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Investment - Measures of Return
Absolute Returns Absolute returns are the returns achieved over a specific time period. Absolute returns do not consider the risk of the investment.
Total Return
The performance of a security, such as an equity (stock) or debt (bond) security, over a defined time period — called the holding period — is referred to as its holding-period return or, as is frequently referred to in industry practice, its total return.
The total return measures the entire gain or loss that an investor owning a security achieves over the defined period compared with the investment at the beginning of the period. The return over the holding period comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest).
The total return from owning an ordinary or common share of a company comes from a change in the price of the share between the beginning and the end of the term as well as from the dividends collected over the course of the period. The change in the price of the shares throughout the time is the capital gain or loss element of the return. The dividends received over the time constitute the income element of the return. Similarly, the entire return from owning a bond comes from changes in price (capital gain or loss) and from generating interest income.
The following example explains how total return is computed. As always, you are not responsible for computations, but the presentation of equations and calculations may increase your knowledge.
Example: Total Return
An investor buys one ordinary share in Company A on 1 January at a price of GBP100. On 31 December, Company A pays a dividend per share of GBP5, and an ordinary share of Company A is selling for GBP110 on that date.
In this scenario, the holding period is one year – from 1 January to 31 December. The return achieved by the investor from the growth (appreciation) in the share price throughout this period is calculated as follows:
Absolute Returns Absolute returns are the returns achieved over a specific time period. Absolute returns do not consider the risk of the investment.
Total Return
The performance of a security, such as an equity (stock) or debt (bond) security, over a defined time period — called the holding period — is referred to as its holding-period return or, as is frequently referred to in industry practice, its total return.
The total return measures the entire gain or loss that an investor owning a security achieves over the defined period compared with the investment at the beginning of the period. The return over the holding period comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest).
The total return from owning an ordinary or common share of a company comes from a change in the price of the share between the beginning and the end of the term as well as from the dividends collected over the course of the period. The change in the price of the shares throughout the time is the capital gain or loss element of the return. The dividends received over the time constitute the income element of the return. Similarly, the entire return from owning a bond comes from changes in price (capital gain or loss) and from generating interest income.
The following example explains how total return is computed. As always, you are not responsible for computations, but the presentation of equations and calculations may increase your knowledge.
Example: Total Return
An investor buys one ordinary share in Company A on 1 January at a price of GBP100. On 31 December, Company A pays a dividend per share of GBP5, and an ordinary share of Company A is selling for GBP110 on that date.
In this scenario, the holding period is one year – from 1 January to 31 December. The return achieved by the investor from the growth (appreciation) in the share price throughout this period is calculated as follows:
But the total return should also include the dividend given to the investor. The return achieved by the investor from the income received on the share is as follows:
The total return is the sum of the capital and income components (i.e., 15%). Mathematically, this total can be shown as:
The return of an investment fund over the course of a given time is typically made of the capital gains or losses on all of the assets held during that period plus any income produced on those assets over the same period. Examples of income include dividend income from equity securities, interest income from debt securities, and rental revenue from commercial real estate.
Cash Flows and Time-Weighted Rates of Return
In the total return calculation example, the income (the dividend) was received at the end of the holding period. The timing of the receipt of this payment, plus the fact that no additional investments were made over the period, makes the calculation of the return reasonably uncomplicated. But in practice, determining a fund’s overall return is more complex.
In particular, funds may consist of hundreds of distinct investments that pay income at different times over the holding period, and investors may make further investments (cash inflows) in and withdrawals (cash outflows) from a fund throughout the holding period. In other words, there is a steady movement of cash into and out of most investment funds. Additional investments and withdrawals by investors will alter the calculation of the performance of the fund. The following example shows this principle.
