|Name||April 2012 - Walking the Walk Part 2|
Structured Asset Management: Walking the Walk Part 2
Last month we presented an account we manage, the Reserve Life Income fund (RLI 1) of our parent organization, the American Institute for Economic Research (AIER). We described our management of that fund to illustrate several useful techniques that all investors can employ when managing their own accounts. This month we will again examine AIER's charitable remainder accounts to demonstrate how investors can assess portfolio performance and to establish reasonable benchmarks for monitoring risk and return.
Investment returns1 come in different forms. Financial assets provide income through dividends or interest, as well as capital appreciation, which reflects the market's collective assessment of the present value of the asset. Having established a portfolio with some initial market value, how should an investor measure returns as time passes? The measure needs to be meaningful-that is, an absolute measure that can be used in planning-but it must also be standardized so that an investor can assess the portfolio's growth relative to what can reasonably be expected in light of the returns available from the markets.
At one time portfolio measurement consisted largely of calculating a simple dollar-weighted return (DWR). This is essentially an internal rate of return (IRR), or that rate which discounts all cash flows, including the ending market value generated by an investment, with its beginning market value. The problem, however, with DWR is that it discounts all cash flows, including deposits or withdrawals that an investor might make over time. It is therefore not useful as a basis for comparison with other benchmarks.
The financial services industry has come up with a measure called Time Weighted Return (TWR) as a means of addressing this problem. TWR is used when external cash flows occur between the beginning and the end of a period. Because they are unaffected by cash flows to the portfolio, TWRs measure the actual rate of return earned by the portfolio manager. Unlike DWR, it is valid to compare a TWR with an appropriate benchmark.
To compute TWR, the portfolio's rate of return is calculated just prior to when the first external cash flow occurs. A rate of return is again calculated from that cash flow until the next , and so on, with the last such measurement ending at the termination of the period being measured. The last step is to link the rates of return over these "sub periods" by calculating the compound rate of return over time. In other words, a rate of return is calculated for each time period, as defined by an external cash flow (deposit or withdrawal), and then a compound rate of return is calculated for the entire period.
If your objective is to capture the rate of return you have earned, then DWR is appropriate, since you have control over the decision to make whatever withdrawals or deposits were made. If your objective is to measure the rate of return earned by the portfolio manager, then TWR is appropriate, since the manager has no control over these external cash flows.
We provide Time Weighted Returns for all of our Professional Asset Management clients. In Table 1, we have provided examples of TWRs for RLI 1 as well as the 66 charitable remainder unitrusts (CRUTs) we manage on behalf of AIER. The benchmark returns provided (Lipper and Passive) are discussed below.
Also in this Issue of Investment Guide
The Dow Jones Industrials Ranked by Yield