Smart Money: Understanding rates

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William C. Fisher
William C. Fisher
All CFOs are taught that past performance is not an indication of future performance. Performance data is only part of how investment consultants evaluate money managers — and they use it with caution. The impact of time-weighted returns versus dollar-weighted returns must be considered carefully.

Somet imes past returns from many years are used to get an expected return in any given future year. An example here is to use the stock, bond and inflation data bases from 1926 to 2011 (S&P / Ibbotson data). If we run a simulation for many future years using these databases, the average return (over the 85 years) will be less than the “expected return” (based on the probability of the events happening).

Bank Administration Institute established the time-weighted rate of return (1968) as the standard method for evaluating investment managers. Time-weighted returns are not affected by dollars moving into/out of an investment. Dollar-weighted returns are affected by flows of dollars into/out of investments, and this is what affects most investor returns.

How often do we read about great past performance for a money manager at which point dollars pour into such investments? Unfortunately, this happens much too often. If the investment then drops in value, the time-weighted return might be good but the average dollar invested might lose money.

Brad Stewart, CFO at Methodist Retirement Communities in The Woodlands, TX, says, “Most senior living organizations have dollars flowing into/out of investment accounts.”

CFOs need to know dollar-weighted investment results to know how they are doing. But, for consistency with reported money manager rates-of-return, it is recommended CFOs use time-weighted rates-of-return to make projections.

Remember, just combining numbers in any way will not do.