Investment Performance: You Don't Know What You Don't Know

By DAVID MOON, Moon Capital Management
Novmeber 6, 2005

Imagine you are considering hiring my firm to invest your fortune. You come into our office to interview us, are favorably disposed, and ask about the returns we've generated for our clients. We show you a dazzling report with colorful graphs that explains that the five-year average annualized return of our growth portfolio was 97 percent. (Note: this is a hypothetical example, for illustrative purposes only. Although we're proud of it, our actual five-year annualized return wasn't 97 percent.)

You don't notice that somewhere on the back of the report, in fine print, is a note something like this: 'These are not the actual returns earned by any of our clients. This is what our clients would have earned if we had owned a portfolio consisting of only one stock, Urban Outfitters. That's not what we owned in the last five years, but that's what we'll buy for you today. When we do, we sure hope it does that well.'

Now imagine that there is not even a disclaimer on the back page of the fancy performance report.

Do you think that sounds farfetched? It's not. I've run across several similar performance presentations in the last few months.

Our industry has always struggled to find a consistent, fair and logical method to compile, present and compare historical performance. Sometimes we fail while trying. Too often, however, we fail on purpose.

My example was based on a real presentation. The firm was offering a service to advise companies which mutual funds to include in their 401(k) plan menus. Its various models suggested owning specific mutual funds to create a growth or income or balanced portfolio. When you look at the mutual funds within each of the models you discover that this firm has managed to select mutual funds that always outperformed the overall market. It is amazing. They never pick a loser!

But you don't know what you didn't know. Nor could you know, unless you asked, because there wasn't even any obscure fine print to reveal the truth.

The mutual funds in the various portfolios were the investments that existed in the models at the present day, not the funds the firm actually owned during the three, five and ten years for which the returns were presented. During those historical periods, the portfolios included mutual funds that are no longer in the model, presumably because of poor performance.

We don't know the actual returns earned by real clients or if the existing clients still own funds that are no longer included in the models being shown to prospective clients.

You might assume that because the returns of a mutual fund are independently verified that they can't be misused. You would be wrong. This is just one of the many kinds of problems that investors face when evaluating a firm's historical returns.

A better approach is at hand. The Chartered Financial Analyst Institute, a global membership organization, has established the most widely accepted methodology for performance calculation. In January 2006 these so-called AIMR Performance Presentation Standards (AIMR-PPS') will become the Global Investment Performance Standards (GIPS').

Don't expect to be overwhelmed with a huge institutional rush to comply with the new standards, however. They are complicated for many firms to compile ' and too often they get in the way of the sales process.

But when you see a firm that uses these standards, your level of confidence in the numbers should improve. And if a firm's performance doesn't comply, you need to ask questions ' a lot of them.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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