Investment Funds

Dr Nurin Haniah Asmuni

Centre for Actuarial Studies
Faculty of Computer and Mathematical Sciences
Universiti Teknologi MARA
5 April 2016
Learning Outcomes
The Students are expected to know:
 Interest Measurement of a Fund:
 Time Weighted Rates of Interest
 Dollar Weighted Rates of Interest
 Allocation of Investment Income
 2 methods:
 Portfolio method
 Investment Year Method

4/5/2016
Introduction
 Consider an investment fund such as a pension fund.
 To evaluate the performance of the fund over a
particular period, we consider:
 The initial value of the fund
 Any external cash flows that take place, such as inflows from
contributions and outflows to retirees, and
 The final value of the fund.
 We then perform calculations to assess the investment
performance
 We look at two methods of doing this:
 Dollar-weighted interest rate
 Time-weighted interest rate

4/5/2016
Example 1
 Suppose an investment has a 3-year
track record. The investment
manager earned 20% in the first year
and 5% in each of the two succeeding
years. If RM1,000 is invested with the
investment manager for three years,
what is the annual effective interest
rate?

4/5/2016
Solution
After three years the fund will grow to:
1,000(1.20)(1.05)(1.05)=RM1,323
Or equivalently it will earn i:
1  i 
3
 1.20 1.05 
2

 1.323  2  1
1

 0.097792
 9.78%
i.e. the annual effective rate is 9.78%
4/5/2016
 The annual effective interest rate of 9.78% is the
geometric average of 1.20 and 1.05.
 Since the rate of 5% was earned for two years, the 1.05
factor has an exponent of 2, giving it more weight than
the 1.20 factor
 Since this kind of average gives more weight to rates of
return that are earned for longer periods of time, it is
called a time weighted rate of return.
 When there are no cash flows into or out of the fund
over the investment period, the time weighted interest
rate is equal to IRR.

4/5/2016
Example 2
 Suppose an investment has a 3-year track
record. The investment manager earned 20%
in the first year and 5% in each of the two
succeeding years. Salman made a three year
investment with RM1,000 deposit at the
beginning of the first year and RM5,000
deposit at the beginning of the second year.
What is the annual effective interest rate?

4/5/2016
Solution to Example 2

At the end of three years these deposits would

have grown to:
1000(1.20)(1.05)(1,05)+5,000(1.05)(1.05)
=RM6,835
IRR for Salman:

1,0001  i   5,0001  i   6 ,835  0

3 2

Thus IRR that satisfies this equation is 6.19%

4/5/2016
 In the example 2, the calculation of IRR
takes into account cash flows that occur
during the investment period.
 Since the cash flows (which are
measured in dollars/ringgit) affect the
IRR, the IRR is also known as the dollar
weighted rate of return.

4/5/2016
Dollar-Weighted Rate of Return
 The dollar weighted rate of interest is
the interest rate that equates the
accumulated value of the initial fund and
the accumulated value of the cash flows
with the final fund value.
 Thus the Equation of value:
Accumulated accumulated Final
value of initial + value of cash = fund
fund flows value

4/5/2016
Dollar Weighted Interest Rate
(cont..)
If the value of the fund is F0 at time 0 and Fr
at ending time T, and there are cash flow (deposits into and
withdrawals from fund) of c1 ,c2 ,c3 ,.....cn
at times t1 ,t 2 ,t3 ,.....t n ,
the equation of value to calculate the dollar weighted rate of
return I for the period from time 0 to time T is:

F0 1  i   c1 1  i   c2 1  i   ....  cn 1  i 
T T t1 T t2 T tn
 Fr

The dollar-weighted interest rate of return is the yield i that

satisfies this equation of value.

4/5/2016
Dollar Weighted Interest Rate
(cont..)
We can simplify the equation of value to:
n
F0 1  i  
T

s 1
cs 1  i 
T t s
 Fr

Note:
 The fund values used in the calculations are
usually the market values of the fund
 The cash flows that are used need to be
external to the fund, i.e. they are not cash
flows generated from the fund itself.

4/5/2016
Example 3
 The value of a pension fund on 1/1/13 was
RM2 million. During 2013, the pension fund
paid out RM100,000 in benefits on June 1 and
September 1 and the fund received a
contribution of RM20,000on November 1. The
value of the fund on 31/12/13 was
RM1,900,000.
 Set up the equation of value to calculate the
dollar weighted rate of interest for the pension
fund in 2013.

4/5/2016
Solution to Example 3
The time line diagram is:
2,000 1,900 fund value
-100 -100 +20 cash flow

Jan 1 Jun 1 Sept 1 Nov 1 Dec 31

The Equation of value (in 1,000s) is:

2,0001  i   1001  i   1001  i   201  i   1,900

7 4 2
12 12 12

4/5/2016
Solution to Example 3 (cont…)

Simple interest approximation for compound interest:

To find an approximate value of the dollar weighted rate of
interest:
1. expand the equation using a first order binomial
expansion, i.e.
2. Replace 1  i n with 1  ni 
3. solve the resulting equation

4/5/2016
Solution to Example 3 (cont…)
 Let’s consider the equation we obtained in the
example 3:
2,0001  i   1001  i   1001  i   201  i   1,900
7 4 2
12 12 12

 Dividing by 10 and using the first-order

binomial expansion, we have:
 7   4   2 
2001  i   10 1  i   10 1  i   2 1  i   190
 12   12   12 
1,147
182  i  190
6
i=4.2%
4/5/2016
Time-Weighted Interest Rate
 Let F0 be the initial value of the fund at time 0 and Fr
be the final value of the fund at ending time T.
 Let the external cash flows be c1 ,c2 ,c3 ,......ct
 Let the value of the fund just before each of these cash
flows be F1 , F2 , F3 ,.......Fn ,
 Then the time weighted rate of return is the value of i
that satisfies the equation:
 F1  F2  F3   Fr 
1  i 
T
    ......... 
 F0  F1  c1  F2  c2   Fn  cn 

4/5/2016
Example 4
 The value of a pension fund on 1/1/13 was RM2 million.
During 2013, the pension fund paid out RM100,000 in
pensions on June 1 and September 1 and the fund
received a contribution of RM20,000 on November 1.
 The value of the fund on 31/12/13 was RM1.900.000. On
May 31, 2013 the fund was valued at RM2.05 million; on
August 31, 2013 its value was RM2 million; and on
October 31, 2013 its value was RM1.99 million.
 Calculate the time-weighted rate of interest of the fund
for 2013.

4/5/2016
Solution to Example 4
The table for the example:
Date Value of Fund just Cash Flow
before the cash flow
1/1/13 2.00
1/6/13 2.05 -0.10
1/9/13 2.00 -0.10
1/11/13 1.99 0.02
31/12/13 1.90

 2.05  2.00  1.99  1.90 

1 i        1.0408
 2.00  2.05  0.10  2.00  0.10  1.99  0.02 

So the time-weighted rate of return is 4.08%

4/5/2016