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.

Time and Money Weighting: making sense of the differences

When teaching our Fundamentals of Investment Performance course, when writing my books, and often when simply having conversations with clients, I am often faced with the task of explaining, in as clear a manner as possible, the differences between time and money weighting. This topic is one of the most confusing in our industry. I've heard, on several occasions, performance measurement veterans misspeak when it comes to these matters.

At the core it all boils down to cash flows: whether to include them in the process, or eliminate (or at least reduce) their impact on the resulting return. And while a few folks suggest that their implementation has nothing to do with who controls the cash flows, the reality is that this is definitely the main reason behind deciding upon which to use (though there are times when we actually ignore this, in favor of the insights provided).

And it also boils down to linking. That is, the geometric linking of returns.

Time weighting comes in two forms: exact and approximate. Exact methods revalue the portfolio for all cash flows, and calculate returns between each of these revaluations. Approximation methods may revalue for large flows, but not all flows (or they'd be exact). And linking occurs at any point when the portfolio is revalued (either when large flows occur, or at month-ends).

We typically use either the Modified Dietz or Internal Rate of Return (IRR) formula in our approximation methods. Both of these formulas, by themselves, are actually money-weighted methods. We transform them into time-weighting when we employ geometric linking!

The following graphic contrasts money and time weighting:

As you can see, we are calculating returns in two ways: by time and money weighting. The essential difference is that with time-weighting, we value the portfolio multiple times during the period, and link the intermediate results, while for money weighting, we only value at the end points.

Can more be said on this topic? Yes! And more will be, so stay tuned.

What are the risk statistics for IRR?

Someone recently asked me what risk statistics should be used with the internal rate of return (IRR), (which, as any reader of this blog knows, is my preferred return measure). Sadly, I didn't have an immediate reply.

The plethora of risk statistics that are available for time-weighted rates of return (TWRR) use the intra-period returns. For example:

• standard deviation (we can continue its appropriateness as a risk statistic)
• beta
• tracking error
• downside deviation

as well as the multitude of risk-adjusted return measures that use these risk measures (such as Sharpe ratio).

Recall that the IRR measures the return for a single period; there is no linking. Comparing the portfolio's IRR with the benchmark's only serves the purpose of seeing how well the portfolio did. But how can we measure risk if we use the IRR?

Reflect on this for a bit;  I will return to this matter soon, with some concrete ideas.

Tracking your performance

This weekend's WSJ has once again provided us with a topic to address, specifically from Jason Zweig's column, titled "Why We Can't Tell if the Market is Half Empty or Half Full." He points out that "For most investors, getting a clear picture of where your portfolio stands isn't easy." The key words here are "your portfolio."

He later quotes Tom Chubb, a retired marketing executive who said "What I want to be able to do is to look at those different locations where my nest egg is stored and try to determine whether my financial advisers are doing a good job." Here we want to evaluate the financial advisers.

Jason identifies a few sites that might help the investor, such as Moringstar's, which has a "performance tab" where an investor can compmare their stock or ETF (exchange-traded fund) against the S&P 500, with dividends included. But would we really want to look at single investments? This has some value, no doubt, but the portfolio view is probably what most want to see. And if these investments are purchased and sold at different times, or in pieces, such a review won't really do us much good.

Apparently Google Finance is considering a "total-return chart," but they don't have any plans to introduce one. Yahoo apparently has one "in the pipeline."

What is it the investors are interested in? We've been through this a few times, yes? It depends on the perspective from which the question is posed:

• How am I doing? We want a money-weighted result.
• How is my portfolio manager or financial advisor doing? We're talking time-weighting.

Modified Dietz isn't a difficult return to calculate, and I'll be happy to provide anyone who'd like it a basic spreadsheet that can be used to derive these returns. They can then be chain-linked to develop an approximation to the true, time-weighted return, which will no doubt suffice for most investors who want to gauge the performance of those they rely on for their investments. For their own performance (i.e., money-weighting), they can rely upon Excel's built-in IRR functionality. We can provide guidance on how to do this, too. It's not really that hard. 

Oh, and for Mr. Chubb and others like him, we are finding more and more broker/dealers (several of whom are our clients) providing their clients with rates of return. Granted, they're often only from one perspective, but this solves at least one of their needs. And many can consolidate the holdings from other managers, so that the investor sees a single report that covers all their investments.

It really shouldn't be that hard, should it? We don't think so.

Even the Bible encourages IRR ...

