Fundamentals of Corporate Finance New York

Question: Your fund managers have complained about another firs's marketing material and the way in which fund performance is presented. It appears that the other firm's equity funds are being promoted using historic comparisons between its fund's absolute returns and your funds time weighted returns for the same period, based on data supplied by your compliance department. Explain how time weighted returns are calculated and why they are useful for the investor. Answer: Investors need to know how have their investments performed in the market and using the time-weighted return formula helps them obtain the desired detail. The term time weighted is a bit of misnomer because it does not weight time actually and instead it depends on the length of time a withdrawal or contribution is made in or out of a portfolio. It requires regular portfolio valuations whenever a deposit or withdrawal is made during a period and it is a preferred industry standard because it is not sensitive to any such withdrawals or contributions. For example: If Mr. X had invested $200and now its value is $400, and then will be considered a good investment? The answer is No, because until and unless Mr. X knows when did he make the investment and when did he cashed in, the question of good or bad does not arise. The deposits and withdrawals are also termed as External Cash Flows and periods in which these occur are further divided into other sub-periods, each having its own return calculations. The returns of these sub-periods are geometrically linked together to obtain the time-weighted return and therefore it is also termed as an average return. By Geometric linking, it implies adding 1 to each of the sub-period returns, then multiply the sub-period returns together and finally subtract 1 from the obtained result.(Parrino et. al, 2012). Time weighted return for a particular period= Ending value- Beginning value / Beginning value Further if any external cash flows occur, then calculation of each sub-period are done using the above formula and then geometrically link it using the following formula. Time weighted return for multiple periods= (1+ 1st period return) * (1+ 2nd period return) 1 It is useful for the investors because first of all, every reporting period is weighted equally regardless of what amount and time being invested. Secondly, it is an effective measurement tool in making an analysis of long time performances of the portfolios assets (Northington, 2011). Thirdly, an investor can evaluate the true performance of an investment by eliminating all contributions and withdrawals from the portfolio so that their size and timing do not distort the percentage returns and can leave only the effects of market and the investors action. Fourthly, investment managers are judged upon their investment activities that are under their control but if they do not have any control over the flow timings, then using the time weighted return for compensating the timings of flow is the best measure for evaluating the investment managers performance and comparing it with different investment managers or market index (Northington, 2011). Fifthly, GIPS i.e. Global Investment Perf ormance Standards must be met by every firm and without using time-weight return, it becomes impossible for the firms to meet this standard. Sixthly, as compared to other methods like Money-Weighted Return, investors do not need to be highly qualified or intelligent for applying this method because it is relatively very easy and simple to understand and calculate. Lastly, an investor can compute the time weighted returns with the help of a computational software when it comes to daily valuation requirement. Any modest investment that had performed quite well in the past may experience disastrous performance in the present, leaving the investors with a huge economic loss. This forces the investors to avoid the historical data or performance for future investment decisions and therefore they need the consistency and objectivity of time-weighted return to make a time-weighted performance report. Hence, time-weighted return enables an investor to ascertain the return and is helpful in the long run. References Northington, S 2011, Finance, New York, NY: Ferguson's. Parrino, R., Kidwell, D. and Bates, T 2012, Fundamentals of corporate finance, Hoboken, NJ: Wiley