As a performance analyst, how many times have you been asked by your clients, your portfolio managers, or your client relationship managers to explain the differences between the NAV return provided in the client report, and the return generated through the attribution analysis?
And what about the differences between the various flavours of preliminary returns versus the final return, transaction-based returns versus holdings-based returns, fair value returns versus returns based on swing pricing, and so on…
My guess is almost every day.
Because returns of a single portfolio can differ depending on the calculation methodology, different pricing, different accounting engines, and underlying data, it can be quite difficult and time-consuming to identify the discrepancies and even more so to explain them. And quite frankly, there is no right or wrong answer or industry standard to follow.
But the existence of those discrepancies is not the real issue. There are always going to be some inconsistencies, so let’s look at few pertinent ones:
Preliminary versus final returns
These return types will typically have two different audiences. Preliminary returns are most often used by portfolio managers who analyze the returns in a specific context and make decisions upon their analysis. The end investor, however, is interested in a more accurate, finalized and validated version of the return. The main challenge for performance measurement teams is to bring those two returns sets as close together so there is very minimal rework. However, this raises an operational hurdle as getting as close to reality as possible should also be driven from the other operational teams involved (data management, corporate action, trade flow teams, etc.). Operational responsibilities for capturing data, transactions, flows, on-time corporate actions, and custodian reconciliation are imperative for daily returns to have a high degree of accuracy and confidence.
Net and gross of fees
Is the difference between gross and net of fees return the management fee impact? Often net of fee returns are net of a bundle of fees such as custody, audit, admin, and management fees. Identifying the true portion of the management fee is the real challenge here. For example, UCITS funds will have different fees for different share classes. For institutional portfolios often fee amounts are bundled into a single transaction or even posted as miscellaneous items in the investment accounting system.
Fair value versus swing price
On October 13, 2016, the SEC finalized rule 22c-1 to permit a registered open-end management investment company to use swing pricing. Swing pricing adjusts the fund’s net asset value per share to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity. When swing pricing is used, a new investor gets a lower return while the existing investors in the fund get a higher return.
The fund itself will get a higher return compared to the return based on the unswung price. But swing pricing raises reconciliation issues of contribution and NAV return.
For attribution purposes, swing pricing is typically outside of the investment portfolio, so returns generated from attribution will always differ.
As there are no recommendations or industry standards when presenting different set of returns for the same fund, it is extremely important to disclose the source of the differences, since different firms might be using different procedures.
Transaction-based returns versus holdings-based returns
From my perspective, when thinking about transaction-based returns versus holdings-based returns, buy and hold is a thing of the past and, if anything, should only be used for preliminary purposes. Transaction-based returns will provide the needed precision and accuracy for both the return calculation and the attribution analysis.
The cost benefit of explaining the relative return varies for different asset classes, as is the case for fixed income versus equity. For fixed income, only a few basis points are explained, while equities’ relative return is more sizeable. Transaction-based returns mean more reconciliation and more data points. But is the extra work justified? In my view, our investors are hungry for more precision, so transaction based is the way to go.
ABOR versus IBOR, Time-Weighted Returns (TWR) versus Money-Weighted Returns (MWR), MWR versus daily-linked returns, cash flow weighting rules for End of Day (EOD) versus Beginning of Day (BOD), and asset transfer weighting can all lead to multiple return iterations. The most important factor, regardless of methodology, is that firms have procedures that they follow and apply consistently across all funds and portfolios.
It is how you identify, distinguish, and explain the discrepancies to the investor that has proved to be a difficult task.
Most of the time, investigating these inconsistencies means spending a lot of time mining data in different systems, engaging with different teams across the organisation, as well as with custodians and fund admins.
Should we just accept that these differences exist, that there is no right or wrong answer, or should we be calling for more rigorous standards?
What is sure is that rigorous internal procedures are critical, and just as important, relevant disclaimers must be used when different returns for a single portfolio or a fund are presented within the same report.