Benchmarking Returns

Judging performance means answering two questions: what return did this portfolio or investor actually earn, and what should it be compared with? This module covers the two ways of measuring returns when money flows in and out (money-weighted and time-weighted), and how the indexes used as benchmarks are built, weighted, maintained and calculated.

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What you will learn

1. Calculate the money-weighted rate of return for a portfolio with external cash flows and interpret what it measures.

MWR = IRR of the investor's cash flows, including the ending value.
Contributions are negative cash flows; withdrawals, cash income and the ending value are positive.
Periods with more money invested carry more weight in the MWR.
If flows are monthly or quarterly, annualize the periodic IRR.
MWR reflects both asset performance and the size and timing of the investor's flows.

2. Calculate the time-weighted rate of return, compare it with the money-weighted return, and select the appropriate measure for evaluating a manager or an investor.

TWR: break the period at each external cash flow, compute subperiod HPRs, link them and annualize if needed.
TWR is unaffected by the size and timing of client cash flows.
TWR is the standard for evaluating and comparing managers; GIPS requires it for most portfolios.
MWR > TWR when money is added before strong periods; MWR < TWR when added before weak periods.
Use MWR when the manager controls cash flows (for example, private equity) or to describe the investor's own result.

3. Describe the main index weighting methods and the choices involved in constructing and maintaining an index, and explain their implications for index behaviour.

Index design: target market, constituent selection, weighting, rebalancing and reconstitution.
Price-weighted: weights depend on share prices; splits reduce a stock's weight and require a new divisor.
Equal-weighted: small-cap tilt and frequent rebalancing with higher turnover.
Market-cap weighted: self-rebalancing, but tilted toward the largest and recently strongest stocks; most benchmarks use float adjustment.
Fundamental weighting: weights from sales, earnings or book value; value tilt and contrarian rebalancing.

4. Calculate and interpret the value and the price and total returns of price-weighted, equal-weighted and market-capitalization-weighted indexes.

Index return = sum of beginning-of-period weights x member returns.
Price return excludes income; total return includes reinvested dividends or interest.
Price-weighted value = sum of prices / divisor; after a split, new divisor = new sum of prices / old index value.
Market-cap-weighted return = percentage change in total market value of members.
Equal-weighted return = simple average of member returns (from equal starting weights).

Module at a glance

Money-weighted return = IRR of the investor's cash flows; it reflects the timing and size of contributions and withdrawals.
Time-weighted return links subperiod returns between cash flows and is unaffected by client flows.
Use TWR to evaluate managers who do not control cash flows; use MWR when they do, or to show an investor's own result.
Price-weighted indexes weight by share price; equal-weighted indexes tilt toward small caps and need rebalancing.
Market-cap weighting is self-rebalancing but tilts toward the largest stocks; most benchmarks are float-adjusted.
After a split in a price-weighted index, new divisor = new sum of prices / old index value.
Compare funds with total-return indexes; price-return indexes leave out income.

This free module has 4 lessons, 12 practice questions with full explanations.

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