A Fund-amental Difference
The retirement-planning industry needs to be more transparent.

By Tom Nugent, PlanMember Advisors, Inc., and Warren E. Bitters
March 8, 2002, 8:00 a.m.

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.