How many times have we invested in a fund based on its past performance. In fact, almost all the time.
How many times, in spite of the lofty performance credentials of the fund, the actual return of our investment sucks. (leave that to you!)
The difference lies in the concept of how performance is measured. A fund’s performance is normally time weighted return (TWR) and is a simple compounding of fund Net Asset Value (NAV) over a period of time. This measure is presented over various time horizons (YTD, 1-year, 3-years, etc). This is the return earned by the fund manager on the fund.
However, this return metric does not provide a completely accurate view of how much return the investors have made on their capital; to find this, an internal rate of return must be calculated to discern the return on the average capital in the fund. In simple terms, the Capital Weighted Return (CWR) takes into account the cash flows at the beginning and end of the month and is the average rate of return of the investors in the fund.
Why does this difference matter? Because it is quite important .
The first tells you how well the fund manager did over time while the second tells you how well his investors did. It is quite possible that a fund gains a TWR of 5% p.a over the last three years while its CWR may be -10%. What this means is that even though the fund manager did manage a positive performance, his investors (as a group) suffered a loss. How can this happen? Because investors may be bad in terms of timing their investments.
Various studies and reports have been commissioned to analyze and illustrate the difference between CWR and TWR and how using TWR exclusively can be misleading to investors. It has been found that CWRs trailed TWRs in major indices by an average of 5 percentage points/year over a 25 year period. Moreover, a Wall Street Journal article highlighted the CGM Focus Fund (which had been named the best-performing US diversified stock mutual fund of the decade by Morningstar); according to the article, the fund produced a TWR of 18% over the last 10 years while underlying investors actually lost 11% per year ending in November 2009! This comes out to a discount of an average of 29 percentage points every year for a decade!
Discounts (CWR being less than TWR) are generally caused by rapid asset growth and mistiming of inflows to the fund by the investors. In other words, investors return may be poor due to wrong timing (buy and sell). Conversely, a Premium is the result of a substantial inflow (as a % of AUM) which is also well-timed in terms of market performance.
In short, cash flows into a fund matter more than stand alone performance. It is no surprise that as per updated standards of GIPS (Global Investment Performance Standards), it is now recommended that NAV’s be calculated and reported as on the date of significant cash flows reiterating the importance of cash flows.
An Indian Case Study-HDFC Bank Equity funds (Dec 2004- Dec 2011)
I took 5 equity funds from the HDFC Bank staple to see if there is a difference between fund performance and the performance of investors underlying in the fund. The analysis was done over 3 time periods (3 years, 5 years, and 7 years). In all but only one instance, the TWR was higher than the CWR leading to a discount. In other words, investors in the fund made lower returns (due to wrong timing) than the fund manager. In some cases, the difference was really significant. Take for instance HDFC Top 200 fund. For the 3 year period ending Dec 2011, the fund returned an impressive annualized 22.56% while the investors in the fund made only 7.38% leading to a discount of 15.18%. We can observe similar discounts throughout the calculation except in one case (highlighted in red) where we see a premium. Another contributing factor to the discount apart from poor market timing by investors could be the rapid growth in assets under management. Invariably all funds experienced extraordinary growth in their asset base. The funds under study grew by an annualized 46% for the last 7 years. Incredible indeed!
What does it say?
Fund managers are good at managing funds and advisors are good at gathering assets but it does not help investors invested in the fund
Investors consistently make wrong timing decisions (both buy and sell) leading to underperformance as compared to the fund manager
Fund houses and advisors do not assist investors in helping them on their timing dilemma leading to such discounts. For them, investment is recommended any time of the year/market cycle.
What should you do as an Investor?
Never base your decision to invest solely on the past performance of the fund. Insist on looking at the CWR as well. A fund that is focused on the returns its investors make should be a better bet.
Since you cannot successfully time the market, always spread your investments over a period as this reduces the possibility of a discount in terms of your performance compared to the fund performance
Be fearful when the market rallies and adventurous when the market tanks. It is psychologically difficult but produces investment magic! And enables you to mitigate the timing risk.
The author thanks Deivanai Arunachalam & Divya Karthik for data support.