Investment Returns — Are We Talking About The Same Thing?

I talked about risk-adjusted returns in one of my earlier post. This time round I am still going to talk about returns, except that it is just going to be plain old returns i.e. one without risk adjustments to complicate matters.

You must think I got nothing better to do to be writing about something that dry and simple. I am not going to blame you. Because, I would think the same in the past. But after all these years talking to people, I realize it is anything but simple. We often took for granted how one looks at investment performance and assume that all are on the same page. And every once in a while, we get a shock. Not only are we not on the same page, we are practically on a different book. And the issue lies not in the math behind computing returns. That is straightforward. The challenge is with the perspective the person is coming from. For example, a fund manager is only interested in pure investment returns. A wealth manager, on the other hand, may prefer to look at a broader picture and use the internal rate of return taking into account all cash flows in and out of an investment. And finally, a man on the street is only concerned with how much more money he ends up with.

Some of you might be wondering — Are these not the same things? NO, THEY ARE NOT. The only similarity, if any, is that they are all trying to measure some sort of performance.

So what are the differences? Let’s try to see it from the different perspectives.

Perspective #1 — Man On The Street

A man on the street looks at things through a simple lens, but not necessarily an objective one. They tend to see only 2 things:

1. How much money have I sunk into the investment?

2. How much money can I get out from the investment?

I would not say this is wrong. After all, you want to make money, and at the end of the day, you made money. I suppose for many people that is all that matters. To a man on the street, he may not bother with cash flow considerations such as how many times did he pump in the capital to when he did it, or if there were any partial withdrawals in between etc.

The Crude Approach

Suppose he set aside $10,000 and use that to buy stocks now. Then as a result of his “impeccable” timing, markets crashed and a year later, his stock portfolio lost 50% becoming a miserable $5,000. But he got lucky that year with a winning lottery ticket giving him $40,000 at year end. And he decided to use it all to buy more stocks. Thankfully, Lady Luck shines on him the following year and his portfolio ramp up 20% to $54,000. To the man on the street, he made a total of $4,000 on $50,000 or a 8% return. To give you an annual return, he might just conveniently divide the 8% over 2 years and say he averaged about 4% a year. This is a rather crude way to talk about returns which I am sure some of you might have come across.

Is This Luck Or Skill?

But is this a good way to talk about investment performance? Well, if it is only for your own consumption, go ahead. You can use any method you like as long as you are happy. No one really cares. But if you are doing comparisons against others, then the answer is NO. For instance, using the example here, what if he did not strike the lottery? Or what if he has a rich dad that keeps giving him more and more money to buy dips after dips. His portfolio will turn out a profit eventually. However, making money here does not translate to having good investment skills.

Perspectives #2 — Wealth Manager

Wealth managers probably have a closer match to how a man on the street thinks when it comes to returns. Because they also look at things from a more holistic angle. Their primary objective is to help one grow their wealth and that can come from many sources. Investment is but one aspect of the total picture.

Professional wealth managers can take into account the timing and amount of external cash flows into an investment using what is known as the money-weighted returns approach. You can view it as a more advance and proper “version” of how a man on the street should think about returns. In simple terms, money-weighted returns is that specific return you can apply across each year to grow all the cash you sunk in to what you have today. Or more technically, it is the internal rate of return that will make the sum of all net cash flows zero. See diagram below.

The diagram presented a forward way of calculation which I thought is more intuitive for lay persons. If you do an internet search or read up else where, you are more likely to see a backward discounting scenario. Not to worry if you do not understand what I am blabbering about, they are essentially the same. Just some simple mathematical manipulation. As for implementing the calculation, you can reverse calculate r% easily using a financial calculator or Excel.

Timing and Cash Weighting Does Matter

So the return of 6.59% is more than what the man on the street estimated. This is entirely expected. Because the timing and weight of the cash flow matters. In Perspective #1, he disregarded when he made his investments and took it as if he had done it all at the start. But, in reality, he started out much smaller as he does not have his lottery winnings until a year later. So the bulk of his capital only has a year to generate the money instead of 2 years.

A money weighted return may be mathematically appropriate for looking at the overall growth of an investment portfolio.It is, nevertheless, still not a good measure for sizing up pure investment performance. A fund manager can contest that this approach skews the picture with external capital injections or withdrawals which are outside of his control.

Perspectives #3 — Fund Manager

A fund manager has the most narrow focus. He is only interested in performance he can attribute to investment skills. He does not have visibility of anyone’s personal savings, sources of income or assets, nor does he care about them. Because he has no business advising or dictating what investors should do with their money. Investors decide if they want to invest, how much to invest and when to invest. Same goes for withdrawals. If investors made more money as a result of good timings, they deserve a pat on their shoulder. But if they made less or lose more as a result, they can only chew themselves for it as well. These are factors outside of a fund manager’s control. The fund manager’s primary responsibility is just to manage whatever is in the fund.

Growing A Dollar Through Investing

To picture what pure investment return entails, imagine you got a dollar. You can use this dollar only for investing and nothing else. And a dollar is what you start with and all that you will ever get till the end of time. So don’t pin your hopes on anything or anyone coming in to bail you out in bad times. No lottery winnings, no rich dads, no huge bonuses, no cash proceeds from selling properties and whatever. Your worth is entirely measured by your ability to grow that dollar through investing.

Stripping out effects of external cash flows

But in reality, money can move in and out of a fund frequently through subscription and redemption. So how do we isolate investment performance amidst all these cash flows? To solve this issue, the fund industry adopt the use of time-weighted returns. This method basically strips out the effects of all external cash flow movements in the return computation. It is an elegant and intuitive solution.

We know a single period return in the absence of any cash flow injections or withdrawals (CFIW) is as follows:

Period Return = Balance (at end of period) / Balance (at start of period)-1

When there are CFIW, we account for them accordingly by adjusting the balances on the day of the CFIW.

Period Return = Balance before CFIW (at end of period) / Balance after CFIW (at start of period) -1

Extending this to a multi-period case using the same example:

Based on the same case, your investment returns is really a rather pathetic -40% over 2 years or -22.54% on an annualized basis. So yes, you did made money. But from a fund manager perspective, you did not manage to grow that dollar given to you. As to whether you did a good job in investing is another question that will require a lot more information than just a number.

Conclusion

As you can see, even when we are talking in terms of absolute returns, we can be referring to radically different things. For instance, your 20% return may not be the 20% I have in my mind. While I am making a distinction between returns from an investment and external cash flow management perspectives here, they are not mutually exclusive. Both work hand in hand to grow your pot of gold. A strong investment strategy can take your mind off external cash flow timing issues and amplify your long term returns. Understanding and using the right returns also reduce miscommunications and allow fund managers to be assessed more objectively based on their merits. So do clarify and define the terms up front the next time you are talking about returns.

Originally published at investmentcache.com on January 11, 2019.