"Men have had recourse to many calculations"

Ecclesiastes 7: 29

What's the interpretation of this line? Sadly, my bible doesn't reference which return formulas the writer was referring to, but one with an open mind can conjecture that it's a verse that recognizes that many return calculations are available and that one would be remiss not to consider them all.

To rely solely on time-weighting, for example, would provide us with limited knowledge. And since Ecclesiastes falls within the "wisdom" books of the bible (along with Job, Psalms, Proverbs, Song of Songs, Wisdom, and Sirach), clearly we're looking for ways to enhance ones wisdom; ones knowledge. A multi-dimensional view can only be obtained by considering alternatives, with each serving a purpose; fulfilling a role.

And so, what further evidence is needed that IRR (internal rate of return; money-weighting) should be part of ones arsenal?

p.s., While I knew that the bible was a source of comfort, insight, and guidance, I didn't realize it could also be a source of support for money-weighting!

How to explain positive returns when losses occur

Today's animation discusses the fairly common situation, where a portfolio loses money but has a positive return.

Pension funds and GIPS

Of late there's been some discussion occurring regarding pension funds (and similar entities, such as endowments, foundations, and even central banks; i.e., "asset owners") becoming compliant with the Global Investment Performance Standards (GIPS®). I believe that I was the first person "on record" supporting such a step, as I commented on this topic in response to an article that harshly criticized the idea, in Pensions & Investments a few years ago (I have the letter somewhere if anyone is interested in seeing it).

I still believe that the idea has merit, though it's important to understand why such an organization would (or perhaps should) seek compliance and what their compliance would mean.

One cannot lose sight of the reason we have the standards in the first place: to provide an ethical framework for asset managers to provide their past performance to prospective clients. This clearly doesn't apply to pension funds. So why would anyone want to go through the time-consuming and costly exercise to achieve compliance if they don't market their services?

One reason is that it helps the firm get their shop in order. It requires the establishment of policies and procedures, and along with that controls. It forces individuals to think about how they organize themselves, what policies make sense, etc.

Would the plan have only one composite or multiple?

The plan might only have one portfolio,  per se, that is broken up across dozens or even hundreds of smaller subportfolios, each geared towards a specific market segment. There can be justification to create a single composite (for the entire portfolio) or multiple composites. If you go with multiple, where each aligns with a subportfolio, what do the numbers represent? The performance of the manager. Therefore, if an external manager is being used, it will be their performance; if it's an internal manager, it will be his or her performance. But not the plan's. And if the plan is set up as a single composite, then the return represents the performance of all the managers in aggregate. But again, not the plan's, because the plan's performance can only be measured in one way: using money-weighting.

The only concern that I have with pension funds, etc. embracing the GIPS standards and becoming compliant is that they will interpret them as being the most appropriate way to represent how they're doing, but this is about as far from the truth as one can get; it represents how their managers are doing. If anyone wants to know how the plan itself is doing, GIPS won't tell them. The Standards don't speak to this.

I have already had discussions on this topic with one pension fund and a central bank, both of whom claim compliance. I cheer them on for wanting to comply, but that is not sufficient as it fails to tell them what is most important: how THEY are doing. Yes, it's important to monitor the managers, but this can be done without the GIPS standards, and has been for many decades. "How are we (the plan) doing?" is a different question, and requires a different way of thinking and calculating returns.

Is a new standard needed?

May I be so bold as to suggest that this part of the market (pension funds, endowments, etc.) would be better served with a standard that is geared specifically to them. That would be preferable. With but one standard, that is the only place one looks for answers. But, it shouldn't be. Perhaps moving to GIPS is a good "first step" in the process; and hopefully at some point in the future we will see a standard that speaks to this market, providing a framework that will result in returns that answer the right questions.

Attribution: a matter of perspective

While I often speak of returns being a matter of perspective (that is, whether we're speaking about how the manager did or how the portfolio or client did) to determine whether time- or money-weighting should be used, the same holds true with attribution. I was recently approached by a portfolio manager who wants to report attribution from a selection, country, and sector perspective. Okay, so right there we have three different effects we may want to consider. But it gets even more interesting. Let's consider this first approach:

Here we see that we are able to reconcile to the excess return, using either the country or sector effects. And notice that the sector's weights are relative to the portfolio, meaning that we are evaluating how each sector (as well as country) contributes to the overall excess return. And so, we see how our allocation and selection decisions worked out at the country, sector, and overall levels.

