We research issues relating to investment performance measurement and attribution.

Measuring the fundamental components of investment performance

Benjamin Graham observed that “In the short run, the market is a voting machine, but in the long run it is a weighing machine”. This article looks at an alternative to the voting machine (i.e. the traditional time-weighted return performance measure using changes in share prices) to instead measure how much ‘weight’ is being added to portfolios.

The standard measure of the relative performance of an investment portfolio is the total return of the portfolio less the return of the appropriate accumulation based benchmark based in local currency. Performance in excess of the index is typically known as ‘alpha’. Generating positive ‘alpha’ is the life blood of the active funds management industry of which we were once part.

Given active funds management is based on the premise that securities can be mis-priced, sometimes for long periods of time, it is therefore somewhat incongruous that the standard measure for assessing the performance of the active funds management industry is based on market prices.

In fact, there is not even one 'market price'. The market consists of a bid price and an offer price. The bid price is formed by competition of sellers until the marginal seller does not accept the bid. The offer price is formed by competition of the buyers until the marginal buyer does not accept the offer price. As such, it is the marginal seller and the marginal buyer who help set the bid price and offer price respectively. It is quite unlikely that your subjective value assessment is the same as the marginal buyer or the marginal seller, so in most situations the 'market price' is simply not relevant for you.

As the 'market price' (comprised of a 'bid price' and an 'offer price') is set by the marginal actors, you may well be unable to determine from the 'market price' what price you would get if you were to try to buy a large stake or sell the entirety of your asset. As arbitrage is at the margin, with the marginal buyers and the marginal sellers, for many assets it therefore helps to be small and nimble. Heavy footed sellers may well be forced to take large discounts to the 'market price', especially in less marketable assets. Large buyers may well be forced to pay up for volume. 

If a share price has fallen the key thing to determine is if the fundamentals of the business have deteriorated or if the company has become cheaper. Assuming the market is not fully efficient, the share price move on its own will not tell you which of these is true.

We believe that the quality portfolio managers are those that over the long-term are able to grow the 'weight' of their portfolios at a rate significantly in excess of the broader market and provide careful selection of the initial portfolio investment. The other component of investment performance as traditionally measured is the degree of convergence between the 'market price' of the portfolio and your subjective value assessment of the 'weight' of the portfolio. The subjective value assessment of others is out of your control, so you are unable to control the 'market price' of stocks in your portfolio. As this third component is only important when you decide to sell your portfolio, the ability to remain patient is an important capability of any investor. 

How well an investor times cash flows into and out of a fund will have a significant effect on that investor’s ultimate money-weighted investment return. We believe measures that address the returns of the investor, rather than the fund manager, should become the primary focus of the industry. A positive example of this issue being highlighted is Platinum Asset Management’s Chief Executive Officer Kerr Neilson who said in a 2014 investor roadshow presentation that of their long-term average reported return (time-weighted) of 13% pa compound, the average client return (money-weighted) was only about half of that. He said he would be delighted if his investors controlled their emotions and had some form of regular savings scheme.

In conclusion, we believe the three components that should be used to measure the investment performance of a managed fund are:

  1. How much initial 'weight' is in the portfolio on purchase;

  2. How much 'weight', if any, is regularly added net of fees and taxes by active management through security selection and arbitrage; and

  3. What loss of 'weight' would you suffer if you were to now exit the managed fund

We define 'weight' as the amount of gold coin that is expected to be generated from the invested wealth subjectively valued reflecting the likelihood of payment. Your subjective value assessment will depend on your personal financial position and many other factors.

In order to gain a better understanding in choosing the right solution to measure investment success, we recommend reading the works of Yuri Shestopaloff and Alexander Shestopaloff – including ‘A hierarchy of methods for calculating rates of return’, 2007; ‘Science of Inexact Mathematics, Investment Performance Measurement’ 2009; and ‘Solving the Puzzle of IRR Equation’ 2011.