by Kevin Kroskey, CFP, MBA
Investors usually define successful investment performance when investments increase in value and failure when investments decline in value. While this simple definition is useful on a very high level, it fails to measure a percentage return calculation. Without the return calculation investing tends to be a black box, lacking essential feedback mechanisms to monitor progress towards investment objectives.
Methods of Measurement
Rates of return are usually not displayed on statements received from the account custodian. Rather, statements simply show a summary of inflows, outflows, and any gain or loss in dollar terms. This reinforces the simplistic definition of success or failure and keeps investors largely uninformed.
Global Investment Performance Standards or GIPS® are a set of standardized, industry-wide ethical principles, established by the Chartered Financial Analyst Institute, that provide investment firms with guidance on how to calculate and report their investment results. GIPS® tends to favor using time-weighted-return calculations over money-weighted-return calculations, though it is important to understand both.
Time-weighted returns measure how much the combination of your investment choices returned on average. This return calculation ignores the effect of cash flows into and out of the portfolio and calculates the compound growth rate of a single dollar in a portfolio over a stated period. The downside to this return calculation is that you don’t have the ability to spend time-weighted returns.
Money-weighted returns measure how much your investment dollars returned on average. With this measurement the total amount of cash flows and timing of these cash flows into and out of the portfolio are considered. This measurement is the most economically relevant to an investor, as money-weighted returns are those that can be spent to meet needs and wants. The downside to this calculation is that it doesn’t necessarily tell you whether or not your investment manager is doing a good job, as this calculation may penalize or reward a manager on factors outside of their control.
For example, suppose you leave your current employer and roll over your $500,000 401(k) into a $100,000 IRA. Immediately after the rollover, the market declines substantially. In this case your money-weighted return can be substantially lower than your time-weighted return due to the large cash inflow and subsequent market decline. However, if the market substantially increased after the $500,000 rollover, the money-weighted return can be substantially greater than the time-weighted return.
Investor Behavior and Impact on Mutual Fund Returns
There have been many studies over the last decade studying the differences between time-weighted returns and money-weighted returns realized in mutual funds. Evidence has shown that the average do-it-yourself investor is not disciplined. Rather, investors act emotionally and base decisions on fear or greed, which often causes an investor to buy a fund after it already has gone up or sell a fund after it has gone done. This violates a basic rule of investing: buy low and sell high.
Investors also hold their funds an average of only two to three years. This shows that investors tend to follow a short term strategy of chasing recent winners whose outperformance does not persist into the future. This cycle tends to repeat time and again.
In a 2005 study, Indexing Goes Hollywood, Morningstar found that this lack of discipline and poor timing cost investors differently whether they used actively managed mutual funds or passively managed mutual funds. For actively managed funds investors lost 10% of the fund return. Said another way, the time-weighted returns were 12% and the money-weighted returns were 2%. For passively managed funds, investors lost 1.88% of the fund returns.
Of interesting note were results Morningstar found for passive asset class funds managed by Dimensional Fund Advisors (DFA). These funds are institutional and available through approved fee-only advisors who adhere to a passive investment philosophy. Morningstar found that that the money-weighted returns of DFA’s funds were 106% of the time-weighted fund returns. A plausible explanation for this is that advisors encouraged disciplined investor behavior via portfolio rebalancing, which requires an investor to sell recent winners and buy recent losers. This in effect adheres to a buy low and sell high discipline. This discipline equated to a 2.32% yearly advantage over the returns of the do-it-yourself index investor.
Most publicly available information on fund returns is published using time-weighted returns. Morningstar now publishes time-weighted returns, called Total Returns, and also publishes money-weighted returns, called Investor Returns. You can visit www.morningstar.com to check your fund returns.
Implications for Investors
Just as parents demand feedback for their child’s performance in schools via report cards and parent-teacher conferences, investors should demand similar feedback on their investment results. Investors tend to define investment success by simple gains or losses and don’t measure actual results on a money-weighted or a time-weighted basis.
For the majority of investors, these calculations are too complex to do. Statements provided by account custodians generally do not help even though the custodians have the information required to make the performance calculations. Yet, any good investment advisor should be able to provide the requisite information. Understanding the purposes and limitations of investment performance measurement enables investors to make sound judgments, regarding their portfolio, and allows investors to monitor progress to investing objectives.
Unfortunately for investors, Wall Street tends to follow a firm-first rather than a client-first mentality of caveat emptor (buyer beware). As former SEC Chairman Arthur Levitt stated: “They (Wall Street) know they can make more money off uniformed investors.”
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.
