One of those confusing things in the world of performance measurement: Modified Dietz
Modified Dietz is one of the most commonly used return measures. Granted, Peter Dietz probably never referred to it as “Modified” (he called it “Day-Weighted,” as opposed to “Mid-Point Weighted”), but that’s the term we all know. Most investment firms used it at least one time, if not still today. And what’s it used for? Primarily as an approximation to the true, exact, time-weighted return (TWR).
It also serves as an approximation to the true, exact, money-weighted return (MWR): the internal rate of return (IRR).
Doing double-duty: Modified Dietz as an approximation for both MWR & TWR
Let’s say you’re calculating returns for 2018 using Modified Dietz. How do you do it for both TWR and MWR?
- For TWR, we value the portfolio monthly, and calculate returns for each of the 12 months. AND, we will value for large cash flows, and calculate two or more returns for months that experience them. We geometrically link (“chain link”) the individual returns to derive the annual return.
- For MWR, we value the portfolio at the start and end of year (i.e., just two valuations), and day-weight any flows that occurred throughout the year
If you’ve been introduced to the IRR, you know it cannot usually be solved directly (rather, it’s solved through trial-and-error). Ideally, we start with a “guess,” which is generally recommended to be the result obtained from using Modified Dietz (the “first order approximation”).
2020 GIPS Standards open to Modified Dietz for money-weighting, but wait …
The 2020 GIPS® standards allows firms to use any money-weighted method; this is a change from prior versions, where only the IRR can be used.
It so happens that Modified Dietz is often an excellent estimate for the IRR. However, there are times when it isn’t. I have not done any research to try to ascertain when it is or when it isn’t; I just know that it can be WAY OFF!
I discuss this topic in this video. And, I recommend that you avoid using it for money-weighting, but instead use the IRR.