Briefing The Basics of Performance Reporting An Investor s Guide Performance reporting is a critical part of any investment program. Accurate, timely information can help investors better evaluate the success of their portfolio strategy, monitor progress towards their financial objectives and set realistic goals for future performance. However, effective performance reporting may involve the use of technical terms that are unfamiliar to some investors. Financial concepts such as time-weighted and dollar-weighted returns, statistical terms such as standard deviation, and asset categories such as large cap and small cap or growth and value, may appear in a quarterly performance statement. These terms, however, may prevent, rather than promote, understanding. The purpose of this paper is to briefly review some key tools used in the performance-reporting process, and show how those tools can help you evaluate your progress toward your own financial goals. This could mean comparing your portfolio to the market as a whole, determining whether the returns you are earning appear reasonable in light of the risks being taken or distinguishing between the impact of your own investment decisions and those of your investment advisors. A glossary of some specific terms used in this process can be found on page 11.
The Basics of Performance Reporting Dollar Value Growth of the s&p 500 Index $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 90 $383,496 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Data Source: Consulting Group at Morgan Stanley Smith Barney, December 1990 through December 2008 Like other return calculations, cumulative returns are typically expressed in percentage terms. However, it is also common to display cumulative performance by showing the change in dollar value over time either of an actual portfolio or of a hypothetical invested amount. The chart above shows the cumulative growth of $100,000 over the 18 years ending December 2008. The values are based on the total returns for the S&P 500 Index during the period, and assume no cash inflows or outflows. However, the example does not reflect deductions for management fees or transaction costs. Actual results would be reduced by these costs. An investment cannot be made directly in a market index. Past performance is no guarantee of future results. 08 Return appearance The most important single performance concept for most investors is return the change in the dollar value of your investment over a given period. This change may be due to a rise in the value of a stock or bond or to the income it provides (such as interest or dividend payments). By combining these value changes, investors can calculate the total return that is the change in value of the investment plus any income it may have provided on a specific asset or for their entire portfolio. While some investors may have a need to distinguish between capital appreciation and income, for most people, total return is the most appropriate measure of investment success. Total return can be expressed in two different ways as the cumulative return over a particular period, or as an annualized equivalent. For short periods, such as a month or a quarter, the cumulative return is most typically used. However, for periods of more than a year, the annualized return is often shown. The annualized return is the percentage change, which, if repeated each year over the full reporting period, would equal the cumulative return for that period. It is computed using a mathematical formula that takes into account the compounding effect of gains and losses over time. Consider the hypothetical example shown in the table on page 3. It shows the growth in a portfolio over three years. In the first year, the investor earns a 40% return. In 2 investor Guide
the second year, she loses 20%. In the third year, she gains 10%. This produces a cumulative return of 23.2% for the entire period. Annualized REturn EXAMPLE Portfolio Value Annual Return Now assume the same investor earned a return of just over 7.2% in each of those same three years. This annualized return would equal the 23.2% cumulative return for the entire period. Returns are most often expressed in absolute, nominal terms that is, they aren t compared to the performance of some larger benchmark, or adjusted for inflation or taxes. There are, however, several performance measures that do take such factors into account. These include: Relative returns. Investors may want to know whether their performance exceeds or lags a specific benchmark, such as the S&P 500 Index. This can be done by showing the two returns side by side on a chart, or by subtracting the index return from the portfolio return, producing either a positive or negative net result, or spread. After-inflation returns. In times of high inflation as during much of the 1970s nominal returns may appear high even though the investor is actually losing money in after-inflation, or real, terms. After-inflation returns are usually calculated simply by subtracting the change in the consumer price index from the nominal return for the same period, although a more precise formula also exists. Initial Investment $100,000 N/A Year 1 $140,000 40% Year 2 $112,000-20% Year 3 $123,000 10% Cumulative Return 23.2% Annualized Return 7.2% Data Source: Consulting Group at Morgan Stanley Smith Barney For illustrative purposes only While some investors may have a need to distinguish between capital appreciation and income, for most people, total return is the most appropriate measure of investment success. investor Guide 3
