Tuesday, April 7, 2009

Portfolio returns: Are you comparing apples to oranges?

Computing the returns on my two portfolios—the Channeling Stocks and MANDA—got me thinking about how fund managers calculate their returns and what those returns reflect. Most folks probably have no idea how portfolio returns are calculated nor what exactly goes into them and I'm not sure that it's even spelled out in fund prospectuses. I thought an article or two investigating this subject might be instructive especially as an aid when it comes to comparing similar types of funds. Readers can also incorporate some of these points into their own portfolio management.

Return calculations can vary greatly according to the input parameters and the administration method which determines how returns are calculated. In this article we'll be looking how returns vary according to input factors. Tomorrow, we'll see how portfolio administration techniques affect yields.

Cash allocations and hedging techniques
There are two major inputs that can affect overall returns:

1. The amount of the portfolio allocated to cash. Fund managers need to have a certain percentage of assets in cash to honor redemptions. Generally speaking, the more the fund is traded, the higher the percentage of the portfolio will be allocated to cash. The amount in cash represents the percentage of the portfolio that is not invested, meaning that in favorable markets, returns will be reduced according to increases in the cash position. On the other hand, in unfavorable markets a larger cash position will help to mitigate losses. The table below illustrates the cash effect.

2. The types of hedging techniques used. Many fund managers earmark a portion of fund's holdings for hedging purposes to guard against currency and interest rate fluctuations. Options and futures are common hedging instruments. Proper hedging techniques can reduce portfolio risk but at the expense of reducing yields. The amount of the reduction depends on the type of hedging instrument and the size of the fund's resources allocated to it.

Fund prospectuses generally give hedging guidelines. Although I've never seen the impact that hedging has had on performance, it doesn't mean that it can't be found somewhere in the fine print.

Tomorrow we'll see how returns are affected by management methods.

Channeling Stock Portfolio Update
Because of the market sell-off in the past two days, I've added more short positions to the portfolio. I just hope they don't bite me in the butt if the market resumes its upward movement which it could do shortly. Although the market moved lower today, so did the VIX which is contrarian sign. Also, the Trin is moving into heady territory, closing the day at 2.29—another bullish sign.

The point of this fund is to learn and have some fun, so here's a list of today's shorts: AMG, LRY, MHP, PANL, PAS, PCAR, and our old friend ROP which I exited a couple of days ago. Yesterday, I also shorted BGG. All prices are closing prices.

The portfolio table will be updated on Friday.

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