Measuring Performance
An investor chats up with an investment adviser and decides to give him a chance. He gives $1 to the adviser to invest. A year later the investor’s money has grown to $2, a “100% return over one year” claims the adviser. Impressed, the investor ups his stake and gives another $98 to the same adviser to invest. Another year later they meet again. The investor’s money now amounts to $50.
The Investor feels horrible and decides to compute his Internal Rate of Return (IRR) over the two year period. So he does the following computation
Cash flow at beginning of year 1: $1, at beginning of year 2: $98, at beginning of year 3: -$50
The IRR is the constant rate, which applied to all cash flows, leads to a present value of $0. So our investor is looking for variable IRR such that
$1 x (1+IRR)^2 + $98 x (1+IRR) -$50 = 0 solved to find IRR= -49.25%
The constant annual rate of return on the investor’s money has been -49.25%, the investor lost $49 this is indeed a very poor return.
But the adviser objects. He tells the investor that using the performance measuring method recommended by the Global Investment Performance Standards fostered by the Certified Financial Analyst Institute, the return is computed as follows
Year 1: start with $1 ends with $2, yearly return: 100%
Year 2: start with $100 ends with $50, yearly return: -50%
So over the two years the return is (1+100/100) x (1–50/100) = (1+X) which can be solved to find X=0%
0% over two years which makes 0% annually. That’s the claim of the Adviser.
What is going on? How can an approved standard way to report performance do such a poor job of reporting the Investor’s experience? Well, the two methods are different. The first thing to note is that the methods only differ in the way they treat the deposits and withdrawals during the investment period. If the Investor had not added any capital at the end of the first year he would end up with $1 after two years and both his IRR and the return claimed by the adviser would be 0%
The standard GIPS method, also called “Time Weighted Return”, computes return between cashflows and then combines these returns to make the return for the total period, it is a tool designed to assess the quality of your adviser independently from the timing of the capital increases or withdrawals that you subject your adviser to. The decision to add or withdraw capital to/from the adviser is considered to be the responsibility of the investor. The IRR is different; it includes the effect of the timing and amount of the investor’s deposits or withdrawal during the period, which gives a more accurate picture to the investor.
This is no different than an investor investing in a mutual fund. The fund will measure and report its performance independently from the dollar amounts and time at which the investor invested in the fund. The fund actually uses the GIPS method. But to have a realistic idea of his return, the investor should compute his own IRR which will account for the size and timing of his investments. The GIPS method should be used to see if the fund is any good, but the IRR will capture the actual investor experience. And for your info, the investor’s IRR is usually inferior to the fund’s GIPS return because investors as a whole attempt to time markets and fail at it.
Up to now Anselme Capital gave its client access to a service called Ewebportfolio that computed return using the GIPS method, and it did create some confusion for some of you. So I have decided to give you two tools.
- This week I will invite Anselme Capital customers to sign up to a service called Blueleaf. This service will allow you to get an easy summary, allocation, transactions for each of your accounts and will let you compute an IRR for any account or for all your accounts as a whole, for any period you choose (going back to January 1 2014). All your TD Ameritrade accounts have already been put on the system, but the cool thing is that you can add yourself any other accounts you have at any financial institution, go ahead, compute and compare the IRR on any account you have anywhere. This service will be free to you. You will find your Blueleaf login there.
- In a week or two, I will report the performance of the model portfolios I have used over the years to invest almost all of Anselme Capital client’s money. This will use the GIPS method, and will compare these returns with appropriate benchmarks.
I want you to be able to clearly judge your performance and mine.
Cheers
Marc Anselme
This is the Blueleaf look I’ve been working on…it’s not quite ready yet.
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Originally published at anselmecapitalblog.com on April 15, 2014.