The Basics of Performance Reporting After-tax returns. Most investors want to improve their own net worth, not Uncle Sam s. The distinction can be critical when comparing certain assets such as Treasury bonds and taxexempt municipal bonds. A municipal portfolio, for example, may generate lower before-tax returns but yield greater after-tax benefits. However, this after-tax return will depend on the investor s top marginal rate, state of residence and other personal factors. Risk-adjusted returns. A fundamental principle of modern investing is that the investors should only take risks if they expect to be rewarded for them. The greater the risk (typically measured in terms of volatility), the higher the long-term return they should target. Various statistical measures have been created to compare the return earned to the risk taken. These are discussed in more detail later in this paper. Some specialized performance measures are reported in your Morgan Stanley Smith Barney account statement or performance report. Others can be calculated for you by your Financial Advisor. Various formulas exist for measuring after-tax returns. 1 Investors should consult their tax attorneys, accountants or other tax professionals for more information. Time and Dollars When measuring performance, it s important to distinguish between what investors could have earned if their returns had simply tracked the overall market, and what they actually earned. Investors often have great influence over the latter because they control the timing of cash flows into and out of their accounts. Reflecting this fact, two different methods can be used to measure the relative importance, or weight, of the stream of returns generated by a portfolio. The first method, timeweighted returns, is most familiar to investors because it s also the one used to calculate the published returns on the S&P 500, the Dow Jones Industrial Average and other major market benchmarks. Time-weighted returns are calculated without regard to cash additions or withdrawals during the performance period. This is done by measuring the growth of the portfolio between each cash flow, then linking the results to create a single return for the entire period. Thus, all that matters are the returns earned during those periods, not the amounts invested at any particular time. Dollar-weighted returns, on the other hand, do take cash flows into account. This measure essentially calculates the returns on each cash inflow, as determined by the cash outflows and the ending value of the portfolio. These returns are then weighted based on how long each specific inflow has been invested, to produce a single, annualized return also known as the internal rate of return. Because investors decide when to put money into their portfolios and when to take it out, time-weighted returns can differ considerably from dollar-weighted returns. A portfolio could even show a time-weighted gain but a dollar-weighted loss for the same reporting period. To understand why, consider the two charts on page 5. The top chart shows the growth of a $100,000 investment over three years, assuming the same annual portfolio gains and losses shown in the previous example on page 3. Under these conditions, calculating the investor s returns is easy: Because the investor hasn t added or withdrawn money, the market and the portfolio have both grown at the same rate. The timeweighted and the dollar-weighted returns are identical: 7.2%. Going With the Flows But life is rarely that simple. So the bottom chart on page 5 compares the experiences of two hypothetical investors over the same three-year period, assuming the same market performance. Both investors start with $100,000. But while the first investor puts $80,000 into the market at the beginning of the first year, and $20,000 at the beginning of the next year, the other investor does exactly the opposite: He or she starts by investing $20,000, then adds $80,000 in the second year. 1 The Chartered Financial Analyst (CFA) Institute, a nonprofit group for investment professionals, has developed various formulas for calculating after-tax returns on different types of investment income. For more information, see Global Investment Performance Standards (GIPS) Handbook, CFA Institute, May 2006. 4 investor Guide
As you can see, the time-weighted return on both portfolios is still the same: 7.2%. However, the difference in portfolio growth is considerable. The first investor ends up with a 5.5% dollarweighted gain, while the second investor loses 2.3%. That s because the second investor had relatively little money invested in year one, when returns were very good, but more money in year two, when returns were negative. Time-Weighted Returns $100,000 $140,000 $112,000 $123,000 Judgment Call Investors who rely on professional asset managers to handle their portfolios have particular reason to pay close attention to the difference between time-weighted and dollar-weighted returns. It can help them figure out how much of the credit (or blame) for their performance should go to themselves, and how much rightly belongs to their managers. Initial Investment Year 1 Return =+40% Data Source: Consulting Group at Morgan Stanley Smith Barney For illustrative purposes only Year 2 Return =-20% Year 3 Return =+10% Because cash-flow decisions can have such a big impact, it isn t fair to hold a portfolio manager responsible for the influence those decisions may have on dollar-weighted returns. That s why timeweighted returns are a more appropriate way of evaluating manager performance. Bottom line: investors need to take both return measures into account. If your time-weighted returns consistently trail the appropriate benchmark, you may need to take a hard look at your portfolio manager. But if your dollar-weighted returns consistently trail your time-weighted returns, you probably need to evaluate your own cash-flow decisions. Time-Weighted and dollar-weighted REturns Investment Investor 1 Investor 2 Year-End Portfolio Value Investment Year-End Portfolio Value Year 1 (+40%) $80,000 $112,000 $20,000 $28,000 Year 2 (-20%) $20,000 $105,600 $80,000 $86,400 Year 3 (+20%) $0 $116,100 $0 $95,040 Time-Weighted Return Dollar-Weighted Return 7.2% 7.2% 5.5% -2.3% Data Source: Consulting Group at Morgan Stanley Smith Barney For illustrative purposes only investor Guide 5
