 ver
the past few weeks, the loss of retirement savings by Enron employees
has become a cause célébre for portfolio diversification.
Enron employees were urged to concentrate their retirement plans in
Enron stock — while senior officers of the company were selling
that same stock. So now the retirement-planning industry is urging
plan participants to diversify their portfolios. One way to accomplish
that feat is to invest in mutual funds. Unfortunately, the measurement
used to promote mutual funds is not as transparent as it should be.
The first thing
participants see when choosing to diversify their portfolios is
a full-page mutual-fund advertisement touting past performance.
While many studies have demonstrated that past performance does
not guarantee future returns, mutual-fund companies persist in advertising
"performance." The question is: How accurate are mutual-fund
performance measures?
Investment
performance has become the marketing and advertising tool of the
mutual-fund industry. There are various strategies employed by mutual-fund
companies to sell their funds, and most often they focus on those
funds that have had the best performance. In recent years, Morningstar,
a company that provides mutual-fund analysis services, has introduced
a rating system that incorporates both return and risk in gauging
the overall performance of a mutual fund. The highest Morningstar
rating is five stars while the lowest rating is one star. Using
these popular ratings, mutual-fund companies tout their highest-rated
funds while hiding their poorest-rated funds.
This marketing
practice has been enormously successful in attracting shareholders.
The problem is that the dramatic changes in the number of shareholders
and in the size of these funds nullify the validity of the traditional
performance-measurement techniques that are used to qualify these
funds for Morningstar star ratings.
There are two
generally accepted techniques for measuring investment performance:
time-weighted rates of return and dollar-weighted rates of return.
The time-weighted rate of return treats the returns earned in all
time periods alike, regardless of the amount of assets under management
at the time. This calculation is appropriate for measurement of
investment performance, especially where a portfolio manager had
little or no control over the cash flows into his fund.
The dollar-weighted
rate of return, however, takes into account the cash flow in and
out of a portfolio. In other words, using a dollar-weighted return
would count more heavily the time periods when the portfolio was
larger, and would answer the question of how well a portfolio manager
did when the portfolio grew rapidly due to a substantial surge in
money or new shareholders.
So, if the
cash flows in and out of a mutual fund are influenced by the marketing
of that mutual fund, the performance reporting standards should
reflect the investment experience for all fund shareholders,
not just the few who experienced above-average returns and the many
who experienced below-average returns.
To accurately
reflect the impact of fund performance on all shareholders, a dollar-weighted
rate-of-return calculation should be made available to the public.
The following example for a hypothetical mutual fund shows why.
Period
1:
Number of shareholders: 1,000
Initial share price: $10
Subsequent share price: $12
Period 1 performance: +20.0%
After this
stellar performance, the mutual-fund company advertises the +20%
period and attracts many new shareholders:
Period
2:
Number of shareholders: 10,000
Initial share price: $12
Subsequent share price: $10
Period 2 performance: -16.7%
Despite the
loss, using a time-weighted rate of return, the company can show
a two-year total rate of return of 0.0%. Not quite the whole story,
huh?
Now, in order
to calculate a dollar-weighted rate of return, it is necessary to
weight the performance of each shareholder. Since there are ten
times as many shareholders in Period 2 as there were in Period 1,
the investment returns for Period 2 receive ten times the weight
than does the performance in Period 1. Here's the dollar-weighted
math:
Period 1
performance: 20.0% x 1 = 20.0%
Period 2 performance: -16.7% x 10 = -167%
Dollar-weighted performance: -13.3%
So, instead
of reporting a break-even result under a time-weighted rate-of-return
calculation, the fund would report a loss of 13.3% for both periods
under a dollar-weighted rate of return. A little better? We agree.
Traditional
investment-return calculations may not accurately reflect investment
performance for all investors in a mutual fund. More importantly,
the use of investment performance by mutual-fund marketers to attract
investors to specific mutual funds after they have achieved
unusually good performance can undermine the ability of an investor
to achieve average success when making investment decisions.
Perhaps professional
investment organizations, such as AIMR, should revisit acceptable
measures of investment performance for mutual funds, and should
require the disclosure of dollar-weighted rates of returns in addition
to time-weighted rates of return. That's the kind of transparency
fund-investors deserve.
|