Example: Effect of a Deposit on a Fund’s Investment Performance
Suppose that an investment fund has a value of USD100 million on 1 January. By 31 December, the fund has risen in value to USD110 million. The increase in the value of this fund comes from changes in the values of the securities owned in the fund and from income collected during the year. The overall return of the fund is 10%, computed as follows:
Cash Flows and Time-Weighted Rates of Return
In the total return calculation example, the income (the dividend) was received at the end of the holding period. The timing of the receipt of this payment, plus the fact that no additional investments were made over the period, makes the calculation of the return reasonably uncomplicated. But in practice, determining a fund’s overall return is more complex.
In particular, funds may consist of hundreds of distinct investments that pay income at different times over the holding period, and investors may make further investments (cash inflows) in and withdrawals (cash outflows) from a fund throughout the holding period. In other words, there is a steady movement of cash into and out of most investment funds. Additional investments and withdrawals by investors will alter the calculation of the performance of the fund. The following example shows this principle.
Example: Effect of a Deposit on a Fund’s Investment Performance
Suppose that an investment fund has a value of USD100 million on 1 January. By 31 December, the fund has risen in value to USD110 million. The increase in the value of this fund comes from changes in the values of the securities owned in the fund and from income collected during the year. The overall return of the fund is 10%, computed as follows:
But imagine that one of the fund’s investors contributed an additional USD5 million into the fund on 30 June. This contribution means that some of the changes in the fund’s value over the year were not from the performance of the securities or the income on these securities but were instead attributed to the receipt of extra investor money. In other words, a total return of 10% overstates the fund’s investing performance.
Flows of money into and out of funds throughout time can be accounted for by breaking the measuring period into shorter holding periods. A new holding period starts each time a cash flow happens – that is, each time money flows into or out of a fund. If there is just one cash flow during the holding period, the measurement period will be divided into two shorter holding periods. If there are two cash flows, there will be three holding periods, and so on. In actuality, investor cash inflows and outflows may occur on a daily basis, in which case an annual holding term is broken into daily holding periods.
The next example explains how the total return is computed when a cash flow happens during the holding period. There are two ways used to combine returns. The first way is to calculate the arithmetic mean by summing the two six-month returns. But this approach does not consider compounding; in the time value of money discussion in Course 3, Investment Instruments, you learned that compounding is the process in which interest is added to the principal and reinvested to generate its own interest. The second way is to calculate the geometric mean, which does consider compounding and is the preferable option.
Example: Calculation of a Fund’s Return When There Is a Contribution
Suppose that the fund from the prior example had received one investor cash contribution of USD5 million at the close of business on 30 June. No additional cash inflows or outflows happened in the time. The holding time of one year can be broken into two periods of six months. The overall return is computed as follows:
First, compute the six-month total return for the period from 1 January to 30 June, before the additional contribution.
Next, compute the six-month total return for the period from 1 July to 31 December, including the cash influx of USD5 million that raised the value of the fund on 30 June.
Finally, calculate the annual total return by adding the two six-month total returns.
There is one more piece of information required to determine the return over each of these two six-month periods: the valuation of the fund on 30 June immediately before the intake of USD5 million.
Date Fund’s Value
1 January. $100 million
30 June $98 million
31 December. $110 million
The overall return during the first six months (1 January to 30 June) is computed as follows:
Flows of money into and out of funds throughout time can be accounted for by breaking the measuring period into shorter holding periods. A new holding period starts each time a cash flow happens – that is, each time money flows into or out of a fund. If there is just one cash flow during the holding period, the measurement period will be divided into two shorter holding periods. If there are two cash flows, there will be three holding periods, and so on. In actuality, investor cash inflows and outflows may occur on a daily basis, in which case an annual holding term is broken into daily holding periods.
The next example explains how the total return is computed when a cash flow happens during the holding period. There are two ways used to combine returns. The first way is to calculate the arithmetic mean by summing the two six-month returns. But this approach does not consider compounding; in the time value of money discussion in Course 3, Investment Instruments, you learned that compounding is the process in which interest is added to the principal and reinvested to generate its own interest. The second way is to calculate the geometric mean, which does consider compounding and is the preferable option.
