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Time-weighted versus money-weighted returns

Stephen Kelly, investment analyst, Maitland looks at time-weighted versus money-weighted returns and the impact of behavioural finance on portfolios

A pick-up in equity market volatility, like the one experienced recently, can lead to greater disparity amongst portfolio returns as different investors make different decisions based on the information they see and the emotions they feel.

Making more tactical changes within a portfolio when volatility picks up and more opportunities present themselves can help to generate excess returns but it is useful to remind ourselves at times like these, that attempting to time the market has historically cost investors dearly and so decisions should be high conviction and appropriately sized.

The chart below, which uses data from Ilia D. Dichev’s 2004 paper titled What are stock investors’ actual historical returns? Evidence from dollar-weighted returns, shows the difference between the money-weighted return to investors – which incorporates the timing of investor flows into assets – versus the time-weighted return. The majority of the data runs over a 31-year period to February 2004 and it is clear that over this period and across almost all countries analysed, investors received lower money-weighted returns than time-weighted returns. In other words, they timed the market poorly.

The data is significant both in the sense that it made a genuinely noticeable difference to investors’ returns, especially when those “lost” returns were compounded over time (the difference is over $71,000 in nominal terms for a US investor who invested $10,000 from 1973 to 2004), as well as in a statistical sense at a 99% confidence level for the major markets including the US, Japan and the UK.

Time-weighted versus money-weighted returns (the perils of market timing)

So what is the most likely cause of this and how can we try to make sure that we do not give up returns by timing the market poorly?

Ultimately the cause of this phenomenon is investors buying high and selling low, the main reasons for which are:

1) Technical– for example, “lifestyling” within a retirement pot or forced equity sales for liquidity reasons;

2) Rational (or at least justifiable)– for example, buying equites when they are expensive simply because the alternatives appear to offer even worse value; and

3) Psychological– a consequence of investors buying assets at high levels whilst chasing strong recent returns in a fear of missing out and selling after times have been tough, in the fear that things will get even worse.

The technical factors above can be mitigated with good wealth planning. The rational reasons can be justifiable depending upon the market conditions – lower interest rates, for instance, undoubtedly imply that we should be willing to pay more for equities, all other things being equal. The psychological factors however, should be avoided at all costs and there are a few simple guidelines which can help:

• Strategic asset allocation:As your asset allocation will drive the majority of your returns, you should be comfortable that your strategic asset allocation is right for your level of risk and capacity for loss. This should ensure that you are less likely to experience an investment result with which you are completely unable to cope (both mentally and financially) and this should allow you to remain invested through the tough times, rather than selling in fear.

• Tactical asset allocation:Have a rough idea (or a strict limit if you prefer) of a tactical range around which you would be willing to stray from your strategic allocation. This should be small enough to ensure that you do not stray completely from the target of your strategic allocation but large enough to make high conviction tactical decisions when the opportunities present themselves. Once you have this level, consider what would cause you to stray from your strategic allocation. For example, if your strategic allocation is 70% equities, what must the world look like for you to have only 50% invested in equities. Hint:Pretty bad!

• Pound cost averaging:Phasing into and out of investments can reduce the effect of an inherent level of market timing to which all investors are exposed. Trying to time the market perfectly and invest your entire position in one go can pay off if prices just go higher from that point, but short-term market moves can be volatile and so phasing in can provide you with comfort that if prices immediately go down after your initial investment, you will pick up an even greater bargain with the next phase of your investment.

Following these guidelines should help to reduce the gap between the return that you as an investor experience and the return which the fund delivers – and that can make a significant difference to the growth of your wealth.

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