility of returns in aportfolio measured by standard deviation. Volatility isused as a proxy for risk. Volatility is a measure ofhow much a given number can vary over time and the
wider the range of possibilities
Return : It is ultimately the rate of growth of yourportfolio. Given enough time a high-risk portfoliowill earn higher returns than a low-risk portfolio.
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High Risk :High risk means there is a strong chance
that you could lose a substantial amount (or all) of
your investment.
Low risk : Low risk means when it is thought to bejust a small chance of losing some or all of your
money.
F t t id i M i
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Factors to consider in Measuring
Portfolio Performance
Differential Risk Levels: In order to Evaluate portfolio
performance properly, we must determine whether the returns
are large enough given the risk involved.
Differential Time Periods : In order to evaluate performance oftwo funds of same type with different time periods, time element
must be adjusted.
Appropriate Benchmarks: In evaluating portfolio performance
to compare the returns, the portfolio must be evaluated with thereturns that could have been obtained from a comparable
alternative.
T diti l
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Traditional
Performance Measures
Sharpe Measure
Treynor Measures
Jensen Measure
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Sharpe and Treynor Measures
The Sharpe measureevaluates return relative
to total risk
Appropriate for a well-diversified portfolio,
but not for individual securities
The Treynor measureevaluates the return
relative to beta, a measure of systematic risk
It ignores any unsystematic risk
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Sharpe and Treynor Measures
The Sharpe and Treynor measures:
Sharpe measure
Treynor measure
where average return
risk-free ratestandard deviation of returns
beta
f
f
f
R R
R R
R
R
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Jensen Measure
The Jensen measure is also based on CAPM.
Named after its creator, Michael C. Jensen.
The Jensen measure is a risk-adjusted performance
measure that represents the average return on aportfolio over and above that predicted by the capital
asset pricing model (CAPM), given the portfolio's
beta and the average market return.
This measure of return is also known as alpha.
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Jensen Measure
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Measuring Returns
How to measure returns generated by an investmentmanager?
Two ways to measure returns:
1. Dollar Weighted Rate of Return
2. Time Weighted Rate of Return
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Measuring Returns
Dollar weighted rate of return is the internal rate ofreturn (IRR) of an investment
In investment management industry, time weightedrate of return is preferred
Rate does not depend on when investment ismade (timing of cashflows)
Since different clients will invest at differenttimes, need a measure that is independent oftiming
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PROBLEM
Four years ago, this investor put $200,000 in a
portfolio aligned with her long-term goals. This
portfolio then grew by 10% a year for 4 years. At thestart of the 5th year the investor received a large
inheritance, worth $1,000,000, and added it to the
account. During this same year the market happened
to decline, and the portfolio lost 10%. The portfoliovalue historically would look like this:
Solution dollar Weighted Rate Of
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Solution-dollar Weighted Rate Of
Return
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SOLUTION
Because her account was so much larger during the
market decline of the 5th year, the investor has
actually lost money ($1,163,538 - $1,200,000 = -$36,462) when compared to her total contributions.
However, the statement shows a positive time-
weighted annualized rate of return. How can this be
correct?
Solution time Weighted Rate Of
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Solution-time Weighted Rate Of
Return
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FORMULA
TWRR = (1+10%) x (1+10%) x (1+10%) x (1+10%)
x (1+(-10%)) -1 = 32% cumulative return. Total
returns greater than 1 year are then annualized.
The annualized return is calculated as (1 + totalreturn)^(1/(Time/365))
= (1+ 32%) ^ ((1/1825/365)) -1 = 5.67%.
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SOLUTION
If you were to use dollar-weighted calculations, the 5th yearsperformance would overwhelm the return number, because the
value was so much higher during that one year. In this scenario
theportfoliosprevious 4 years of positive performance would
have less weight, and the focus would almost entirely be onthe 5th year, during which the market happened to decline. In
this scenario the DWRR would be (1.86%), since the
portfoliosmoney managersperformance is dominated by the
timing of the cash flow received.
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FORMULA
DWRR = Initial cash flow + (CashFlow1) / (1 +
Return)^1 + (CashFlow2) / (1+Return)^2 +
(CashFlowN) / (1+Return)^N
In this scenario the DWRR would =$-200,000 + ($-1,000,000) / (1+R)^4 + ($1,163,538) /
(1+R)^5, solving for return = (1.86%).
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Pros And Cons
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THANK YOU