Lederman's The God Particle. Mind you, I have JUST begun, but already stumbled upon something that I found I could use ... and I'm using it here!
In his definition of "The aether," he wrote "Discredited and discarded by Einstein, the aether is now making a Nixonian comeback."
Wow! Clever!
I immediately thought of my friend, the Internal Rate of Return (IRR): it is making a Nixonian comeback, too. It had ben discarded by virtually the entire investment world in favor of time-weighting. Like Rodney Dangerfield, it got no respect. But alas, it is creeping back, most recently with the introduction of the GIPS(R) guidance statement for asset owners that recommends its use. Excellent!
And while perhaps the IRR, if it was an actual being, might not like being compared with "Tricky Dick," it would still rejoice that it is finally "getting its due" and once again, gaining some respectability. Hurrah!
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I have to admit, I have a TWR bias. One problem I have with IRR is I don't feel it appropriate to compare against an index. For example, if you state a client's IRR is up +10% and the S&P is up +5%, the client's return looks favorable. However, it could be the case that given the same cash flows, the S&P would have been up +15%, and the client's return doesn't look as good.
ReplyDeleteWhile I recognize IRR can be a better representation of an individual client's actual experience, how do you feel about its comparability to indexes and other managers?
Gene, excellent point. This is an issue of some controversy, but one CAN adjust the time-weighted index to reflect the flows that go into the account, which then produces a money-weighted index. A few firms offer this option. Yes, it can be confusing and requires some education, but allows for an apples-to-apples comparison. My mission: to win you over to the money-weighted side!
ReplyDeleteWhile an index can be adjusted, I think this would lead to confusion when a husband and wife could have 2 different returns quoted for the S&P because they had differing cash flows. Or raise the question of why the S&P on a client's statement doesn't match what's quoted in the paper/on TV.
ReplyDeletePersonally, I think the ideal situation would be to report both an IRR (client return) & TWR (manager return), but realistically this may lead to more questions when the #'s differ. Especially when dealing with less 'sophisticated' investors.
I am in favor of the money-weighted return approach too. However, I recently had someone ask me if I can calculate an average number of the time-weighted and money-weighted returns. At first I laughed at the idea but it made me think that there is a need to utilize the time-weighted return in some way without confusing the client with too many returns. My suggestion was to calculate a "Market Timing" return. In other words, calculate the difference between your money-weighted return and your time-weighted return and present it as the contribution of market timing to your return. Does this make sense? I would like to know your opinion. Thanks.
ReplyDeleteAbsolutely, it can be confusing. Thus, the need for education. But such a need should never stop the showing of more meaningful information. If the husband and wife both control their own cash flows, and both start with $1,000. When the market raises their respective values to $5,000, and the wife stands pat, but the husband decides to put another $1,000 in. At the end of the period the husband's account drops to $1,500, meaning he has lost $500, but his TWR is 25%. The wife's account follows the same return stream and also has a return of 25%, but is actually UP $250. They have the exact same returns, which they compare against the S&P 500 and both rejoice, because they beat the benchmark, but one LOST money while the other MADE money; do you think THIS will make sense?
ReplyDeleteInteresting idea. Some refer to a "timing effect" with attribution (and some calculate it by taking the difference between the transaction and holdings-based methods; I am unsure this actually makes sense. There is no way to bring the TWR and MWR together, I believe; they serve very different purposes.
ReplyDeleteOne of our clients asked us to derive his average return (10-year return divided by 10, to come up with an average annual, for example): this has been rebuffed for years by our industry; it generates misleading info (I'll probably address this in some detail in a newsletter post soon). The difference between the TWR and MWR is, I believe, the effect of cash flows. Some more details are needed here, and perhaps I'll look to do some work on this. Thanks for the inspiration :-)