A Modification of the Modified Dietz Approach

The evaluation of the portfolio performance from the investor perspective is usually computed using the Modified Dietz approach (or the internal rate of return) in order to take into consideration the impact of external flows. On the contrary, the GIPS® standards are based on the assumption of computing the rate of return, ignoring the impact of external flows. The Modified Dietz approach provides a meaningless result when the average investment is negative or close to zero due to huge negative external cash flows. We propose an alternative approach, which is based on the same assumption of the Modified Dietz approach: changing the definition of average investment. In our model, the average capital invested (ACI) is no more the sum of the cash flows time-adjusted, but is the weighted average of the capital invested in each subperiod , using weights given by the length of the subperiod in which the capital is invested. This approach is able to provide a reasonable rate of return even with large volatility of periodical cash flows.