AS OF JULY 2016, LICENSED dealers and financial advisory firms will be required to start reporting personalized performance for each client account. Firms will have to provide clients with a high-level dollar reconciliation and percentage returns at least annually, with an option to show performance by household or against benchmarks.
This initiative is long overdue, so I applaud regulators for finally pushing this over the goal line.
Even though most back-office systems have long had an option to include performance on client statements, personalized returns haven’t been seen for some time, except for wealthy investors and some wrap-program investors.
But the chosen performance calculation method may result in misleading comparisons. Here’s an example to illustrate the potential problem.
If you invested $37,000 three years ago in a balanced portfolio (e.g., 30% Canadian stocks, 30% global stocks and 40% Canadian bonds), held it for three years and had no other transactions in the interim, you would have about $45,600 today. Your total return would be about 7% annually for the three-year period, regardless of whether you use a time-weighted (TW) or dollar-weighted (DW) rate-of-return calculation method.
TW returns tell you how an investment (or investment manager) has performed. DW returns show a client’s returns when his or her cash flow is applied to the investment returns.
If you have transactions during the three years that are small relative to the beginning value, the TW and DW calculations will differ but be very close to each other. The gap between TW and DW return calculations widens with more significant flows into or out of the portfolio, which can mislead and confuse investors.
For instance, instead of a lump sum, suppose you invested $1,000 at the beginning of each month, starting three years ago and allocated as above. Three years later, this hypothetical portfolio would be worth $42,500. The annualized DW return is 9%. Think of this as the average annualized return of each instalment, weighted by the size of each investment (in this case, equal amounts).
The lump-sum scenario results in a higher ultimate value (despite the lower 7% return) because much more money was invested for the entire three-year period in a generally strong market. In the monthly scenario, only the first $1,000 contribution was held for the full three years; one-third of the money was invested for less than a year.
In the monthly investment scenario, the dollars invested earned a higher annualized percentage return on average, but there was less money invested for a shorter period on average for the money to compound to a higher amount.
On a stand-alone basis, presenting a client with a personalized DW return is great. But if you want to compare that client’s DW performance to a market-based benchmark, you cannot use the benchmark returns reported online or in financial databases – all of which report TW returns. You must apply the client’s actual cash flow – in both amount and timing – to benchmark returns and use this information to calculate a DW benchmark return.
You should either exercise the option to omit benchmark returns from the report or calculate a personalized benchmark return.
Otherwise, the comparison will be meaningless and your clients will be misinformed. IE
Dan Hallett, CFA, CFP, is vice president & principal for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.
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