Almost Everything We're Taught Is Wrong, well maybe not almost everything

Last year John Stossel wrote a piece titled "Almost Everything We're Taught Is Wrong." When it comes to performance measurement, there's some truth to this, too. Sorrowfully, many refuse to be open to the possibility that the way they've been doing or promoting something is fundamentally wrong. Is it pride, a refusal to be objective, impatience or frustration with those of us who challenge the "conventional wisdom," a resolute commitment to the traditional methods, or some other reason? 

I must confess I've been guilty of this, too. We learn something at an early age, and it gets reinforced along the way. Then, out of the blue, someone comes and says "no, there's a different way," or "no, what you're doing is wrong," or, "no, your understand is incorrect." How do we react? Our natural reaction is usually a defensive one: that is often the case with me. I have to learn to pause, listen, reflect, consider. A lot to ask, but really what's necessary.

Take Modified Dietz, for example. I was taught that it was a time-weighted rate of return: FULL STOP! That's it. And then I'm told (by my friend Carl Bacon and a few others) "no, actually it's a money-weighted rate of return." "WHAT!" And so, I turn to the literature, and nowhere do I read that this is true; on the contrary, everything points to it being a time-weighted rate of return. Carl is clearly mistaken.

Somewhere along the way I realized that (dare I say it?) Carl was correct. BUT, do I confess (mea culpa)? And, do I tell others? After all, just about everyone knows that Mod Dietz is time-weighted. By coming out with this revelation, won't confusion be rampant? Can the performance measurement industry stand such a jolt? Well, after much soul searching, I realized that regardless of the impact, the truth must be told: Modified Dietz is money-weighted ... unless, of course, you link it, and then it's an approximation to time-weighting (right, Steve?). 

But there is so much more that we do that is simply wrong; for example:

• using the aggregate method for GIPS(R) (Global Investment Performance Standards) compliance
• relying so heavily on time-weighting, when money-weighting is a superior method
• requiring asset-weighted composite returns rather than (or, at a minimum, along with) equal-weighted composite returns for GIPS compliance.

Opportunities still arise for change, however. And it will come, eventually.

Mixing & changing returns

A GIPS(R) (Global Investment Performance Standards) verification client sent me a note recently, stating that they had historically used Modified Dietz for their returns, but will be switching to "true daily." He asked if this was permitted or if they would have to restate their history. This also raises the question about multiple methods being used simultaneously.

The answer to both is "yes, it's permitted." As long as the returns that are employed meet the GIPS requirements, you can switch. Of course we wouldn't expect that you would be switching in order to obtain a higher return, meaning that if we saw a lot of switching, back-and-forth, then we'd object, but this isn't what is happening here.

And, it's not uncommon for GIPS compliant firms to have accounts in the same composite whose returns are calculated differently. This can happen, for example, if you have a mutual fund (that has daily returns) along with a separate account (which might use Modified Dietz).

Your calculation policy document should explain the returns employed, historically and currently.

Why time-weighting if we don't weight time?

There seems to be some confusion as to what "time-weighting" actually means. The term was coined in the 1968 Bank Administration Institute (BAI) standards. The BAI proposed three ways to calculate returns:

• the "exact method," whereby we revalue the portfolio for any cash flow
• the "linked IRR," where we geometrically link subperiod (e.g., monthly) returns which were derived using the internal rate of return (IRR); this is similar to the Modified Dietz formula
• the time-weighted method, where instead of geometrically linking, we link returns based on the length of time between flows.

The third method can produce returns which are in error, thus it's been abandoned. However, the term "time-weighting" remains in our lexicon. But do we "weight" time? Nope! In fact, time has no bearing whatsoever on our returns. If we link a one day return, with a one week, one month, one quarter, one year, and one decade return, we will obtain a cumulative return across the full period, but in no way do we give extra "weight" to any of these periods.

In no way do we weight time in time-weighting. Granted, we weight cash flows based on their time in the Modified Dietz and Linked IRR, but this wasn't the source of the expression. Time-weighting simply means that we are eliminating or reducing the impact of cash flows. That's it! No time weighting.

Consolidated reporting

Many firms like to group a client's accounts together, to provide a consolidated report that presents the client with the "overall picture" of what they hold. This is commonly done in the brokerage arena, as well as by others. So, how does one calculate performance for such an arrangement?

Well, what question are you trying to answer? I believe it's "how am I (the client) doing, overall?

And if so, then the answer is quite simple: a money-weighted return. Ideally, we'd use the internal rate of return to do this, though Modified Dietz would work as an approximation to the IRR.