Today’s blog is the first in a new recurring series on Common Performance Questions. In this series Joe Porter, Orion’s Product Manager of Composites and Performance, will detail how to correctly read Orion performance reports and help you understand the various performance reporting methods available in Orion, all to help you have better conversations with your clients.
We’ve all had the experience of picking up something, expecting to understand it, and having it turn out more complicated than we originally thought. For most of us, it’s the instructions to assembling that new IKEA desk, or programming the new DVD player.
You may have experienced another type of confusion though, if you’ve ever reviewed a report where your account values were higher, or lower, than their time-weighted return performance would seem to suggest.
When looking at a performance report, there are times when performance is positive, but the account or household value is lower—or vice versa. The natural inclination would be that if we have positive performance, then the value should have gone up.
In today’s post, let’s take a look at how cash flows have an impact on the value, but don’t have an impact on time-weighted-return (TWR) performance.
Cash Flows and TWR Performance
The first thing we need to remember is that cash flows do not impact TWR performance.
The reason for this is because managers who manage the money typically do not have control of when money enters or leaves the account. For this reason, how the manager manages the account shouldn’t be rewarded or penalized by the cash flows in an account.
In the chart below, we’ll look at three accounts with a starting value of $1,000,000. Each account has the same positive period performance.
Cash Flows and Positive TWR Performance
The difference is account A had no cash flows, account B had a positive cash flow at the beginning of the period, and account C had a negative cash flow.
Account A started with $1,000,000 and was up +0.50% because ($1,000,000 * +0.50%) = $5,000, which is what we ended up with in the chart.
If account B was looking at a report, they would see that the value of the account is now up $30,125. You might see this and think the account gained $30,125, which should make the period performance return = +3%. However, this is not the case. The account added $25,000 at the beginning of the period, so the gain from performance is ($1,025,000 * +0.50%) = $5,125. We then take the cash flow of $25,000 + the period gain of $5,125 = $30,125.
The most confusing scenario for many advisors is when the ending value is less than the beginning value, but performance is positive.
This type of scenario has to do with a negative cash flow, which we see in Account C.
A cash flow of -$25,000 dropped the account value down to $975,000. Performance was positive, so it did bring the ending value up to $979,875 for a gain of $4,875 ($975,000 * +0.50%).
Cash Flows and Negative TWR Performance
You will see the same event happen with cash flows and negative performance, but in the opposite fashion. Let’s look at the chart below for the next three examples.
With no cash flows, shown in account A, we would expect a drop of -$5,000 on an account that had $1,000,000 and -0.50%, which is what we see.
This time, Account B is the one which confuses advisors the most. We see a positive value change, but negative performance.
The performance downturn has to do with the $25,000 added to the account. The overall value is greater than the $1,000,000, but the value is down from $1,025,000 to $1,019,875. The account did lose -$5,125 ($1,025,000 * -0.50%).
Account C looks like it dropped more than -0.50%, because the ending value is $970,125. We have to remember that -$25,000 of this came from the distribution and the rest, -$4,875, ($975,000 * -0.50%) of the reduction comes from the drop in performance.
As we have seen, cash flows affect the value of the account, while the TWR performance removes the effects of cash flows. Calculations for TWR remove this effect to show how the account performed without the impact of cash flows, because most managers do not have control of cash flows.
Have more questions about TWR Performance? Get in touch with our SME Performance Team.