For all intents and purposes the success or failure of personal investments hinges on four factors:
- Savings rate
- Fees paid
- Return on investment
- Taxes paid
Taxes become much less of a factor when investments are held in non-registered accounts such as RRSPs and TFSAs. In terms of importance, I would rank in order presented but have come across many persuasive arguments for some rearranging…but let’s save that for another day.
Today I’m zeroing in on investment rate of return (AKA investment performance). This is in part inspired by upcoming regulatory changes to the Canadian investment landscape.
Beginning in July 2016, investment firms will be required to provide clients their money-weighted rate of return (AKA personal rate of return). Currently, most firms only provide clients their time-weighted rate of return. More on the details of each shortly.
All investors understand this simple construct: the higher their rate of return, the more money they’re making. They should therefore also accept this slight twist on the notion: rate of return (impacting cash flow) will often have a material impact on the quality of their retirement (not uncommon to span 30+ in this age of modern medicine). So given how vital investment performance is to our future wellbeing, we’re all on top of it, right?
The reality is that many (dare I say, most) of us have absolutely no idea how our investments have fared over the last year, last 5 years, last ten years etc; and in comparison to a relevant benchmark. Many of us take solace in the fact that after mustering up the courage to sneak-a-peak at our December 31 investment statement, most years the total portfolio has at least gone in the right direction. To this I say…not good enough! It wouldn’t be uncommon for such an increase to relate solely to the injection of hard earned savings year after year and nothing to do with acceptable performance.
Let’s understand a few key investment performance concepts before finishing off with some best practices to implement.
Investment benchmarking is no different than other contexts. It’s all about having a suitable measuring stick to ensure you’re keeping up with – or even better – exceeding your peers.
Investment statements can be littered with rate of return information and your advisor may spew all sorts of numbers at your annual get-together – but how do you know if the numbers are good, bad or average?
A 10% annual rate of return is fantastic in today’s investment reality but not so fantastic if the market as a whole returned 20%. And consider the reverse scenario: if your portfolio lost 5% in a year when the market was down 15%, in a counterintuitive way it was a good year. If your advisor is consistently tight-lipped on benchmarks, they may be pulling the wool over your eyes.
The straight forward takeaway is that individual investment performance can only be reliably sized up by comparing against a suitable benchmark. In Canada, the most common benchmark is the S&P/TSX Composite Index. It represents the aggregated return from most of the large public companies listed on the Toronto Stock Exchange. If your portfolio comprises only Canadian investments, this is the perfect benchmark for you. Determining a suitable benchmark should fall to your advisor.
Rate of return: cash weighted vs. time weighted
The comparison between cash weighted and time weighted rate of return is most relevant to investment funds (i.e. mutual funds, exchange traded funds etc). Before delving into, it’s important to understand the basics of a fund.
In a nutshell, funds pool together the investment dollars of individual investors and turnaround to invest them in a basket of stocks and/or bonds as determined by the fund manager. The various fund investors put money in and take money out on a daily basis.
Time weighted return is determined at the fund level. It factors all cash in and out of the fund to provide the return of the fund as a whole. Cash weighted return is determined at the individual investor level. It factors all cash in and out of the fund by only the individual investor. It therefore follows that unless individual fund investors perfectly mimic the cash flows in and out of the fund as a whole, their money weighted (personal) rate of return will differ from the funds’ time weighted rate of return.
The straight forward takeaway is that the rate of return information published by investment funds online, in marketing material and maybe even investor statements can be materially different than the personal return of the individual investors within the fund. The disparity is often compounded by the fact that as a cohort, mutual fund investors have historically tended to buy and sell at the wrong times (the unfortunate, “buy high, sell low” phenomenon).
Realistic investor best practices
So what is a realistic reaction to this free education for the everyday investor? Broadly speaking, investors need to ensure interaction with their advisor is an honest two-way communication. Getting specific, I recommend the following, which truly is not terribly onerous when considering what’s at stake:
- Understand whether investment statement rate of return information is time or money weighted. Insist on money weighted as this represents actual personalized rate of return.
- Request investment statements (or other document) include suitable benchmark(s) returns for comparison.
- Meet with your advisor once a year to review investment performance. Seek explanation for long-term performance that lags the benchmark comparison. Decide whether the explanation is satisfactory or whether a change is worth considering. This could come in the form of a new investment approach or a new advisor – one at your existing firm or more drastically a new firm altogether.
I urge extreme caution in jumping from advisor to advisor and firm to firm based on short-term results (under three years give-or-take). There is significant cost, both in time and cash money, in this course of action.
No advisor employs an investment strategy that works all of the time. Many strategies actually have inverse relationships, as one starts to fade away, another begins its time in the limelight. It is quite common for an investor focused on short-term results to jump ship for the more favourable short-term results of a new advisor at the worst possible time – just as the old begins a long ascent and the new about to fall off a cliff.
So there we have it, more thoughtful ideas for the everyday investor from the Wealth Brick Road. With a little knowhow (namely the above), a mild time commitment and the right advisor, being aware of personal investment return is within reach for any investor. Only then can investors begin to maximize this return for the best possible outcome – be it a secure retirement, saving for a home, charitable giving, assisting loved ones or otherwise.
The author, Pat Kenney, is a Certified Professional Accountant. He has worked in public practice at a local boutique CPA firm in Mississauga for 9 years. He currently holds a senior management position.by