Updated July 11, 2023
What is Modified, Dietz?
The term “modified Dietz” (M.D) refers to the algebraic method used in calculating the rate of return of an investment portfolio on the basis of the cash inflows and outflows of the portfolio. This method takes cognizance of the timing of the cash flows, which is where it overcomes the issue of the simple Dietz method, which assumes that all cash flows occur in the middle of the reporting period.
The Explanation for Modified Dietz
Modified Dietz’s return consider the most accurate reflection of an investment portfolio’s rate of return. The calculation of M.D.’s return takes into account the market value of the portfolio at the start of the period and at the end of the period, along with all the cash inflows and outflows during that period and the associated period of investment of each cash flow event. In some cases, the result of modified Dietz is known as the Modified Internal Rate of Return (MIRR), a frequently used metric of capital budgeting.
The Formula for Modified Dietz
The formula for M.D. return can express the portfolio’s value at the start and end of the reporting period, cash inflow and outflow during the period, and effective investment period (ratio of time to end of the reporting period to overall reporting period). Mathematically, it is represented as,
- where V0 = Market value of the portfolio at the start of the period
- V1 = Market value of the portfolio at the end of the period
- CFi = Cash flow at the interval I during the period
- wi = Weightage of ith cash flow
Examples of Modified Dietz
Following examples are as follows :
Example #1
Let us take the simple example of an investment portfolio to illustrate the calculation of M.D’s return. Let us assume that the portfolio was worth $1,000,000 at the start of the calendar year, and by the end of December, the portfolio had grown up to $1,250,000. During the year, there was a cash inflow of $100,000in April and a cash outflow of $150,000 in October. Calculate the return of the portfolio based on the M.D. method.
Solution:
- Given, V0 = $1,000,000
- V1 = $1,250,000
- CF1 = $100,000
- CF2 = – $150,000
- w1 = (12 – 3) / 12 = 0.75 [Since April is the 4th month of the year]
- w2 = (12 – 9) / 12 = 0.25 [Since October is the 10th month of the year]
Now, the M.D return of the portfolio can calculate using the above formula,
Modified Dietz Return = (V1 – V0 – ∑CFi ) / ( V0 ∑wi * CFi)
- Modified Dietz Return = ($1,250,000 -$1,000,000 -($100,000 – $150,000)) / ($1,000,000 + (0.75* $100,000 – 0.25* $150,000))
- Modified Dietz Return = 28.9%
Therefore, using the M.D. method, the portfolio’s return calculates at 28.9%.
Example #2
Let us take the example of two portfolios and compare their returns using the M.D. method.
Portfolio I: The portfolio’s market value at the start of the year was $2,000,000, which reached $3,000,000 by the end of the year. During the year, additional capital was the infusion of $500,000 in September.
Portfolio II: The portfolio’s market value at the start of the year was $2,000,000, which reached $2,200,000 by the end of the year. During the year, there was a withdrawal of $500,000 in September.
Portfolio I
- Given, V0 = $2,000,000
- V1 = $3,000,000
- CF1 = $500,000
- w1 = (12 – 8) / 12 = 0.33 [Since September is the 9th month of the year]
Now, the M.D return of the portfolio, I can calculate using the above formula as,
Modified Dietz Return = (V1 – V0 – ∑CFi ) / ( V0 ∑wi * CFi)
- Modified Dietz Return = ($3,000,000 – $2,000,000 – $500,000) / ($2,000,000 + (0.33 * $500,000))
- Modified Dietz Return = 23.1%
Portfolio II
- Given, V0 = $2,000,000
- V1 = $2,100,000
- CF1 = -$500,000
- w1 = (12 – 8) / 12 = 0.33 [Since September is the 9th month of the year]
Now, the modified Dietz return of portfolio II can calculate using the above formula,
Modified Dietz Return = (V1 – V0 – ∑CFi ) / ( V0 ∑wi * CFi)
- Modified Dietz Return = ($3,000,000 – $2,000,000 + $500,000)/($2,000,000 – (0.33 * $500,000))
- Modified Dietz Return = 32.7%
Therefore, in the above example, it can be seen that even though it might initially seem that portfolio I generated better returns, after considering the cash flow movement, it is clear that portfolio II has produced better results. This is how M.D.’s return helps in the calculation of portfolio return.
Importance of Modified Dietz
In the financial industry, regulators and investors have been increasing their focus toward a greater level of transparency regarding the calculation and reporting of investment returns. Now, a stream of cash inflows and outflows is a very frequent occurrence in an investment portfolio, which makes it difficult to track how much profit has been generated by the portfolio. Consequently, the M.D. method was developed to calculate the portfolio return while keeping track of the magnitude and timing of the cash flows occurring during the investment period.
Advantages
Some of the major advantages of Modified Dietzare as follows:
- It doesn’t need the portfolio’s value on each cash flow day.
- A time-weighted rate of return facilitates more accurate results.
Disadvantages
Some of the major disadvantages of M.D are as follows:
- Given the technological advancement, most return calculation tools nowadays allow continuous performance monitoring, making the Modified Dietz method look very basic and naive.
- The assumption that all transactions will take place at the same time may lead to erroneous results.
Conclusion
So, it can be seen that the modified Dietz method helps us measure returns on portfolios involving multiple cash inflows and outflows. Although the underlying principle of the method is very useful, it is difficult for this method to find use in today’s world owing to the rapid progress made in the field of computing that facilitates monitoring with higher frequency.
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