INVESTMENT RISK AND PERFORMANCE

by PANAGIOTIS AVRAMIDIS

Measuring Portfolio Mean Performance: Cash

Flows and Approximation Methods
According to the Global Investment Performance Standards requirements, presentation
of portfolio returns should be based on time-weighted rates, which adjust for external
cash flows. The study reported here assessed the margin of error in mean performance
if, instead, returns were approximated by using the original Dietz method. The param-
eters that affect the approximation error are the size of the external cash flows relative
to portfolio value, the duration of the underlying period, and the total number of periods.

T
he Global Investment Performance Standards the original Dietz method, X i . We denote with 1 + b the
(GIPS) Handbook states that presentation of error factor—that is, X i = X i x(1 + b) . If b > 0, we have an
a portfolio’s performance should be based on overestimation of the return, and the opposite holds if b < 0.
time-weighted rates of return, which adjust for external For simplicity, we assume that during period i, the port-
cash flows. In particular, the guidance on the method- folio receives one large cash flow, CF, in a single period (the
ology cites that for periods after 1 January 2010, firms single-period assumption will be relaxed later).1 Right after
must assess the performance for interim subperiods the cash flow occurs, the portfolio value (including the cash
between all large cash flows and geometrically link the flow) is P1. The beginning and end values are, respectively, P0
performance to calculate periodic returns. For presen- and P2. The actual compounding factor at period i is
tation of historical periods, the Handbook recommends P1 − CF P2  
using approximation methods, such as the original Dietz Xi = ×
P0 P1
and the modified Dietz methods, as a good compromise (1)
between accuracy and practicality in computing cash P2  CF 
= × 1 − .
flow–adjusted time-weighted rates of return. P0  P1 
This study aimed to identify the conditions in which whereas the original Dietz formula generates
the original Dietz method generates an unacceptable error
P − P − CF
and to answer such questions as how large a cash flow X i = 1 + 2 0
should be for the firm to determine that it distorts mean P0 + 0.5 × CF
(2)
performance if the portfolio is not valued at the time of the P2 − 0.5 × CF
= .
external cash flow. Knowing these answers should be help- P0 + 0.5 × CF
ful for investment firms wishing to give a rigorous defini-
Hence, the error factor, 1 + b, is
tion of “large” cash flow, as required by the GIPS standards.
1 − 0.5 × Z 2  1   
1+ b = × , (3)
THEORETICAL GAINS FROM EXACT 1 + 0.5 × Z 0  1 − Z1 
CALCULATION OF RETURN RATES
To begin, we denote with Xi a sample of n observations that where Zs equals CF/Ps, the weights of the cash flow
represent return rates in the form of a compounding factor relative to the portfolio value at the beginning (s = 0),
(i.e., Xi =1 + Ri over n periods). Assume that at period i, right after the cash flow (s = 1), and at the end (s = 2)
instead of the actual value Xi, we approximate the rate as in of the period.

©2013 CFA INSTITUTE ◆ 1

 If G X designates the geometric mean after the
replacement of the period i return, calculus yields
lim n→∞ G X − G X = lim n→∞ G X × (1 + b)1/ n − 1  (4)
 
= 0.
That is, for fixed error b at a single period, the effect on
mean performance vanishes when the total number of
periods increases. In the extreme case, where margin of
error b is proportional to period size n,
lim n→∞ G X − G X = lim n→∞ G X × (1 + n)1/ n − 1 (5)
 
= 0.
Property 4 implies that the distance between the approxi-
mated 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 sin-
gle 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 lon-
ger needed. Property 4 could be useful, however, in evalu-
ating the long-term mean of portfolios with frequent
intraday cash transactions (and several multiple periods).
Let’s 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 approxi-
mated period is irrelevant to the final outcome, and for
convenience in notation, we will use the first k without
any loss of generality. Furthermore, the margin of error
may vary by period, depending on the size of the cash
flows. Allowing for different margins would add com-
plexity in notation without changing the core conclusion
about the error approximation. So, we will present the
theoretical results based on the “average” margin of error.
Property 4 is adjusted to
lim n→∞ G X − G X = lim n→∞ G X × (1 + b)k / n − 1 . (6)
 
