Common pitfalls to be avoided in investment performance reporting

In the last few years, the buy-side industry has witnessed strong traction with digital adoption. Technology has aided asset managers and asset owners with significant computing power to navigate through years of seemingly impossible calculation barriers. Along with the computational boost, technology has supported the middle and back-office departments with improved process automations and highly efficient business intelligence tools to visualise multiple layers of structured and unstructured investment datasets in various ways. Technology vendors have also been helping asset manager and asset owner clients through improving overall Straight Through Processing (STP) rates to achieve operational alpha.

Performance & Risk departments have also benefited from technology. These departments are trying to gain deeper insights on risk and performance. They are also increasing the number of reconciliation processes, make data integration and calculation workflows more efficient with less time and more intraday calculation flexibility, make data exception handling processes smarter to flag real issues and train systems (with the help of Machine Learning) to decrease false positives and negatives.

While some firms are leading the charge on technology adoption, others are playing catch-up. However, in the pursuit of higher operational alpha, buy-side firms should not lose focus on their core ethos. We understand that a fundamental requirement for all asset managers, wealth managers, pension funds, endowment funds, superannuation firms and even sovereign wealth firms is to publish the performance of their portfolios on a periodic and ad hoc basis. It is unfortunate that some firms still tend to do an inadequate job in their performance reporting obligations and present results in a manner that suits them.

This article has compiled six common pitfalls to be avoided in investment performance reporting at all costs.

1) Computing annualised performance for periods less than 1 year: After launching a fund, asset managers must publish fund factsheets or other client reports for their existing and prospective investors. Apart from carrying the general information about the fund like its name, objective, benchmark, inception date, management fee, risk band etc., these reports typically include official performance and ex-post risk figures of the portfolio for standard periods aided with the portfolio manager’s commentaries about the portfolio holdings, the impact of broader markets and their outlook on the macroeconomic factors.

If a fund has not crossed 1-year history, some asset and wealth management firms compute a hypothetical annual performance of the portfolio using short term history. However, since past returns are not indicative of future returns, these firms should never indulge in publishing the expected performance of the portfolio based on past data in their client reports. Even though it is statistically permissible to compute anticipated return with the help of past performance, publishing those returns on fund factsheets or other marketing collaterals can often confuse or mislead many investors.

Surprisingly, some asset managers continue this practice on an ongoing basis. For example, consider a managed fund which has achieved a monthly Time Weighted Return (TWR) of 1.74% on a Gross of Fee (GoF) basis for Dec 2020. This monthly performance number was derived by geometrically chain-linking daily returns while these daily returns were computed on the back of daily Net Asset Value (NAV) of that fund. While most managers would be happy to report the 1-month GoF TWR as it is in their client reports and compare it with the respective benchmark and peer group funds to show out/under performance of the portfolio. Some also take the liberty to annualise the monthly return and convert it into a 1-year performance number of 22.99% in the example, using the formula:

By doing so, the manager is indirectly claiming that they will be able to replicate the 1-month performance for the next 11 months. In the volatile and fragile environment, we all are surrounded with today; this is a significant forward-looking statement. Refer to exhibit 1 below.

Exhibit 1

Also, as per Global Investment Performance Standards (GIPS), a set of voluntary ethical standards for reporting performance developed by the CFA Institute, any investment product that does not have a track record of at least 365 days cannot “ratchet up” its performance to be annualised.

Some firms continue the practice of annualising short-term performance despite building several years of portfolio history. This can look highly counter-intuitive. Refer to the above exhibit again. If a fund already has a history of eleven years, then what’s the purpose of annualising 1-month return. 

2) Computing cumulative performance for extended periods (> 1 year period mark): While displaying performance for periods more than a year, the thumb rule is to compute annualised return instead of cumulative return. For investors, this offers a couple of advantages. First, annualised returns capture the effects of compounding, whereas a cumulative return does not. For example, an investment posted a loss of 50% in year 1 but  gained 105% return in year 2. Performance would translate into a cumulative return of 2.50%. However, after factoring in the effect of time with an annualised return, the performance would reduce to 1.24%.

Second, annualised return also facilitates easy comparison between various investment products like stocks, bonds or managed funds held over different periods. As the name suggests, an annualised return calculates the average amount of money earned by an investment on an annual basis. Also, when an investment product has survived the test of time and has witnessed multiple bull and bear cycles in its lifetime, it can showcase high cumulative performance on long term time scales like 3-years, 5-years, 10-years, 15-years, 20-years etc. It is only when you annualise these returns, you get a normalised view of the performance. Refer to exhibit 2 below.

Exhibit 2

3) Comparing portfolio performance with an inappropriate benchmark: Comparing a portfolio’s performance against an appropriate benchmark and calling it “out” or “under” performance has been a traditional way of measuring the investment skill of portfolio managers.

