Understand Investment Performance
You, of course, are interested in knowing how your investments have performed. And you, likely, have noticed that there seem to be different ways of measuring performance. Which one is most relevant to you?
Key points in the article:
Returns can be measured by taking into account the cash flows into and out of a fund over time – this is called Money-weighted Rate of Return, often called Personal Rate of Return on your statements
Time-weighted rates of return are not distorted by cash flows, so they reflect the performance of the fund itself, not your personal rate of return which is a function of your contributions or withdrawals
Standard deviation is a commonly used measure of investment return risk because it gives an indication of expected volatility
Downside deviation is similar to standard deviation, except that it only includes negative deviations (outcomes less than the average)
Reward-to-risk ratios compare a fund’s return with a measure of portfolio risk, giving you an indicator of the return achieved per unit of risk taken
Relative returns allow you to compare a fund’s return with the return of an appropriate benchmark
Let me just jump right into it, without preamble, and introduce the related components of performance evaluation in this article.
Absolute Returns
Absolute returns are the returns achieved over a certain time period. Absolute returns do not consider the risk of the investment or the returns achieved by similar investments.
The performance of an investment over a specific time period is referred to as the holding-period return. The holding-period return measures the total gain or loss that your investment achieved over the specified period compared with the investment at the beginning of the period.
The return over the holding period usually comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest).
In a simple case of holding-period return, the income is received at the end of the holding period and there are no additional investments or withdrawals during the period.
Time-Weighted Rates of Return
In a more complex case of holding-period return, there are deposits of interest and dividends, and some savings or withdrawals on your part. These flows of cash into and out of the investment make the holding-period return calculation more complex.
If you make several deposits throughout the year, the performance calculation needs to separate that ‘gain’ of new cash from the gain or loss of the investment itself.
Similarly, if you make a withdrawal during the year, that ‘loss’ of cash needs to be separate from the gain or loss of the investment itself.
Hence the different ways to calculate performance: to separate the impacts of your savings and withdrawals from the impacts of the gains, losses, dividends and interest of the investment itself.
Flows of money into and out of funds over time are accounted for by dividing the measurement period into shorter holding periods. A new holding period starts each time a cash flow occurs, meaning, each time money flows into or out of a fund.
Returns calculated in the above manner (by dividing the measurement period up into shorter holding periods) are known as time-weighted rates of returns.
The time-weighted rate of return calculation divides the overall measurement period (for example, one year) into sub-periods. Each sub-period has its own separate rate of return.
These sub-period returns are then used to calculate the return for the whole period. By calculating holding-period returns in this manner, your cash inflows and outflows do not distort the measurement and reporting of your investment’s performance.
Mutual fund companies use this time-weighted rate of return because it is a measure of their performance regardless of your deposits or withdrawals.
This is fair.
Knowing that this is the case, you know to interpret the time-weighted rate of return as a measure of the performance of your funds (or account).
Money-Weighted Rate of Return (or Personal Rate of Return)
Unlike the time-weighted rate of return, the procedure for calculating your money-weighted rate of return includes the impact of your contributions to, or withdrawals from, your portfolio.
For example, if you contribute money to your portfolio just prior to the overall market performance rising, intuitively you expect that this is positive.
Now your larger portfolio benefits more in dollar terms from the overall market move than if the contribution had not been made.
Conversely, if you withdrew money from your portfolio just prior to overall market performance rising, intuitively you expect this to be negative.
Now your smaller portfolio benefits less in dollar terms from the overall market move than if the withdrawal had not been made.
Regulators in Canada believe a rate of return that factors in the impact of your contributions and withdrawals is the most appropriate way to measure the returns of your portfolios.
While time-weighted returns are more appropriate for assessing mutual fund manager performance, money-weighted is more suitable for assessing your personal performance.
This money-weighted rate of return factors in how much you buy or sell and when those transactions occur. Remember it this way:
It’s your money, so the money-weighted rate of return (personal rate of return) on your statements tells you how your money performed (not just how the fund product performed without concern to the date you invested).
So, don’t get too mad at your advisor if your return looks bad because you took money out; but don’t let them take credit for a great return if you happened to have saved and contributed a lot either!
Returns Adjusted for Risk
You want to get as much return as possible for as little risk as possible. So, if two investments have a holding-period return of 10% but the first investment has very little risk whereas the second one is very risky, the first investment is better than the second one on a risk-adjusted basis.
Standard Deviation
Risk can take different forms. The risk we’re considering here is investment risk, which is often measured using the volatility of returns. A common measure of volatility is the standard deviation, which reflects the variability of returns around the average return. The higher the standard deviation of returns, the higher the variability or volatility of returns and the higher the risk.
There are at least two reasons why you should care about historical variability (the standard deviation of past returns).
First, past variability of returns might be indicative of how variable your returns are going to be in the future. But it is important to be aware that volatility can change over time, so you can never know if future returns will behave like past returns.
Second, the variability of returns may affect your objectives. Investing in a portfolio or fund whose returns vary significantly over time could potentially disrupt your plans. If returns are very negative one year, then your commitments, such as paying tuition, may be harder to meet.
Downside Deviation
Standard deviation is a convenient measure of the variability of returns around the average return. Sometimes there is a positive deviation (the return is greater than the average, happy face) and sometimes there is a negative deviation (the return is less than the average, sad face).
