Tuesday, June 1, 2010
Residuals when you don't expect to see them
However, if you're using a monthly return formula (e.g., Modified Dietz), then you may still end up with residuals, because the transaction-based approach is capturing an exact return, while the Modified Dietz arrives at an approximation to the true, TWRR. Ideally, you should be using a daily return method so that you will eliminate the residual.
Note: you can still have what might be called a longitudinal or intertemporal (occurring across time) residual, unless you employ an appropriate linking method.
p.s., I believe I'm the first to use the term "intertemporal" to describe this form of a residual. I believe it's a handy way to distinguish between single-period residuals which can arise from using a holdings-based model, and residuals across time, when using an arithmetic approach.