Now, let's consider the following:

Here we have grouped the sector data together, so that we are only focusing on how each sector contributed to the overall return. You'll notice that the portfolio's effects are different than what we saw in the earlier example, but that's because our analysis is now from the perspective of the sectors and the way the manager invested relative to them.

In our third example you can see how the sector weights are now relative to their respective countries:

We are now answering the question, how did the manager's actions at the sector level contribute to each country's performance?

And so, there are lots of ways to "slice-and-dice" our numbers, to provide us with different perspectives as to what is going on. It's important to understand that this is possible and to decide which way(s) makes the most sense for you. You may want to look at attribution from multiple perspectives, which is great, but understand what the information is reporting to you.

By the way, I have ignored the currency effects to make this presentation easier; perhaps we'll add this factor at a later time.

Plan sponsor performance

I recently suggested to a plan sponsor that they consider using money-weighting as well as time-weighting, pointing out that since they control the cash flows, such an analysis would provide some value. Well, today I got an email which offered the following:

It appears that you believe a plan sponsor has 100% control of their cash flows, but this is not true. At the total fund level, the drivers of cash flows are contributions and retirements, and these are impacted by pension legislation and other factors. Within the asset classes, things like the asset allocation study and board policy (acceptable ranges within each asset class) are key drivers affecting allocation changes.

I won't argue that the external cash flows may be controlled by other parties, but the allocations across sectors, as well as the selection of the managers are controlled by the plan sponsor, even if the board is involved in these decisions. Thus, money-weighting has value here, too. I guess one question to ask: "what does a time-weighted return tell us at the fund level?" Your thoughts are invited.

Let's stop celebrating GIPS as the only answer to our return questions

I recently wrote a letter to Pensions & Investments, which was published in their February 21 issue. Titled "Flaw in time-weighting return," it was a response to an earlier P&I article that discussed how plan sponsors need to ensure they're using the right benchmarks. And while I agreed that having the correct benchmark is critically important, it's even more important that plan sponsors employ the correct return methodology. I'm sure that you're not surprised that I was advocating the use of money-weighting for the plan to understand how they are doing, separate from the use of time weighting to see how the manager has done.

I posted the piece on Linkedin, and it has engendered a fairly lengthy discussion in one of the groups. Not surprisingly, there still seems to be interest in relying on what GIPS(R) (Global Investment Performance Standards) has to say, when the standards do not speak to client or in-house reporting. And I am not advocating that the standards should. But it's important that we recognize where the standards begin and end, and it all has to do with what a manager gives to their prospects.

In a recent animation, which I posted here earlier this week, I touched on the frequent use of time-weighting and suggested that one of the reasons is that this is just the way we've always done it. Obviously, this is a topic I have a lot of passion about. If this was an idea that had little chance of succeeding, I would have given up some time ago; however, we are making progress in educating folks, as evidenced by some of the Linkedin comments. But that being said, I will try to be "mum" on it for a while, as there are lot of other things to address.

The last 10% & Mulligans

I am confident that anyone who has been involved with the development of software will agree that the first 90% of a project is much easier to accomplish than the last 10%; the balance sometimes takes "forever!" Even husbands who take on home projects often get 90% of it done, with a plan to finish the rest, but simply never get around to it. Well, the same issue seems to apply to writing books, as getting most of the work done is much easier, at least to me, then the balance.

Case in point: the second edition of my third book, The Handbook of Investment Performance. I got the transcript wrapped up in relatively quick time, but the editing, layout, etc. seemed to take much longer than we had planned. And as we neared the "finish line," I got an email from someone from CalPERS who had some corrections to errors he discovered: talk about perfect timing! For this I was quite grateful, as I had overlooked some of them in my review. Well, the wait is almost over and the book is at the printers, with a delivery date fast approaching.

The book has served as a "Mulligan" for me. If you're not a golfer you may not be familiar with this term, easily translatable as a "do over." In a casual, friendly game of golf, if a player hits an errant drive it isn't uncommon for him or her to say "I'll take a Mulligan," meaning I will hit that shot again, without any penalty. This book is a Mulligan for me as it is allowing me to make some significant changes to the first edition, which was arguably a Mulligan for my very first book, published by McGraw-Hill.

Shortly after the earlier edition went to print I had an "epiphany" which I would liken almost to being "born again," as it has caused me to develop passion for what has become one of my favorite topics: money- versus time-weighting. I was so pleased to be able to write it that this chapter will be available on the CFA website.

