Investment Review (EBI #5)
The challenge of performance measurement
Periodic reviews of an investor’s portfolio helps ascertain whether the investment process is working, but more importantly, whether it’s on the right course for the individual investor.
The Beardstown Ladies was a 12-woman investment club that gathered monthly and managed their own stock portfolio. They became celebrities in the mid-1990s when news of their track record went viral: since their 1983 inception, The Beardstown Ladies claimed their portfolio had returned 23.4% versus the S&P 500’s 14.9% return. But in 1998, an audited performance record was released showing the club’s actual returns were actually 9.1% per year.
This example illustrates the fact that most investors simply don’t have proper performance data to assess their investments.
Investment Review Considerations
For individual investors who have frequent cash flows in and out of their accounts, a time-weighted return is the proper performance measurement. The time-weighted formula compares the periods of performance against the value of the account during that period in order to adjust for cash inflows and outflows. For example, if the value of the account increased due to a large deposit, the time-weighted return adjusts for this. As a result, the performance number is not reflective of the deposit, but rather the true performance of the underlying investments.
The main takeaway for the investor is not to become a skilled mathematician, adjusting and calculating for every dollar of cash flow. Rather, investors must require their wealth managers to show time-weighted returns so that an accurate assessment of the portfolio’s investments relative to their respective benchmarks is clear and informative.
Regular reviews help to determine if the portfolio’s active managers are delivering returns above their benchmark. If not, why not? Is there a large exposure in the portfolio that’s not performing? Was there an organizational change that impacted the portfolio manager’s ability to run the portfolio? Or is it too short a period to make a determination?
Far too often, investors observe positive results and stop reviewing their performance. But was the manager’s over-performance the result of the manager’s skill and expertise? Was it pure luck? Or did the manager deviate from the objective?
Case in point: In May, 2012, shares of Apple Computer Inc. were soaring. The stock had gained 65% the previous 12 months, and 357% the previous three years. Apple was the largest company in the S&P 500 Index and paid no dividends. However, a study by The Wall Street Journal found Apple shares were held by at least 50 mid- and small-cap funds, 40 dividend paying equity funds, numerous non-U.S. stock funds, and even one bond fund! The article quoted John Bogle, founder of Vanguard Group, stating: “It would clearly be inappropriate for a midcap fund to hold Apple. You’ve got to say that manager is violating his reason for being. I can’t help but believe that is going to end up in disappointment for his shareholders. I don’t know when, but it will.”
A periodic review must include not only the quantitative metrics within the portfolio, but also the qualitative assessment of the portfolio within an investor’s overall financial picture:
- Is the portfolio and its risk being managed within the investor’s overall wealth?
- Has anything changed outside of the portfolio that would warrant a change within the portfolio?
- If so, is this change being properly assessed and acted upon by the wealth manager?
Key Insight #7: Investors must require their wealth managers to show properly calculated time-weighted returns so that an accurate assessment of the portfolio’s investments, relative to their respective benchmarks, is clear and informative.
This article is adapted from “Evidence Based Investing for High & Ultra-High Net Worth Investors,” a white paper published by Janiczek & Company, Ltd. The full paper is available here. Also see our previous posts on asset allocation, passive investing, tax strategies, and tactical adjustments.