With the help of benchmark data, Performance Analysts can also compute attribution and ex-post risk statistics such as Information ratio, Tracking error, Treynor ratio etc. Since a benchmark has the power to make a portfolio look poor, outstanding or average, it is imperative to select something highly appropriate as a benchmark. So, what constitutes a suitable benchmark? A suitable benchmark should represent a portfolio’s investment universe and hence considered a good proxy of its risk and return characteristics. For example, an Australian Equities portfolio posted a monthly return of 5.55% in Mar 2020, but the benchmark (i.e., S&P/ASX 200) fell down by -21.18%. In theory, the portfolio achieved an outperformance of 26.73%, which is undoubtedly impressive on a relative scale. Refer to exhibit 3 below.

Exhibit 3

However, scrutinising the investment policy statement confirmed that the security universe of the portfolio was supposed to be domestic large caps only. But the portfolio had taken significant exposure ~60% in small cap stocks, international equities, and an unlisted infrastructure fund long before the pandemic. So outperformance, in this case, was not a function of skill or increasing allocation to a cash asset class, or healthcare, or IT sector within the domestic large cap space. Performance was driven by unconstrained exposure to outside benchmark security universe.

It can be concluded that even though the portfolio fared well on a relative scale, S&P/ASX 200 was not the most appropriate benchmark for this portfolio. Please note that the objective here is not to encourage closet indexing for active managers but to ensure that they stay within the perimeters defined by the Investment Policy Statement (IPS).

4) Not showing hypothetical growth of $10K: Asset & wealth managers and superannuation firms should also publish a graphical representation of 10,000 dollars via a line chart highlighting the change in value of an initial $ 10,000 investment in a fund over a given period. If the growth is published as a pdf, then the time frame to display the result is often set to the portfolio’s inception. While when presented on an interactive dashboard, the choice of time frame (1-year, year to date, 3 years-annualised, 5 years-annualised, 10 years-annualised, since inception-annualised) is usually left to the discretion of the client or the end-user. Though this line chart doesn’t present a holistic story for risk and return, it adds a visualisation flavour to the journey of the portfolio with a good starting point particularly for retail investors. A highly uneven line with multiple peaks and troughs shows that the portfolio has had sizeable variation in performance, while a smooth slope indicates a more stable return during the selected period. A bar graph can showcase performance for multiple discrete periods, while a line graph can capture trends over time with a logical evolution of the portfolio Net Asset Value (NAV). Refer to exhibit 4 below.

Exhibit 4

In the United States, SEC has even made it mandatory for asset managers to present this graph in mutual fund annual reports. Technically it’s also quite easy to backfill portfolio NAVs based on daily or monthly performance data.

5) Not showing a comparison between the portfolio’s current market value and the book value for the client: Unlike other metrics listed in this article, book value is not a true measure of performance, it is rather an accounting term. It is calculated by adding the starting investment made by an investor into their portfolio, plus subsequent subscription, plus reinvested portfolio distributions, minus any withdrawals. Book value is also used in tax computations to determine if an investor is in a capital gain or loss position on a portfolio. While portfolio returns give a sense of gain or loss in a ratio format, comparing a portfolio’s end market value with its book value gives another flavour of the capital gain or loss in a dollar value format. However, just like money-weighted return measures, book value can’t be published directly in fund factsheets because most asset managers don’t have any discretion on the amount and timing of investor’s contributions and withdrawals. It is also unique to each unitholder. Hence, the best place to highlight this is on the landing page of client account dashboard or via monthly client account statements. See below exhibits.

Exhibit 5

Sometimes, “book value” and “adjusted cost basis” terms are used interchangeably.

Exhibit 6

Buy-side firms should publish both or either of the above results. Notwithstanding tax computation, this reporting is helpful for investors to assess whether their investments are above or under water and with what magnitude.

6) Inadequate disclosures: A performance report may include several investment metrics. As a publisher of such a report, buy-side firms need to ensure that their clients do not misinterpret any metric. Disclosures help bridge the understanding gaps in performance reports. GIPS has laid down an extensive framework for highlighting disclosures in a performance report. Some of the common examples are listed below:

  1. Confirm which returns are gross of fee and which ones are net of manager fee?
  2. Describe the benchmarks used in the reports. If changed, reporting should indicate when this occurred and the rationale.
  3. Summarise the valuation policy, highlighting if fair value policy is applicable on any holding for lack of liquidity.
  4. Confirm the extent of leverage, short positions and derivatives in the portfolio.
  5. Advise the treatment of withholding taxes on dividends, interest income, and capital gains, if material, should be highlighted.
  6. What the cash flow weighting rules are.

Buy-side firms should always have an internal governance structure to ensure consistency in performance presentation beyond the regulatory obligations. Many global asset managers and few leading asset owners have already complied with GIPS to pursue best practices in performance reporting standards. No matter what level of resource bandwidth a firm has available to commit to a formalised compliance framework, it should always try to present performance in an ethically and logically accepted industry standard.

How Shoreline can help?

With our expertise in various performance and risk calculation methodologies combined with our unparalleled knowledge of Global Investment Performance Standards (GIPS), we can assist both asset managers and asset owners in adopting best practices to their performance reporting processes.

For more information, please contact us.

Saurabh Kumar
Managing Consultant

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