Which return measure is generally preferred for evaluating a portfolio manager's performance, and why?

Which return measure is generally preferred for evaluating a portfolio manager's performance, and why?

• A. Dollar-weighted returns because cash flows are taken into consideration
• B. Time-weighted returns because cash flows are taken into consideration
• C. Time-weighted returns because cash flows are not taken into consideration
• D. Dollar-weighted returns because cash flows are not taken into consideration

Answer: (C)

Time-weighted returns are used because they isolate the portfolio manager’s investment decisions from the effects of cash flows. By calculating returns in each period between external contributions or withdrawals and then linking those periods, this method removes the impact of when money comes in or goes out, allowing a fair assessment of skill and decision quality. Dollar-weighted (money-weighted) returns, on the other hand, incorporate cash-flow timing, so results can reflect investor actions as well as manager decisions, which can distort comparisons of skill. Thus, time-weighted returns are preferred for evaluating a manager, since cash flows are not taken into consideration.

Time-weighted returns are used because they isolate the portfolio manager’s investment decisions from the effects of cash flows. By calculating returns in each period between external contributions or withdrawals and then linking those periods, this method removes the impact of when money comes in or goes out, allowing a fair assessment of skill and decision quality. Dollar-weighted (money-weighted) returns, on the other hand, incorporate cash-flow timing, so results can reflect investor actions as well as manager decisions, which can distort comparisons of skill. Thus, time-weighted returns are preferred for evaluating a manager, since cash flows are not taken into consideration.