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
Now imagine that there is not even a
disclaimer on the back page of the fancy performance
Do you think that sounds farfetched?
It's not. I've run across several similar performance presentations in the last
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
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
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
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).