Managing Investment Results
March 3, 2009
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There is an old saying that “You cannot manage what you do not measure.” A lot of effort in the investment consulting and financial advising industry involves measurement, specifically performance measurement. Track records of funds and money managers are measured and benchmarked versus indices or ranked among supposed “peers.” Many financial advisors represent to their clients that part of their ongoing value is regularly measuring account performance.
But, is measuring results the same as managing results?
I personally think the old saying should be appended with the statement, “But, just because you measure something does not mean you are managing it.”
Sophistication in investment performance measurement has advanced remarkably over the last several decades with custom benchmarking, dollar and time weighted return calculations, and even online daily reporting. The financial services industry is clearly measuring a lot of returns, but does doing so add any value? Is the measurement of returns leaving investors with a potentially false and misleading impression those returns are also being managed, merely because they are measured? Is it even possible to manage returns? If so, what would successful management mean to the end investor and how would one manage it?
What are we measuring?
Which returns are we attempting to manage? Are we measuring and managing, time weighted returns (those that ignore cash flows and wealth results) or dollar weighted returns (those tied to wealth results)? There is a massive difference and we will remind everyone of that difference in this article. Most of the financial services industry claims they manage and measure both time and dollar weighted results. Advertisements profess a tradition of a “disciplined approach” with “vast resources of a global organization” to control risk, produce superior returns, or even do both measured on a time weighted market relative basis. Such results are often used to justify the cost of their “wealth management” services.
But are superior time weighted risk adjusted returns of any value to the investor? One would think it would be with the effort being spent measuring, reporting and selecting investment alternatives to produce superior time weighted returns. But, if obtaining successful results on a time weighted basis doesn’t necessarily produce more wealth on a dollar weighted basis, what good is the ability to manage it? Is it all just an optical illusion, or a marketing sleight of hand?
The premise in attempting to produce superior time weighted returns often completely ignores the risk introduced of materially underperforming – risk one can have certainty of avoiding by indexing. Finally, how long a time frame is needed for the evidence supposedly provided by the measurement of returns to draw an objective valid conclusion of “success” (instead of randomness)? If successful management is evidenced in the results, is the period long enough to avoid being skewed by one data point, or the random timing thereof that might occur with dollar weighted returns? In essence, is ten years of “success” truly successful if the results were merely caused by timing of one or two years when the superior market relative returns occurred?
Testing premises
To test whether there is real wealth value in the ability to produce superior time weighted returns (risk adjusted) over the long term, we need to examine the ultimate effect on real investor scenarios so we can see the wealth impact on a dollar weighted basis. We also have to eliminate the extreme random noise that often occurs with improper benchmarking or extreme deviations from the allocation policy (extreme random noise could excessively skew the results and would be misleading, a legal and ethical violation). We would also need to observe the effect in both dollars and time weighted returns of fairly small changes to the timing of just one or two data points. This is necessary to test the validity of whether ten years of data is merely the effect of when one or two years of superior or inferior market relative results occur.
The investor scenarios used will contrast three investors to test these effects and the ultimate dollar benefit (or cost) of the supposed value of “successfully” managing “superior” results.
Our first investor is represented by the typical growth of $100, as is often used in examining time weighted returns that will always precisely match the compound return. This of course is a result that assumes the investor is neither contributing to, nor withdrawing money from, the portfolio over the entire time horizon. Judge for yourself how many investors neither save nor spend money.Display article as PDF for printing.
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