You'll also notice that I have clearly admitted that "Modified Dietz returns are money-weighted." There, I said it again! I have caved into my colleague and friend, Carl Bacon, who long ago chastised me for failing to acknowledge this. And although I had known for some time that he was correct, I hesitated in stating it because it only, I thought, makes this topic even more confusing. I hope that my presentation in the book is lucid. And as for Carl, I do hate it when he is right, but fortunately this does not occur too often.

Our firm is actually running a "pre-order" or "pre-release" special on the book, so if you're inclined to purchase a copy, this is the perfect time. For details please contact Patrick Fowler

More support for changing the way we do things ...

I love the weekend edition of The Wall Street Journal. Invariably I find one or more articles to reference in one place or another. And this past weekend it was Matt Ridley's "A Key Lesson of Adulthood: The Need to Unlearn." As Matt so correctly put it, "We all think that we know certain things to be true beyond doubt, but these things often turn out to be false and, until we unlearn them, they get in the way of new understanding." It's ironic that this article appeared as President George W. Bush's former Defense Secretary, Donald Rumsfeld's Known and Unknown: A Memoir was being released. Rumsfeld spoke of the "unknown unknowns," as things we don't know that we don't know. While he was ridiculed for what some thought was a silly statement, it has a great deal of value.

In our slice of the investment universe, many performance measurement professionals should strive to be open to unlearning concepts they've embraced for years or, in some cases, decades. I have commented at length in this blog, our newsletter, and articles about the undeserved adulation awarded to time-weighting, and how money-weighting should be the most commonly used method to derive returns.

Matt Ridley cites the word "disenthrall" from Mark Stevenson's An Optimist's Tour of the Future," who borrowed it from an 1862 message from Abraham Lincoln to Congress, suggesting that they disenthrall themselves from "the dogmas of the quiet past," meaning to "think anew." Well, performance measurers should disenthrall themselves from the belief that there is one way and one way alone to measure performance and think anew! And, for that matter, that GIPS(R) (Global Investment  Performance Standards) hold the key to everything we do in performance measurement. We very much need to "think anew" about much of what we do.

Best practice when it comes to rates of return

A client asked about the "general landscape among financial companies in terms of usage of different performance engines/performance calculations." Specifically whether true daily or Modified Dietz is prevalent when it comes to portfolio and security level returns. I admire his due diligence in trying to obtain this information as they move forward with their own decisions.

When we use the term "best practice" what exactly do we mean? Unfortunately the GIPS(R) standards (Global Investment Performance Standards) uses this term for recommendations, suggesting that they are "best practice," but fails to define what "best practice" means? Is it:

• what is most commonly done (hardly, I would argue, the best basis for "best practice")
• what the leading firms do (again, not necessarily the best "best practice" source)
• what a few individuals on the GIPS Executive Committee think is what firms should be doing (arguably not "best practice," as the mix of members can change, would could cause a total redefinition as to what the term means).

Not knowing makes it a little mysterious and murky, does it not? I hesitate to offer my own definition, but may post this question on one or more of the Linkedin groups in the hopes that we might arrive at some consensus. But moving on to the questions at hand.

My thoughts:

• Portfolio level performance: it is evident that the industry is moving to daily time-weighted performance at the portfolio level. This should (assuming there aren't any data issues) result in the most accurate return. I would argue that the best approach would be to also have money-weighted returns at this level, so that the firm can provide multiple perspectives as to what is going on in the portfolio (i.e., how the manager did as well as the portfolio).
• Security, sector, asset class (i.e., sub-portfolio level) performance: here again we see a lot of firms employing time-weighting which I would say is the wrong approach (and I'm sure that some of my readers have heard this countless times from me and are thinking that I'm sounding like a "broken record," whatever that is!). If we go with what everyone else is doing, then do time-weighting and ideally daily; but this, to me, is incorrect: there is only one way to measure sub-portfolio performance: money-weighting. If you want to use Modified Dietz, that will be an improvement over true daily.

I thank our client for providing me with material for this blog and invite your thoughts.

p.s., I will most likely take the broad topic of "best practice" up in our newsletter

A different way to measure ROR

While "risk" seems to be a more commonly found topic in the Wall Street Journal, I was pleased to see this advertisement appear in this past weekend's edition. First, it's wonderful to see a focus on diplomas, especially for inter-city children; as a former "inter-city" child myself (though we didn't use the term in the '50s and '60s), I have an appreciation for such achievements.