The Basics of Performance Reporting risk-and-return Example 20% Portfolio 1 Return S&P 500 Index Portfolio 2 4% 0% Risk 28% Data Source: Consulting Group at Morgan Stanley Smith Barney Example of risk-and-return analysis 20% Portfolio 1 Return S&P 500 Index Portfolio 2 4% 0% Risk 28% Higher Return/Less Risk Higher Return/More Risk Lower Return/Less Risk Lower Return/More Risk Data Source: Consulting Group at Morgan Stanley Smith Barney Likewise, while time-weighted returns can help you decide how well or poorly your managers are doing, they don t really tell you how much progress you are making toward your personal financial goals. Dollar-weighted returns and even more importantly, the cumulative growth of your portfolio will show you that. Risk Analysis To get a useful picture of their financial progress, investors need more than just return data. They also need to know how those returns were generated. It s particularly important to be able to measure the risks they are taking, and see how those risks compare to an appropriate market benchmark. This emphasis on risk is based on decades of financial research. Collectively, these findings are known as Modern Portfolio Theory. The theory assumes the returns on various assets are related to the risk of holding them. The greater the risk, the greater the potential reward investors should expect for taking that risk. The goal of a sound investment strategy, then, is to achieve the best possible trade-off between risk and return. There are many different kinds of risk, but for most investors the most critical one is volatility the degree to which the returns on an asset or portfolio deviate from their long-term average. High volatility increases the probability an investor s portfolio might experience deep losses just at the time they need to sell those assets to raise cash. 6 investor Guide
For individual stocks, such risk is typically expressed in terms of beta the degree to which a stock s price is more or less volatile than the market as a whole. For diversified portfolios, the most common risk measurement is standard deviation, a kind of statistical average of the volatility of monthly or quarterly returns. The relationship between risk and return can be expressed graphically, using charts like the ones shown on page 6. Risk (represented as standard deviation) is shown on the horizontal axis; annualized return is on the vertical axis. Such charts are often used to compare an investor s risk-and-return results to an appropriate benchmark, such as the S&P 500 Index for equity portfolios. For diversified portfolios, a blended benchmark one that combines indexes for several different asset classes in the same weights as in the portfolio might be used. When analyzing risk-adjusted performance, analysts typically divide such a chart into four boxes, or quadrants. The best-performing assets are in the upper-left-hand box the quadrant that combines a higher return than the benchmark with a lower level of risk. The worst-performing assets are those in the lower-right-hand box combining higher risk with lower returns. The other two boxes on the chart are neutral. Performance results that fall in those quadrants may be good or bad, depending on the investor s goals and tolerance for risk. More conservative investors might be content with lower return and less risk. More aggressive investors might be willing to accept higher risk in exchange for higher returns. Risk-adjusted performance can also be expressed in a single statistic that captures the return per unit of risk. There are several such measures; the most common one is the Sharpe Ratio, named after William Sharpe, one of the pioneers of modern financial theory. Sharpe s formula can be used to evaluate both individual portfolios and broader market benchmarks. Sharpe Ratios are calculated by taking the return on a portfolio or a benchmark, subtracting the yield on an extremely low-risk asset, such as the 90-day Treasury bill, and then dividing the result by the standard deviation of the portfolio or benchmark returns. The higher the resulting number, the better the riskadjusted performance. Over the 20 years ending in 2008, for example, the S&P 500 Index had a Sharpe Ratio of 0.27, slightly higher than the 0.11 ratio for the 20 years ending in 1988. Class and Style Measures of relative performance inevitably will depend on the specific benchmarks used in the comparison. Comparing the returns on your large-cap equity portfolio to a Treasury bond index, for example, won t provide much useful information. In addition to broad market benchmarks such as the S&P 500, a large number of specialized indexes also exist. These may cover a particular asset class such as large-cap stocks or short-term government Measures of relative performance inevitably will depend on the specific benchmarks used in the comparison. 2 Value-oriented equity managers typically prefer stocks that appear to be bargains based on current economic fundamentals such as earnings, book value or sales. Growth managers tend to focus on a stock s future earnings prospects. investor Guide 7
The Basics of Performance Reporting Asset and style categories Value Core Growth Small Mid Large bonds and/or a specific investment style, such as value and growth. 2 Benchmark construction is a complicated task, as is selecting the most appropriate index for comparison. That s why Morgan Stanley Smith Barney analysts carefully review the performance track records and investment strategies of the portfolio managers and mutual funds they cover, and assign an appropriate asset class or style benchmark to each one. These are the comparisons shown in both manager-research reports and quarterly client-account statements. As part of this process, managers and funds are categorized using a grid like the one shown at left. An equity manager, for example, may invest primarily in small-cap, mid-cap or large-cap stocks, and may follow the value style, the growth style or combine both growth and value stocks in a core portfolio. The example shown here is a large-value manager. Bond portfolios, by contrast, are classified by the duration, or weighted maturity, of the bonds they contain, and the credit quality of those securities. This information is also included in research reports and client statements. Data Source: Consulting Group at Morgan Stanley Smith Barney 8 investor Guide
