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OBJECTIVE

“Understanding CRM II’s performance reporting requirements” is eligible for CE credits, see Accreditation details for more information

[Please note: this course does not qualify for compliance credits. Click on “Accreditation Details,” above, for information on credits this course qualifies for.]

The rules associated with Phase II of the Client Relationship Model (CRM II) were finalized earlier this year. Among other requirements, CRM II requires dealers and portfolio advisors to provide investment performance reports to their clients every year. Implementation of the performance reports will take place gradually starting in 2016.

The performance report will show the annualized percentage return for the client’s account. The return will include dividends and interest in addition to capital gains and losses, be calculated net of charges, and use a money-weighted method generally accepted in the securities industry. When the requirement is fully implemented, annualized returns will be provided for the 12 months, three years, five years and 10 years preceding the date at which the returns are calculated, and since the opening of the account.

A Mythical Investor

Let us fast-forward into the future. Dino, an investor, has just received the first set of performance reports from his portfolio advisors. He firmly believes in the virtues of advisor diversification and has allocated his money among several advisors. Like most investors, he does not feel that he owes them any particular duty of loyalty. He pays them and expects them to perform.

After looking at the various performance reports, Dino muses: “Portfolio Advisor A gave me a decent return of 12% last year, but Portfolio Advisor B only gave me a measly 2%. Quite clearly, B is not performing. I will move my money from B to A.”

Dino’s analysis can be faulted on several grounds. First, portfolio advisors should not be evaluated on the basis of a single year’s performance. In the short term, luck probably plays a greater role than skill. We need a lifetime’s worth of performance data in order to evaluate properly whether an advisor’s performance is due to luck or skill. This is because the analysis of advisor performance relies on statistical inference, which requires a lot of data.

Another issue is that the two portfolios may have different risks. Portfolio Advisor A may have produced better performance last year by taking more risk than B. If so, Dino should realize that Portfolio Advisor A is more likely to lose money in the future when the tide turns.

However, even if we allowed for these factors, Dino’s conclusion would still be unwarranted. Assume that we have many years of performance data on both portfolio advisors and that the two portfolios have the same risk. Dino would still be wrong to use the returns in the performance reports to judge the performance of his advisors. This is because of the way that CRM II requires the returns to be calculated.

What Does a Portfolio’s Performance Depend on?

Over the long term, the performance of a portfolio depends on the following factors:

  1. the performance of the market as a whole;
  2. the skill of the portfolio advisor; and
  3. the actions of the investor

Influence of the Market

Most portfolios do well when the market does well. A common saying is that a rising tide lifts all boats. On the other hand, when the market is experiencing a correction, the advisor would have to be either very skilful or very lucky to generate a positive return for the portfolio.

Influence of the Portfolio Advisor

The composition of an actively managed portfolio is usually different from that of the market portfolio. Portfolio advisors add value by using their analytical skills and knowledge of companies to identify stocks they believe will outperform the market. The additional return, after allowing for risk, is sometimes referred to as alpha, as opposed to beta, which is the return from simply tracking the market. Of course, it is possible for portfolio advisors to make mistakes and choose stocks that end up underperforming. In this case, the alpha is negative.

Influence of the Investor

Most investors probably think that, having entrusted their portfolio to an advisor, they are entitled to hold him or her fully responsible for its performance. This is incorrect. The client’s own actions also have a major impact on the portfolio’s performance, for better or worse.

Most of the time, it’s for worse. Investors contribute to their portfolio’s performance through their decisions to add more money to the portfolio or withdraw money from it. Studies have shown that investors’ actions reduce the annual return on their portfolio by approximately 1.5 percentage points. Think of it as a kind of negative alpha attributable to the investor. The negative alpha is truly enormous, especially when compounded over time. It can make the difference between a comfortable and a frugal retirement.

Investors’ alpha is negative because their decisions are often driven by emotion. Suppose they inject new money. This may be at a time when the market is overvalued and good investment opportunities are scarce. The portfolio advisor will then have to decide whether to buy investments for the portfolio at inflated prices or keep the money in cash—a choice between the devil and the deep blue sea.

Alternatively, suppose investors decide to withdraw money from their portfolios. Perhaps they have been spooked by a recent drop in the market. This is actually the worst time to withdraw money. In order to satisfy the client, the portfolio advisor will need to sell some investments at depressed prices.

The sad reality is that investors consistently choose the wrong timing. They tend to inject new money after a run-up in stock prices, when everything has become expensive, and withdraw from the market after a large drop in stock prices, when everything has become a bargain.

Two Families of Investment Returns

There are two main approaches to calculating investment returns:

  1. The first approach is to measure the impact of the market together with the skill of the portfolio advisor. The impact of the investor’s actions is excluded. Rates of return calculated using this approach are known as time-weighted returns.
  2. The second approach is to measure the impact of all the factors that affect a portfolio’s performance, including the actions of the investor. Rates of return in this family are known as money-weighted returns or dollar-weighted returns.

Each of these families of returns has its own use. The mistake of our mythical investor is that he used the wrong rate of return in assessing the performance of Portfolio Advisors A and B.

Performance Reports under CRM II

When developing CRM II, the concern of the securities regulators was to enable investors to figure out how they are progressing towards their investment objectives. Quite rightly in the view of this author, the return that CRM II requires dealers and portfolio advisors to provide to their clients is the money-weighted return.

The money-weighted return is a personal rate of return. It is most unlikely that two investors will have the same personal rate of return even if they happen to use the services of the same portfolio advisor. This is because the money-weighted return takes into account all the factors that affect the return on a portfolio, including the investor’s decisions. It is most unlikely that two investors will add money to or withdraw money from their respective portfolios at precisely the same time.

Dino was wrong to use the performance reports required by CRM II to evaluate the performance of his portfolio advisors because the reported returns are money-weighted returns—they include the impact of Dino’s decisions, for which the advisors cannot be held responsible. To evaluate the performance of his advisors, Dino should use a time-weighted return, which specifically excludes the impact of investor decisions.

More on the Mythical Investor

Like all thoughtful investors, Dino has a personal financial plan. His advisor interviewed him extensively—they discussed investment objectives, investment horizons, financial circumstances, risk tolerance and other subjects. In the end, the advisor used an optimizer to devise an asset allocation. For example:

Canadian stocks 20%

US stocks 20%

International stocks 20%

Bonds 35%

Cash 5%

Total 100%

Using expected returns for each asset class, the advisor calculated that the portfolio would generate an average annual return of 6%. Under certain assumptions, which are beyond the scope of this course, this return would be sufficient to enable Dino to accumulate enough money by the time of his retirement to live a comfortable life. It therefore represents his target return.

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