What is the Modified Dietz Method (MDM)?
The Modified Dietz Method (MDM) is a method that is used to measure a portfolio’s historical returns based on a weighted calculation of its cash flows. MDM takes into account the timing of the cash flows and assumes that a constant rate of return is achieved over a certain time period.
The MDM is considered to be an extremely precise and exact measurement of portfolio returns due to accounting for timing, as opposed to the Simple Dietz Method, which assumes that all cash flows are collected in the middle of an investment period.
The Basic Premise of the Modified Dietz Method
The performance of a portfolio or an investment can be calculated in a number of ways. Some ways include:
Basic Rate of Return
The basic rate of return is the usual market value divided by the book value formula. It provides a simple, but not entirely accurate, depiction of investment growth.
Time-Weighted Rate of Return
It measures the results of an investment strategy as it is applied to a portfolio. A time-weighted rate of return aims to remove the impact of cash flows that individuals made to or from the portfolio to calculate the actual investment performance that is attributable to actual investment decisions.
Dollar-Weighted Rate of Return
A complicated, but more accurate, measurement of the actual investment growth derived from the initial investment in addition to further investments made in a security. Whereas the time-weighted rate of return analyzes the returns of an investment strategy, the dollar-weighted rate of return represents the return achieved by implementing that strategy.
The MDM argues that that computing returns for smaller time frames (i.e., a month), and then using a geometric equation to link the returns of each time period, will more accurately reflect the return of an investment over an entire time horizon. As such, MDM depicts that a time-weighted rate of return is the best measurement of an investment’s performance.
Modified Dietz Method: A More In-Depth Exploration
The Modified Dietz Method reflects an individual’s rate of return from a given investment, and it is usually considered much more accurate than the Simple Dietz Method. The MDM takes several factors into account, including:
- The market value of the holdings
- All cash flows from the investment
- Length of time each cash flow event occurred
The formula for the MDM, which is explored in the next section, provides an individual with a measurement called the modified internal rate of return. The modified internal rate of return differs from the internal rate of return because it assumes that positive cash flows are reinvested in the firm’s cost of capital, and that any initial cost outlay by the firm is financed by the firm. The modified internal rate of return is usually used for capital budgeting decisions.
There are several reasons that Peter O. Dietz – an academic whose works were extremely influential in measuring the returns of pension investment funds – created the MDM, including:
- Improved investment portfolio reporting (i.e., does not require portfolio valuation on the date of each individual cash flow)
- A quicker way to calculate IRR than other methods that were available at the time
However, according to critics, MDM also comes with some disadvantages. One of the disadvantages is that it provides a less accurate estimate of the true time-weighted rate of return. It may result from one or more large cash flows or the cash flows occur during periods of high market volatility.
The MDM Formula
The MDM formula is utilized to calculate the modified internal rate of return using a geometric formula. The equation is as follows:
- V1 = Portfolio value at end date
- V0 = Initial portfolio value at start date
- CF = Cash flows throughout the investment horizon
- T = Investment horizon length
- t = Time of the cash flow
- CF(t) = Cash flow at a certain time
Application of the Modified Dietz Method
To apply the MDM, consider the following information from an investor:
- Initial investment = $1 million
- Subsequent investment = $300,000
- Ending portfolio value = $1.33 million
- Investment horizon = 365 days
- Time of cash flow = 213 days
The calculation of the modified internal rate of return would be as follows:
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