Asset Allocation Finally, investors need to be able to monitor the composition of their portfolios over time. Asset allocations can change as market trends add or subtract value from different assets at different rates. These changes can reduce diversification and leave investors more exposed to risk. A pie chart or a table showing the percentage shares of each asset class in the portfolio at the end of the reporting period typically illustrates asset allocations. An example is shown at right. More detailed reports might also describe the sectors within those asset classes such as the economic or industry breakdown in an equity allocation. There are several different sector-classification systems in use. For most reporting purposes, the Global Industry Classification System (GICS) is used. The GICS system includes 10 broad economic sectors, 24 industry groups and 64 industries within those groups. The 10 economic sectors, and their percentage shares in the S&P 500 Index, are shown here. sample asset Allocation Economic Sectors in the S&P 500 INdex As of december 31, 2008 Information Technology 15.60% Health Care Financial Energy 18% Fixed Income 24% International Stocks Consumer Staples 41% US Large-Cap 10% US Mid- Cap 2% Cash 5% US Small-Cap Data Source: Consulting Group at Morgan Stanley Smith Barney as of May 2008 14.30% 14.00% 13.30% 13.10% Industrials Consumer Discretionary Utilities Telecom Services Materials 4.00% 3.60% 3.10% 8.10% 11.00% Total doesn t add to 100% due to rounding Data Source: Vestek Systems investor Guide 9
The Basics of Performance Reporting The kind of data clients receive is often more important than the amount of information they are provided. Informed interpretation is a must. Conclusions Accurate, timely performance reporting is essential if investors are to make informed decisions about their overall financial strategy and the quality of the advice they are getting from their professional asset managers and other investment advisors. But the kind of data clients receive is often more important than the amount of information they are provided. Informed interpretation is a must. Some points to keep in mind: Total returns are important, particularly in assessing your progress towards your personal financial goals. However, they do not tell the whole story, or provide an accurate measure of the success or failure of your investment strategy and/or your portfolio managers. Relative performance data is critical for making informed assessments. But relative to what? Selecting the appropriate benchmarks and correctly identifying the asset class or investment style of each manager or fund in your portfolio is critical. Risk matters. Investors need to know whether the returns they see reflected in their account statements are the product of investment skill or just a willingness to take greater risks risks the investor may not be prepared to accept. Your Morgan Stanley Smith Barney Financial Advisor would be more than happy to provide more information on the topics discussed in this paper, and answer any questions about your own account statements or other performance reports provided by Morgan Stanley Smith Barney. Please don t hesitate to give him or her a call. 10 investor Guide
Glossary Annualized Return: A measure of investment performance that allows comparisons between different time periods. The cumulative return is converted into an annual return that would, if repeated each year during the period, produce the same cumulative result. Asset Allocation: An investment technique that creates diversified portfolios by dividing funds among different asset classes, such as stocks, bonds, international equities and short-term cash instruments. Beta: A measure of the degree to which a stock s returns track the broader market. A stock with a beta higher than one is considered more volatile and therefore more risky than the market. A stock with a beta lower than one is considered less risky. Cumulative Return: The total change in the value of an asset or a portfolio over a given period of time, expressed in percentage terms. Often displayed as the growth of a given sum of money over the time period. Dollar Weighting: A method of measuring portfolio performance that takes into account cash inflows and outflows. Expresses the return on each dollar invested, not the returns earned in each time period. Duration: A measure of the sensitivity of a bond or bond portfolio to changes in interest rates. The higher the duration, the greater the exposure to rate fluctuations. Internal Rate of Return: The mathematical formula used to calculate dollar-weighted returns. Technically, the discount rate that makes the net present value of a defined stream of cash flows equal zero. Sharpe Ratio: A measure of risk-adjusted performance. The ratio expresses the amount of return achieved for each unit of risk assumed by the investor. The higher the ratio, the better the riskadjusted performance. Standard Deviation: A statistical measure of the variability of monthly or quarterly returns. This result is annualized to make it comparable with annualized returns. The higher the standard deviation, the greater the volatility of an asset. Time Weighting: A method of measuring portfolio performance that does not take cash inflows and outflows into account. Expresses the linked returns for each time period, regardless of the amount of money invested. Total Return: The change in the value of an asset or portfolio due to both capital appreciation or depreciation and/or dividends, interest payments or other income. Volatility: Fluctuations in the value or periodic returns of an asset, a portfolio or an entire market. Volatility is one common measurement of investment risk. To help investors and their Financial Advisors with these critical tasks, Morgan Stanley Smith Barney provides a variety of detailed performance reports. These may cover specific assets, such as a stock or bond holdings, track the performance of diversified investment vehicles such as managed accounts or mutual funds, or provide a comprehensive overview of the client s total account relationship. Your Morgan Stanley Smith Barney Financial Advisor can answer any questions about your own account statements or other performance reports provided by Morgan Stanley Smith Barney. Please don t hesitate to give him or her a call. investor Guide 11
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