Measures of Return

Financial market assets generate two different streams of return: income through cash dividends or interest payments and capital growth through the price appreciation of the asset. Headline stock market indices typically report on price appreciation only and do not include the dividend income unless the index specifies it is a “total return” series. It is important to be able to compute and compare different measures of return to properly evaluate portfolio performance.

Holding Period Return

A holding period return is a return earned from holding an asset for a specified period of time. The time period may be as short as a day or many years and is expressed as a total return. This means we look at the return as a composite of the price appreciation and the income stream.

The formula for the holding period return computation is as follows:

$$ Holding \quad Period \quad Return \quad (HPR) = \frac {P_t – P_{t-1} + D_t} {P_{t-1}} $$

Where

\(P_t\) is the price of the asset at time t when the asset is sold

\(P_{t-1}\) is the price of the asset at time t-1 when the asset was bought

\(D_t\) is the dividend per share paid between t and t-1

Arithmetic or Mean Return

When we have assets for multiple holding periods, it is necessary to aggregate the returns into one overall return. An arithmetic mean is a simple process of finding the average of the holding period returns. For example, if a share has returned 15%, 10%, 12% and 3% over the last four years, then the arithmetic mean is as follows:

$$ Arithmetic \quad mean = \frac {15\% + 10\% + 12\% + 3\%} {4} = 10\% $$

Geometric Mean Return

Computing a geometric mean follows a principle similar to the computation of compound interest. The previous year’s returns are compounded to the beginning value of the investment at the start of the new period in order to earn returns on your returns. A geometric return provides a more accurate representation of the portfolio value growth than an arithmetic return. Using the same annual returns of 15%, 10%, 12% and 3% as above, we compute the geometric mean as follows:

$$ Geometric \quad mean = [(1+15\%) × (1+10\%) × (1+12\%) × (1+3\%)]^{1/4} – 1 = 9.9\% $$

We note the geometric return is slightly less than the arithmetic return. Arithmetic returns tend to be biased upwards unless the holding period returns are all equal.

Money-weighted or Internal Rate of Return

Arithmetic and geometric returns do not take into account the money invested in a portfolio in different time periods. A money-weighted return is similar in computation methodology to an internal rate of return (IRR) or a yield to maturity. We examine the cash flows from the perspective of the investor where amounts invested in the portfolio are seen as cash outflows and amounts withdrawn from the portfolio by the investor are cash inflows.

The IRR is the discount rate applied to determining the present value of the cash flows such that the cumulative present value of all the cash flows is zero. The IRR provides the investor with an accurate measure of what was actually earned on the money invested but does not allow for easy comparison between individuals.

Annualized Return

If the period during which the return is earned is not exactly one year, we can annualize the return to enable an easy comparative return. To annualize a return earned for a period shorter than one year, the return must be compounded by the number of periods in the year. A monthly return must be compounded 12 times, a weekly return 52 times and a daily return 365 times. A weekly return of 2%, when annualized, is as follows:

$$ Annualized \quad return = (1+2\%)^{52} – 1 = 180\% $$

When the holding period is longer than one year, we need to express the year as a fraction of the holding period and compound using this fractional number. For example, a year relative to a 20-month holding period is a fraction of 12/20. If we had a return of 12% for 20 months, then the annualized return is as follows:

$$ Annualized \quad return = (1+12\%)^{12/20} – 1 = 7\% $$

Portfolio Return

When a portfolio is made up of several assets, we may want to find the aggregate return of the portfolio as a whole. In order to compute this, we weight the returns of the underlying assets by the amounts allocated to them. A portfolio that consists of 70% equities which return 10%, 20% bonds which return 4%, and 10% cash which returns 1% would have a portfolio return as follows:

$$ Portfolio \quad return = (70\% × 10\%) + (20\% × 4\%) + (10\% × 1\%) = 7.9\% $$

Other Major Return Measures

There are other measures of returns that need to be taken into account when evaluating performance. These are as follows:

Gross and net return

A gross return is earned prior to the deduction of fees (management fees, custodial fees, and other administrative expenses). A net return is the return post-deduction of fees.

Pre-tax and after-tax nominal returns

In general, returns are presented pre-tax and with no adjustment for the effects of inflation. Tax considerations like capital gains tax and tax on interest or dividend income will need to be deducted from the investment to determine post-tax returns.

Real returns

Returns are typically presented in nominal terms which consist of three components: the real risk-free return as compensation for postponing consumption, inflation as compensation for the loss of purchasing power and a risk premium. Real returns are useful for comparing returns over different time periods as inflation rates vary over time.

Leverage returns

If an investor makes use of derivative instruments within a portfolio or borrows money to invest, then leverage is introduced into the portfolio. The leverage amplifies the returns on the investor’s capital, both upwards and downwards.

Question

What are the arithmetic mean and geometric mean, respectively, of an investment which returns 8%, -2% and 6% each year for three years?

A. Arithmetic mean = 5.3%; Geometric mean = 2.6%

B. Arithmetic mean = 4.0%; Geometric mean = 12%

C. Arithmentic mean = 4.0%; Geometric mean = 2.6%

Solution

The correct answer is C.

$$ Arithmetic \quad mean = \frac {8\% + (-2\%) + 6\%} {3} = 4\% $$

$$ Geometric \quad mean = [(1+8\%) × (1+(-2\%)) × (1+6\%)]^{1/3} – 1 = 2.6\% $$

Reading 39 LOS 39a:

Calculate and interpret major return measures and describe their appropriate uses

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