Tuesday, July 16, 2013

Should returns be net of inflation?

I had a discussion recently with a good friend and colleague, who suggested that when evaluating a manager's performance, returns should be net of inflation. I'm not so sure about this.

What are the "nets" we're familiar with:
  • Net-of-fees: most managers charge an advisory fee for their skill in investing their clients' assets. To report to their clients without the impact of fees is not showing the full picture. Yes, perhaps before the fees are removed (i.e., a gross-of-fee return) the manager did well, but the client wants to know the impact of the costs they incurred, which means transaction costs and management fees. Therefore, when reporting to clients, net-of-fee returns are, in my view, better than gross-of-fee.
  • Net-of-taxes: a few years back, reporting "after tax" returns was being encouraged quite a bit. This was perhaps stimulated by what appeared to be excessively high double- or triple-digit returns which managers were regularly producing. If a manager provided a +50% return (net-of-fees, of course), but taxes took a big chunk out of it, because of capital gains, how well did the client actually do? Thus, the encouragement to show after-tax returns. Even the AIMR-PPS(R) and GIPS(R) (Global Investment Performance Standards) had provisions for after-tax returns (since dropped from GIPS)). In my view, managers who claim to provide tax-efficient management are obligated to provide after-tax returns. Clients who want to see them should be given them, too. As for everyone else, I'm not sure, but it would be an interesting conversation to have. If the manager isn't making an attempt to avoid the impact of taxable events, should they be required or encouraged to report the impact their trading has? If a manager is extremely inefficient when it comes to managing vis-a-vis the impact of taxes, surely their clients (and the market) would want to know this. Again, could be fun to discuss.
  • Net-of-withholding taxes: When investing overseas, portions of income are withheld to pay local taxes. These funds may be recoverable. But until they are, should the returns reflect their impact? Probably, since the manager made the decision to invest in those countries and securities.
  • Net-of-risk: Risk-adjusted returns are, in reality, a return that has risk stripped away. Measures such as the Sharpe ratio, Treynor measure, Jensen's Alpha, and Information Ratio produce a form of risk-adjusted (i.e., net-of-risk) returns. My favorite risk-adjusted measure, as you may be aware, is Modigliani-Modigliani (aka, M-squared). Its use results in returns that are truly net-of-risk, which can be easily shown next to the portfolio's benchmark(s), to better judge how the manager performed.
To show returns to clients that are net of:
  • fees,
  • withholding taxes,
  • and risk
is, I believe ideal. To include taxes is also beneficial.

Okay, so what about net-of-inflation?

First, the manager obviously cannot control inflation. Inflation figures are reported ex post. And so, I don't know today what the inflation rate is; it's based on price changes over time. Can or should managers invest in a way to avoid or exploit inflation? Perhaps if they recognize that certain industries will benefit from inflation, they may invest in them, and industries that suffer, to avoid; is that reasonable? Do managers tout themselves as "inflation avoidance/efficient managers," as we have "tax avoidance/efficient managers? Not that I'm aware of, but clearly if someone does hold themselves out this way or employs such a strategy, then reporting net-of-inflation would seem to make sense.

We encourage managers to report the internal rate of return (IRR), or money-weighted return, to their clients, in order to represent how the client did. Should the manager judged on the IRR? In general, no, since the manager can't control the client's cash flow decisions, which may have a negative impact on performance. Perhaps net-of-inflation should fall under this idea, too; to show the client yet another net-of- figure, especially since their wealth is impacted by the effects of inflation. But, for the manager not to be judged. Again, an interesting question, worthy of some discussion.


    Bravo. You almost get this right. To get this completely right, you will have to fully embrace the idea of seeing performance reporting as a responsibility to provide information that helps asset owners see that they are achieving their financial goals. You are still somewhat stuck in the details of the pieces of the puzzle (individual funds vs. total portfolio) and you still express the returns as a goal, instead of a means to an end and not the end itself.

    Showing a client how many dollars they've earned, but not what those dollars can buy is nearly useless. The same is true for returns that are partially the result of the inflation factor. Even if we were to express the client's goal in terms of a return, that return would have to be adjusted for inflation, since the goal of investing is to increase wealth, or purchasing power.

    In addition, when we introduce the reality of inflation, we see that this changes not only return but risk. After inflation, risk tends to increase slightly and correlations between assets increase, thereby decreasing expected diversification and increasing the volatility of portfolios. The "real" world is quite a bit different than the fantasy of the nominal return world. This is especially true as investment horizons and performance reporting periods increase, in line with client goals. Isn't this what performance is (or should be) all about - showing clients whether their investments are meeting their financial goals? Or are we still stuck on "the mission" of simply helping fund managers sell their wares?

    If you're still wondering if inflation matters, and whether it should be included in performance reports, just ask yourself: "Does it matter how much my money will buy?"

  2. Thanks, Steve. As always, we appreciate your thoughts and insights!


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