CON­FU­SION

Cal­cu­la­tion of re­turns on a dol­lar-weighted ba­sis could per­plex clients

Investment Executive - - FRONT PAGE - BY DAN HALLETT

Ex­plain­ing dol­lar-weighted rate of re­turn to clients isn’t easy.

the sec­ond phase of the client re­la­tion­ship model (CRM2) re­quires ac­count per­for­mance to be cal­cu­lated us­ing a dol­lar­weighted rate of re­turn (DWRR) met­ric.

How­ever well in­tended, I an­tic­i­pate that this choice by se­cu­ri­ties reg­u­la­tors will re­sult in some con­fu­sion for clients. The DWRR has some odd­i­ties of which you need to be aware when dis­cussing the per­for­mance of in­vest­ments with your clients.

Per­for­mance is ad­ver­tised as time-weighted re­turn; a cal­cu­la­tion of the prod­uct or port­fo­lio man­ager’s re­turns. DWRR, on the other hand, in­cor­po­rates a client’s cash flow — size, di­rec­tion and tim­ing — to pro­vide a per­son­al­ized port­fo­lio re­turn fig­ure.

Be­cause of the use of DWRR, CRM2 per­for­mance re­ports will pre­clude all sorts of com­par­isons. For ex­am­ple, clients usu­ally have mul­ti­ple ac­counts with their main fi­nan­cial ad­vi­sor, but of­ten have more than one ad­vi­sor.

To the ex­tent that cash flow pat­terns are ma­te­ri­ally dif­fer­ent across ac­counts, per­for­mance com­par­isons will be mean­ing­less.

Con­sider a client with an RRSP and a TFSA. Each ac­count is in­vested in an iden­ti­cal bal­anced port­fo­lio be­gin­ning with $10,000 in­vested on Dec. 31, 2015.

The RRSP has no ac­tiv­ity through 2016 and holds the ini­tial $10,000 through the end of 2016. The RRSP ac­count’s DWRR was 6.5% for cal­en­dar 2016.

How­ever, $5,000 was with­drawn from the TFSA on Feb. 29, 2016, a low point dur­ing the year. The TFSA’s DWRR was 2.4% for 2016. The RRSP and TFSA held iden­ti­cal in­vest­ments (al­though dif­fer­ent amounts) through the year; with iden­ti­cal prod­uct (i.e., time-weighted) re­turns.

But, in the TFSA, money leaves the port­fo­lio at a low point — leav­ing fewer dol­lars in­vested to en­joy the re­bound — re­sult­ing in a lower DWRR. Thus, com­par­ing th­ese ac­counts’ DWRR mean­ing­fully is im­pos­si­ble.

Sim­i­larly, com­par­isons of ac­count DWRRs with widely fol­lowed bench­marks — such as the S&P/TSX com­pos­ite in­dex, S&P 500 com­pos­ite in­dex, etc., or a blend thereof — will be point­less.

That’s why reg­u­la­tors made bench­mark­ing op­tional. (Note that com­par­isons aren’t as prob­lem­atic when in­terim cash flows are rel­a­tively small com­pared with be­gin­ning and end­ing val­ues.)

More­over, the DWRR may not make much sense to clients. Most peo­ple can un­der­stand that be­gin­ning the year with $100,000 and end­ing the year with $120,000 equates to a 20% rate of re­turn. But DWRR doesn’t al­low for the same in­tu­itive ob­ser­va­tion, mak­ing that met­ric chal­leng­ing to in­ter­pret.

Fi­nally, here’s an ex­am­ple I de­signed to ex­pose the odd prob­lem of mul­ti­ple DWRR so­lu­tions for the same ac­count, which can oc­cur if cash flows are pro­por­tion­ately large and er­ratic. Let’s be­gin with a $1,000 de­posit in a hy­po­thet­i­cal med­i­cal mar­i­juana stock.

The stock triples in value and the client with­draws $3,180 at the end of Year 1, then makes a de­posit of $3,369.20 in Year 2. But then the stock tanks, so the client is left with a value of $1,189.32 at the end of Year 3.

In this ex­am­ple, DWRR of 2%, 6% and 10% are all math­e­mat­i­cally cor­rect. This makes no sense; hence, the prob­lem. For­tu­nately, this is rare, but it can hap­pen in clients’ smaller, spec­u­la­tive ac­counts. It’s for all of th­ese rea­sons that many peo­ple in the in­vest­ment in­dus­try ad­vo­cated us­ing timeweighted re­turn met­rics.

In any event, keep­ing th­ese DWRR quirks i n mind can be help­ful when pro­vid­ing per­for­mance re­views and tack­ling clients’ ques­tions.

Be aware of odd­i­ties that can arise when dis­cussing re­turns with clients

Dan Hallett, CFA, CFP, is vice pres­i­dent and prin­ci­pal with Oakville, Ont.-based HighView Fi­nan­cial Group, which de­signs port­fo­lio so­lu­tions for af­flu­ent fam­i­lies and in­sti­tu­tions.

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