Example: Calculation of a Fund’s Return When There Is a Contribution
Suppose that the fund from the prior example had received one investor cash contribution of USD5 million at the close of business on 30 June. No additional cash inflows or outflows happened in the time. The holding time of one year can be broken into two periods of six months. The overall return is computed as follows:
First, compute the six-month total return for the period from 1 January to 30 June, before the additional contribution.
Next, compute the six-month total return for the period from 1 July to 31 December, including the cash influx of USD5 million that raised the value of the fund on 30 June.
Finally, calculate the annual total return by adding the two six-month total returns.
There is one more piece of information required to determine the return over each of these two six-month periods: the valuation of the fund on 30 June immediately before the intake of USD5 million.
Date Fund’s Value
1 January. $100 million
30 June $98 million
31 December. $110 million
The overall return during the first six months (1 January to 30 June) is computed as follows:
On 30 June, the fund’s worth is USD98 million, a fall in value of USD2 million from the 1 January fund value. But on this date, the fund receives a cash inflow of USD5 million. Therefore, at the commencement of the second holding period on 1 July, the fund has a value of USD103 million ($98 million + $5 million). On 31 December, the fund has a value of USD110 million. Thus, the total return for the second six-month period (1 July to 31 December) is determined as follows:
The fund’s investors may prefer to know the return achieved by the fund throughout the full calendar year rather than during each six-month period. Using our present example, the fund return was –2.0% for the first six months and 6.8% for the last six months. The fund’s compounded return for the year is computed as follows:
Fund return = [(1 – 2.0%) × (1 + 6.8%)] – 1 = 0.0466 = 4.66%
The fund achieved an annual total return of 4.66% between 1 January and 31 December.
Returns determined in the way shown in the above example are known as time-weighted rates of returns. The time-weighted rate of return computation separates the entire measurement period (e.g., one year) into sub-periods reflecting one month, week, or day of that year. The timing of each individual cash flow specifies the sub-periods to employ for calculating sub-period total returns. Each sub-period has its own independent rate of return. These sub-period returns are then utilized to compute the return for the total period. By computing total returns in this manner, investor cash inflows and outflows do not skew the assessment and reporting of a fund’s investment performance.
To compare the performance of one fund from one year with the next year or to compare the performance of one fund with another fund necessitates that returns be measured on a consistent basis over time and across funds.
In 1999, a set of voluntary investment performance criteria — the Global Investment Performance criteria (GIPS®) — was proposed for this purpose. Investment management firms around the globe have accepted the GIPS standards, and organisations in more than 40 markets sponsor and promote the GIPS standards, which were designed by and are maintained by CFA Institute. In most circumstances, the GIPS guidelines demand the adoption of a time-weighted rate of return technique since time-weighted returns are not skewed by cash inflows and outflows.
Fund return = [(1 – 2.0%) × (1 + 6.8%)] – 1 = 0.0466 = 4.66%
The fund achieved an annual total return of 4.66% between 1 January and 31 December.
Returns determined in the way shown in the above example are known as time-weighted rates of returns. The time-weighted rate of return computation separates the entire measurement period (e.g., one year) into sub-periods reflecting one month, week, or day of that year. The timing of each individual cash flow specifies the sub-periods to employ for calculating sub-period total returns. Each sub-period has its own independent rate of return. These sub-period returns are then utilized to compute the return for the total period. By computing total returns in this manner, investor cash inflows and outflows do not skew the assessment and reporting of a fund’s investment performance.
To compare the performance of one fund from one year with the next year or to compare the performance of one fund with another fund necessitates that returns be measured on a consistent basis over time and across funds.
In 1999, a set of voluntary investment performance criteria — the Global Investment Performance criteria (GIPS®) — was proposed for this purpose. Investment management firms around the globe have accepted the GIPS standards, and organisations in more than 40 markets sponsor and promote the GIPS standards, which were designed by and are maintained by CFA Institute. In most circumstances, the GIPS guidelines demand the adoption of a time-weighted rate of return technique since time-weighted returns are not skewed by cash inflows and outflows.
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