More on the aggregate method

Fear not!

I haven't given up on my arguments against the use of the aggregate method to derive the extremely important composite returns (which are the bedrock of the Standards).

I was conducting a GIPS(R) verification earlier this week, and stumbled upon the following on page 6 of the 2010 edition of the Global Investment Performance Standards:

"The composite return

is the asset-weighted average

of the performance

of all portfolios in the composite."

[emphasis added]

But, as I have pointed out repeatedly, this does not hold for the aggregate method, which calculates the return of the composite, which can yield a hugely different result. And so, IF this IS the definition, why allow the use of a formula that violates it? We have two measures which DO satisfy this definition, and should be the ONLY ones permitted.

Can I get an "amen" on this?

Now, in reality, I favor equal-weighting, but asset-weighting won't go away. But we can at least adhere to the intended definition and calculate it properly, can't we?

p.s., I learned this form of writing from reading NBA Hall of Famer Dennis Rodman's autobiography (yes, I read it).

p.p.s., Well, actually, Susan Weiner was my inspiration.

When aggregate makes sense

Before you think "oh, here he goes again" please give me a second to explain. Okay, yes, it's true: I've been beating this to death (and will continue to, but not right now).

I was sent the following question from a client:

"How do you calculate performance for a composite that contains two or more funds?  Do you combine multiple funds' cash flows and calculate an IRR [internal rate of return] using all the funds' contributions, distributions and residual values as if they were from a single fund?"

Some background: the writer is speaking about a client's account, where they are reporting to the client, and are using the concept of a "composite" to pool the client's accounts together.

In this case, unlike with time-weighting, we would aggregate the accounts (starting and ending market values, as well as cash flows). We then calculate an IRR across this aggregate account. I would not encourage asset weighting individual IRRs, though to confess I haven't played around with it; my "gut" is speaking here.

And so, there is a place for aggregation: for IRRs, when we are reporting to a client about their return!

What's it all about?

You may recall that I have opined in the past about the problems I've discovered with the aggregate method, both several times in this blog, as well as in our newsletter; I also wrote an article on this topic.

Some individuals who have read my materials argue that the aggregate method is, in fact, the superior method. They find that the case, for example, where all the composite's accounts have identical 4.00% returns, but where the composite has a different return, to be perfectly fine. In fact, that it is the correct return, and that the BMV+weighted cash flow approach to be the one in error (even though it matches the composite's).

I must confess that I found this all quite perplexing and, to some degree, shocking. However, while corresponding with some folks on this topic I had yet another epiphany. I believe there is something more foundational / fundamental going on here, which requires some thought. There is a point which is very important to consider: What is the composite return supposed to represent?  I suggest that you take a moment to reflect on this before continuing to read this post.

If you want to check the definition that is in the GIPS® (Global Investment Performance Standards) glossary, you'll quickly discover something:

it's not there! In spite of the vast importance of the composite return, there is no definition for it. Perhaps there was an expectation that "of course everyone knows what it means or represents," but after some reflection, I don't believe this is true. 

In reality, there are two different answers, depending upon which formula you use to calculate it:

• if you use either the BMV or BMV+WCF approach, the composite return represents the asset-weighted average experience of the accounts that were present in the composite during the given time period. However,
• if you use the aggregate method, the composite return represents the return of the composite, as if it was an account itself.

Therefore, if you believe that the return should treat the composite as a single account, then of course you would believe that the aggregate method is correct; but if, like me, you think it should represent the average experience of REAL accounts, then you would find its result to be a bit confusing at times.

Space doesn't permit me to go much further on this subject here, but I will comment at greater length later this month in our newsletter, so please stay tuned. I am of the firm believe that this is a fundamental issue with the standards, which has been overlooked by the GIPS Executive Committee, and its predecessor groups. I, too, hadn't really given it much thought until recently. But when someone firmly says, in response to my criticisms, that "no, the aggregate method is the most accurate method,  and the BMV+WCF is actually inferior," I was forced to pause and reflect.

p.s., As you no doubt realize, the GIPS standards grew from the AIMR-PPS®. If you take a look at the first edition of the earlier standard you will only see one method to derive the composite return, and it is based solely on the beginning market value. The other two were added in the 1997 editions. I suspect that when this was done, no one on the AIMR-PPS Implementation Subcommittee realized that they were at that moment introducing a second definition or meaning for the composite's return. But they were.