What strikes me about this ad is the personalization of the return; something we've been trying to get folks to identify with for some time. Again, it has to do with perspective. Returns often are multidimensional, and to solely view them through the lens of time-weighting does them an injustice. Perhaps this piece can serve to wake more folks up to the importance of money-weighting.

p.s., we hope you'll consider donating to this worthy cause. Go here for the full size ad and details on how to contribute.

The Poseidon Effect

During our Fundamentals of Investment Performance class, when we get to the discussion of time- versus money-weighting, a question arises as to why firms continue to exclusively employ time-weighting, when it's quite clear that there's a major role for money-weighting. I typically use a scene from the 1972 move, The Poseidon Adventure, as a metaphor for one possible reason.

The scene occurs shortly after the boat has done a "180," and the major characters (Gene Hackman, Ernest Borgnine, Red Buttons, Shellly Winters, etc.) are gathered together along a corridor. Hackman (Rev. Frank Scott) tells them they need to go in the direction that is the complete opposite of where everyone else is running. Borgnine's character (Mike Rogo) challenges him, asking what makes him so sure since everyone else is rushing the other way. Hackman insists that the others are heading to their deaths because that direction won't provide a way out.

Now, if you use the wrong return formula surely death won't follow. However, our natural tendency to want to "go with the crowd" can cause us to miss out on doing things a better way. Avoid the "Poseidon Effect" and take advantage of what money-weighting has to offer.

A place for TWRR and subportfolio returns

If you're a frequent reader of my blog and/or our firm's newsletter, you know of my passion for money-weighting, especially when it comes to subportfolio returns.

I'm teaching classes this week for a client and when we discussed subportfolio returns and my preference for money-weighting, a student asked what the GIPS(R) (Global Investment Performance Standards) rules were regarding this topic. In general, GIPS is silent when it comes to subportfolio returns; the one exception is for carve-outs. But even here, there is no explicit requirement, but it's worth considering how we should handle them.

While I generally favor using MWRR for subportfolio returns, in this (possibly only) case, I'd argue that TWRR is what we should do. And why is this? Well, think about what a carve-out is supposed to be doing: we're taking, for example, the equity portion of a balanced portfolio and putting it into an equity composite. If there are accounts in the composite which are only invested in equities, their returns are measured using TWRR. And, the carved-out portion is supposed to represent what would have happened had the assets been managed separately, and not as part of a balanced portfolio. Therefore, TWRR makes sense.

MWRR @ subportfolio level

A brokerage client just mentioned that one of their reps wants money-weighted returns at the subportfolio level. And I was asked to contrast the advantages and disadvantages of time- versus money-weighting. Well, in one respect he came to the wrong guy, because there is no advantage to time-weighted subportfolio returns, with the only possible exception that someone might want to see how a security performed, irrespective of the flows that occurred, which might have some slight marginal value.

Who controls the flows at the subportfolio level? Well, if it's a managed account it's the portfolio manager...so why wouldn't you want to use money-weighting to capture these decisions? And if it's the client, then again, why wouldn't you want to capture the buy and sell activity?

Money-weighting is the way to go. [full stop!]

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.

Oops!

A few days ago I announced the arrival of the June newsletter, and a couple attentive readers immediately made me aware of a typo. In the "logic" section on page 3 you'll find "And the inverse holds: when the manager does control the cash flows, money-weighting is inappropriate." ERROR! It should, of course, read "time-weighting is inappropriate."

In the original draft I had it correct, but when I reread it I misread it and thus changed it...my goof! Sorry for any confusion.

Time-weighting vs. Money-weighting ... a never ceasing issue

Carl Bacon and I will be battling one another tomorrow at the second day of PMAR Europe I on the subject of time- vs. money-weighting. Carl and I enjoy these debates and have engaged in them several times.

This evening I was speaking with a client who mentioned that she has tried to get her management to accept money-weighting, but to no avail. It occurred to me that she needs to get past the labels: just show the numbers.

Use examples to demonstrate the difference without using labels. We'll discuss three:

Our first example is somewhat classic: we lose money but have a positive return; but, we can also see a negative return. The second shows where our gain/loss is zero but we show a huge return in one case and a zero return in the second. And the third shows us making money but having a negative return in one case and a positive in the other.

And so ask your client what return makes sense to them if we're reporting on how THEIR PORTFOLIO did; not how the manager performed. If the client offers anything but ROR #2 in all cases, we have a problem. And, of course, ROR #2 is MWRR (ROR #1 is TWRR): 'nough said.