7 Measuring and evaluating returns
This chapter covers
- Understanding how deposits and withdrawals complicate the calculation of returns
- Computing time-weighted and dollar-weighted returns
- Deriving two popular measures of risk-adjusted returns: Sharpe ratio and alpha
- Evaluating the performance of an actively managed fund
One of the basic functions of an advisor or a robo-advisor is to provide clients with information about their investment performance. This is particularly important if the advisor is offering actively managed investments or investments that significantly deviate from the market portfolio. Even something as seemingly simple as computing returns can be complex. We mentioned a few problems in chapter 5: the difference between arithmetic average and geometric average returns and between simple returns and continuously compounded returns. In this chapter, we focus on two other problems related to returns:
- How to compute returns when there are cash inflows and outflows
- How to measure risk-adjusted returns