It is no surprise that psychologists and economists have discovered that investors dislike losses more than they like equivalent gains.
So, you might be reasonably pleased about an investment return of +6%, but extremely disappointed about a return of - 6%. Because of this asymmetry in the way people view the variability around the average, thinking beforehand about downside deviation is helpful.
Downside deviation is calculated in almost exactly the same way as standard deviation, but instead of using all the deviations from the mean (positive and negative) downside deviation is calculated using only negative deviations.
In this way, downside deviation is a way to discuss variability that focuses only on outcomes that are less than the mean.
Reward-to-Risk Ratios
I doubt you would prefer to a low return over a high return on your investments.
Similarly, most would prefer lower risk (less variability of returns) over higher risk (more variability of returns). People are, in general, interested in maximizing the return on their investments while simultaneously trying to minimize the risks.
That is, people prefer investments that have a high return per unit of risk, which is how to describe investments with a high reward-to-risk ratio.
All reward-to-risk ratios take the following basic form: (return) divided by (volatility). The higher ratio, the better the risk-adjusted return, meaning the higher the return per unit of risk.
In other words, you want to buy investments with a high risk-adjusted return.
A commonly used reward-to-risk ratio is the Sharpe ratio, named after its creator, Nobel Prize-winning economist William Sharpe.
Reward-to-risk ratios are an important metric for understanding the quality of the returns produced by a portfolio. A portfolio with high returns but with high risk could be described as having lower-quality returns than a portfolio with similarly high returns but with much lower risk.
Such ratios are helpful for comparing investments. You can find the Sharpe ratio on most fund fact sheets online.
Relative Returns
Measuring relative returns by comparing to a suitable benchmark allows you to assess your opportunity cost and determine whether your investments are generating appropriate returns.
The calculation of a reward-to-risk ratio allows you to correctly compare the performance of one investment fund with another.
But you also probably want to compare the performance of your fund or portfolio with that of a benchmark, such as a stock index. It is common practice in all industries, and indeed in many areas of life, to benchmark or compare performance.
Benchmark Indices
A number of organizations produce financial market indices that allow investors to compare the holding-period return of their funds with that generated by the wider market.
For most equity exchanges around the world, there is at least one index that represents the majority of its stocks. In addition to these broad indices, there are also stock indices that measure the performance of industrial sectors, both within a particular country and globally.
A number of bond indices exist too. In addition to aggregate bond indices that are designed to cover the market as a whole, many index providers offer bond indices classified by maturity, credit rating, currency, and industrial category.
Relative Returns
The wide range of benchmark indices available allows you to set performance targets beforehand for your investments and also allows you to evaluate relative returns.
Another way you could evaluate the performance of your mutual funds is to compare each fund to the fund’s “peers”. For example, you could compare the performance of one manager of European equities with that of other managers of European equities.
Each mutual fund manager is assigned a performance ranking within their sector. Managers who are in the top 10% of performers among their peers over a specific period are said to be top-decile performers. The performances of individual fund managers may be collected and then ranked by independent organizations such as Morningstar.
Alpha
All things being equal, a fund that produces a consistently high reward-to-risk ratio could be said to be more skilful than one that consistently produces a lower ratio. If you invest in a fund that is managed actively, you are paying for the fund manager’s investment skill and expertise.
Fund manager skill is often referred to as alpha. Perhaps the best way to explain the concept of alpha is to consider the sources of a fund’s return, which is composed of three elements: market return, luck, and skill.
Market Return:
Managers of passive funds aim to produce returns but are not looking to add value to the portfolios by picking securities that they believe will outperform other securities. Instead, they typically buy and hold in the same proportion as their benchmark.
Although this passive process requires some skill, it’s not so much investment skill as efficient administration. When the passive benchmark rises, the value of the passive fund tracking that index should also rise. And when the benchmark falls, the value of the passive fund should also fall. Therefore, over time, the fund should produce a return similar to that of the chosen benchmark minus fees.
Passive investment managers do not attempt to ‘add alpha’.
Luck:
Some of the return generated by an investment fund is the result of luck rather than judgement. The markets are affected by some events that cannot be foreseen by a fund manager.
Skilled fund managers are unlucky sometimes and unskilled fund managers enjoy good luck on occasion.
Skill:
A skilful fund manager is able to add value to a fund over and above changes driven by market movements, which could have been produced by a passive fund manager.
Because we assume that good and bad luck will tend to even out over time, a skilful fund manager is one who adds this value consistently over time, year after year. This performance over and above the returns from a relevant market benchmark is generally referred to as alpha.
Summary
Remember that when your performance is described as a money-weighted return (or personal rate of return), it includes your savings and withdrawals as part of the gains and losses – it’s your money, so you look at money-weighted return.
But when you want to isolate the returns of your investments from your own savings and withdrawals, you look at the time-weighted return. You can find this on fund fact sheets, which, by the way, is the return after fees.
When you’re comparing funds, a great measure to find on the fact sheets and compare is the Sharpe ratio because it tells you the return the manager achieved per unit of volatility.
And by doing this work, even just making it to the end of this article, you can say you’re adding Alpha to your personal finances!
