Practical analysis for investment professionals
09 October 2013

Performance Reporting: Winning the Scoreless Game

Posted In: Drivers of Value

Lately academics and investment practitioners have been debating over the justification of investment management fees, hedging tail risks, and whether or not active investing is in fact a “loser’s game”. But before we lose any more sleep over the intricacies of the game, shouldn’t we first make sure it’s most valuable player is keeping score?

If you are like most individual investors, you probably do not have an accurate record of how much your investments are up or down since you first started saving for retirement. This is certainly understandable as years of rolling over 401Ks and sporadic account withdrawals can make keeping track of your ongoing investment performance a daunting task. Besides, it is a standard disclaimer that “past investment performance does not guarantee future results”, so what makes having a numerical reminder of your investing trials and tribulations important anyway?

The short answer: Feedback. Numerous studies suggests that receiving precise, timely feedback regarding your past judgments is essential to progression as it minimizes one of the deadliest human biases, overconfidence. But there is a catch: studies also support the notion that you walk a fine line between quality and quantity when it comes to receiving information related to your investments. For instance, Wall Street Journal columnist Jason Zweig has long referenced a series of experiments by psychologist Paul Andreassen which support the notion that the more news investors receive related to their holdings, the more they will trade and the lower their investment returns will be.

It seems the old saying, “figures don’t lie, but liars do figure” not only applies when dealing with slick Wall Street statisticians, but also your own psyche. On top of that, financial news and opinions are now more plentiful than grains of sand. It is likely you are being bombarded with more pseudo-information than precise, timely feedback regarding your investments.

If your financial advisor is worth his salt, he is making an effort to intervene — providing you with customized, accurate feedback regarding your investments via periodic performance reporting. If you and your advisor have not bounced around the idea of performance reporting yet, where should you start?

Recent advances in portfolio accounting software have allowed financial advisors the ability to report your investment performance in a myriad of ways. But the goal here is to clarify the sea of investment information, not make it murkier. “Client reporting and communications are so important and can go wrong in so many ways. Over-time, ill-designed reports and poorly delivered explanations damage relationships and erode trust”, says Dr. Philip Lawton, author of the book “Middle Office: Managing Financial Institutions in Turbulent Times”. With this point in mind, below are four simple requests that should help you get the performance reporting conversation started:

1. A Periodic report separate from your account statements
Account statements and performance reports serve two very different purposes. Your account statements provide very detailed information about the transactions in your account and could alert you to errors, or even misconduct by your financial advisor or account custodian. Account statements can be difficult to decipher — so difficult that FINRA recently issued an investor alert in order to help guide individual investors through the labyrinth of information included in them.

On the other hand, performance reports are usually generated by your financial advisor. The purpose of this report is to augment (not replace) your account statements by customizing your investment information into one easy-to-read report. According to the CFA Institute Principles for Investment Reporting a good performance report should illustrate the investments made, risks taken, results achieved, and the fees incurred over a given period of time.

2. Your rate of return (net-of-fees) and investment values
Your performance report should, at the least, contain your investment portfolio’s rate of return after management fees and other expenses. The returns should be calculated using a method that fairly considers the cash flows in and out of your accounts. The two most widely accepted calculation methods that accomplish this are money-weighted return and time-weighted return. The former includes the market timing impact of your contributions to and withdrawals from your account; the latter removes the effect of those external cash flows. While these are both good methods to use when calculating your investment returns, they answer two different questions.

In general, you will want to use the money-weighted return calculation when you are trying to answer the question, “How am I progressing toward my financial goals?” The time-weighted return calculation would be more appropriate if you are trying to answer the question, “How did my investment advisor perform relative to a market index?”

The periods by which your investment returns are measured may vary depending on your preferences, but should always be standard and relevant. For example, displaying investment performance by periods such as calendar quarter, calendar year, and since inception would be typical.

The overall value of your investment portfolio should also be displayed. This information will allow you to cross reference the investment values on your performance report with the values on your account statements to check for inconsistencies.

3. A benchmark that reflects your investment objectives

Your portfolio’s rate of return becomes more relevant when it is measured against your objectives. For this reason, your performance report should also include the total return of an investment benchmark for each time period in which your returns are measured. Selecting what type of benchmark to use is a personal decision. However, any valid investment benchmark should be appropriate to your investment objectives, agreed upon in advance, transparent, and easy to understand.

4. Additional communication

The performance numbers alone will not tell the whole story. Performance reporting is just as much about transparency and accountability as it is about whether or not you outperformed an investment benchmark. In fact, one of the major benefits of performance reporting is that it will instigate a dialogue between you and your financial advisor about capital market performance and expectations, investment risks, costs, and the progress you are making toward your long-term financial goals. This communication can be as formal as written commentary or as personal as a face-to-face meeting.

These four requests should help you get the performance reporting conversation started. Receiving precise, timely feedback about your investments will not only help you manage overconfidence, but it will also help you build a more trusting relationship with your financial advisor. A recent study by the CFA Institute & Edelman suggests that an advisor who communicates your investment information in transparent, simple metrics is more likely to gain your trust than one who delivers strong investment returns. The study also suggests that trust is the single most important factor when investors are deciding whether to hire an advisor.

At the end of the day, your financial advisor’s investment process is only as good as your trust in it. Having a periodic discussion about your investment performance may keep you from losing trust in your advisor’s well-thought-out investment process at an inopportune time. Use the information above to ask your financial advisor about performance reporting today.
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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
David Allison, CFA, CIPM

David L. Allison, CFA, CIPM, is vice president and founding partner at Allison Investment Management, LLC. He has formal training in investment analysis, portfolio management, and investment performance measuring techniques. Allison has extensive experience managing investment portfolios for high net-worth investors. He is an active member of CFA Institute, the CIPM Association, and the CFA Society of South Carolina, where he is a former president and currently serves on the board of directors. Allison holds a degree in finance from the University of North Carolina at Wilmington.

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