Leverage and Return

Timothy Peterson

When working with an alternative investment portfolio, particularly those with leverage or notional values, it is sometimes the case that an analyst may incorrectly define the components of the return calculation. In other cases, as discussed in previous chapters, meaningful mathematical solutions are elusive even if the components of the return formula are correct.

In this chapter we introduce an approach, termed the “accounting framework”, intended to help portfolio managers and performance analysts calculate the correct return in every circumstance. Once we can construct a balance sheet and profit-and-loss statement for each asset to be measured, we can calculate a return and have confidence that the inputs are correct.

THE ACCOUNTING FRAMEWORK

Many people dealing with unique leverage circumstances or notional values encounter problems when they attempt to take the components of the return calculation and try to plug them directly into a return formula such as Modified Dietz or IRR. This approach is not incorrect but is sometimes prone to mistakes. It could be that no mathematical solution exists. It could be that multiple solutions exist. It could be that the solutions