Average returns 'are not enough to judge outcomes'

Investors should pay more attention to money-weighted returns than time-weighted returns, according to the chair of the 300 Club, an industry think-tank.

Stefan Dunatov, CIO of Coal Pension Trustees, said the shift in focus more towards “wealth” rather than just percentage gains would improve investor understanding of how to achieve investment objectives and the risks involved.

In a new paper – “Using wealth, not returns, to set objectives and measure success” – Dunatov argued that it was the level of wealth, rather than returns, that will determine how well investors with present or future liabilities will achieve their goals.

“While that level of wealth is dependent on investment returns, focussing too much on those returns may lead to objectives not being achieved,” he said. “The path those returns take is also a key consideration.”

For any specific average return over several years, Dunatov argued, there was a multitude of different paths that could have led to that same average return – which can result in very different outcomes for an investor’s fund.

“For example, one path might be that returns are poor to begin with. On another, returns are strong to begin with,” Dunatov explained. “Although the average returns are the same across both scenarios, the total wealth they each generate is quite different because of the effects of compounding.”

The paper highlighted the importance of this factor on funds in either the accumulation or spending phase.

For a fund wanting to build a pot of assets over a five-year period, for example, and with regular contributions, a 50% return in year five would preferable to a 50% return in year one, because the large uplift at the end of the investment period would be on a larger pot of assets. “For those wanting to draw down assets, the reverse is true,” the CIO wrote.

Dunatov told IPE: “We are not advocating taking away time-weighted returns, but if you accept that wealth targets are important, you should consider adding wealth-weighted returns to your arsenal.

“Besides return figures, a pension fund report could also show the projected portfolio values which it might need in specific future years in order to achieve its objectives. But adding money-weighted returns is not a trivial issue because it is not the way the industry thinks.”

The 300 Club is a group of pension professionals from North America and Europe established to challenge traditional industry thinking, and includes current and former pension fund CIOs, asset management leaders, and consultants. Dunatov was named chair last year.