If k < n is fixed, then the asymptotic shrinkage to zero
is still valid. In the alternative case, where all periods are
approximated (k = n),
G X − G X = G X × b
1 − 0.5 × Z 2  1   (7)
= GX ×  ×  − 1 .
1 + 0.5 × Z 0  1 − Z1  
Equation 7 implies that the distance of the approxi-
mated 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 approx-
imation 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 Z1 Z2 Approx. Error Z0 Z1 Z2 Approx. Error Z0 Z1 Z2 Approx. Error
1% 1% 1% 0.01%  1% 1% 5% –2.01% 1% 1% 10% –4.52%
5 1 1 –1.95 5 1 5 –3.92 5 1 10 –6.38
10 1 1 –4.28 10 1 5 –6.20 10 1 10 –8.61
1 5 1 4.22 1 5 5 2.12 1 5 10 –0.50
5 5 1 2.18 5 5 5 0.13 5 5 10 –2.44
10 5 1 –0.25 10 5 5 –2.26 10 5 10 –4.76
1 10 1 10.01 1 10 5 7.79 1 10 10 5.03
5 10 1 7.86 5 10 5 5.69 5 10 10 2.98
10 10 1 5.29 10 10 5 3.17 10 10 10 0.53

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 So, we can conclude that the original Dietz approxi-
mation may produce sufficiently accurate mean estimates
for performance measurement if cash flows are relatively
small (<1%) in relation to portfolio value or if the port-
folio 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 approxima-
tion 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 μ and standard deviation
σ, then the transformed Xi = exp(Yi) = 1 + Ri follows a log-
normal distribution, with μX = eμ+σ2/2 and σX = μX (eσ2 – 1).
Initially, we will simulate the daily return rates of an
equity portfolio, so according to Brown and Warner (1985),
we assume that μ is 0 and σ is 2%. Because the geometric
mean of the lognormal distribution of X is eμ (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 approxima-
tion error is 0.78% with a standard deviation of 0.529%.
As expected, the error shrinks to zero when the number
Table 2:  Approximation Error G − G (μ = 0 and σ = 2%)
X X
Single Period (k = 1) Multiple Periods (k = 5)
Statistic n = 10 n = 100 n = 1,000 n = 10
Mean 0.780% 0.078% 0.008%   3.82%
St dev 0.529 0.053 0.005 2.61
Q3 a
1.199 0.121 0.012 5.76
Max 2.259 0.224 0.022 11.54
The 25% largest errors.
a
of periods increases. If we use an approximation for mul-
tiple 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 aver-
age 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 approxi-
mation. 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 approxi-
mation 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 numeri-
cal approximation errors for μ = 0% and σ = 2% (daily
return rates) and μ = 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 expo-
nentially dependent on expected return μ, GX = eμ). 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.
All Periods (k = n)
n = 100 n = 1,000 n = 10 n = 100 n = 1,000
0.40% 0.04%   7.65%   7.98%   7.99%
0.27 0.03 5.32 5.55 5.56
0.61 0.06 11.44 11.93 11.95
1.15 0.11 24.31 25.36 25.41
©2013 CFA INSTITUTE ◆ 3
 Table 3:  Relative Cash Flow Weights That Yield the Top Five and Lowest Five Errors for n = 10
Single Period (k = 1) All Periods (k = n)

G X − G X Z0 Z1 Z2 G X − G X Z0 Z1 Z2

2.26% 1% 20% 1% 24.31% 1% 20% 1%

2.01 5 20 1 21.38 5 20 1
2.00 1 20 5 21.28 1 20 5
1.76 20 1 20 18.60 10 20 1
1.75 10 20 1 18.43 5 20 5

       
0.028% 10% 10% 10% 0.619% 10% 10% 10%
0.013 5 5 5 0.178 5 5 5
0.001 1 10 20 0.059 1 10 20
10–4 1 5 10 0.030 1 5 10
10–6 1 1 1 0.005 1 1 1

Table 4:  Average Approximation Error, G X − GX , for n = 10

Single Period (k = 1) Multiple Periods(k = 5) All Periods (k = n)
µ σ = 2% σ = 30% σ = 2% σ = 30% σ = 2% σ = 30%
0% 0.78% 0.79% 3.82% 3.80% 7.65% 7.59%
15% 0.91% 0.95% 4.33% 4.15% 9.26% 9.75%

Equivalently, the risk of misrepresentation of portfolio END NOTES

performance because of the use of an approximation
method, such as the original Dietz method, increases as
the duration of the assessment period increases.
CONCLUSION
Numerical and theoretical findings seem to back the recom-
mendation 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 port-
folio value, approximation entails a high chance of significant
misrepresentation of mean performance—especially 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 peri-
ods must exist. A large number of periods and low portfolio
volatility create a high frequency of evaluations, which effec-
tively annuls the usefulness of approximation. Furthermore,
increasing the duration of the periods being examined yields
higher approximation errors via higher mean portfolio values.
1. Contributions to the portfolio are positive flows, CF > 0, and with-
drawals 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):3–31.
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):341–352.
Panagiotis Avramidis is adjunct assistant professor of finance and
quantitative methods at ALBA Graduate Business School at the
American College of Greece.

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