Changing how investment returns are reported
February 9, 2017
Understanding your investment returns is something most investors want. Last year there was a change to how that return is calculated.
The significance is that understanding the simple logic of this change will help investors better understand how well their investments are doing.
Last year the Canadian Securities Administrators mandated that investment returns be calculated differently. The starting point for this topic is to understand what is meant by a “rate of return”.
An investment return is how much the value of your investment changed over a specific time period. If you start the year owning a $100 investment and at the end of the year it has appreciated to $110 you have a positive return of $10, or an annual gain of 10 per cent.
That is pretty simple. Added complication comes from the reality that during the year you might deposit or withdraw funds from your account. Sometimes you might do both, deposit and withdraw.
When a transaction occurs, the year is divided into sections. A new time period is added each time there is a transaction of either a deposit or withdrawal.
Returns for each different time period are calculated and then added together to produce one rate of return for the year. This is referred to as a “time-weighted” rate of return.
Each time period has equal weighting. Just add the different returns together and that is your return. That is the way returns where calculated in the past. Now things have changed.
The reason for the change is that often the invested amount varies. For the above return calculation of 10 per cent, assume your investment at the start of the year was only $10 and during the last few days of the year you invested an additional $90.
Because your return during most of the year was based on a small amount and only the final few days of the year did you add additional funds, the original method of calculating the return on a “time-weighted” bases is misleading.
The new method used to calculate your investment return is based on the different amounts of funds invested at different times during the year. The new calculation method is called a “money weighted” return on investment.
For an investor who added additional funds to their investment late in the year the “dollar weighted” method of calculating the return is more meaningful.
The same logic applies to any investor who had different amounts invested throughout the year.
So far so good. Except… there is an issue. Investors want to compare their returns with a benchmark. How have their investments performed against other similar investments?
If you own a mutual fund that invests in Canadian stocks, then one measure of comparison is benchmarking your investment performance compared to the underlying Canadian stock market.
That is a reasonable comparison. The benchmark index of the Canadian stock market will be based on holding all stocks that make up the index for the entire year with no transactions.
Your return on investment figure will now be based on the timing of your transactions and the different amounts invested throughout the year.
You are comparing apples with oranges. Comparing your return against an index will be less useful in the future.
One suggestion if you want to evaluate the performance of mutual funds you own is to use the publicly available information of mutual fund performance against the underling market the funds invest. For example, how do your Canadian mutual funds perform against the performance of the Canadian market?
Understanding how investment returns are reported will help you be able to evaluate how well your investments are doing.