The Journal of Performance Measurement

Table of Contents
Vol. 15, #2 - Winter 2010/2011
Letter from the Editor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 4
Letter from the Publisher . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Page 6
Beyond Brinson: Establishing the Link between Sector and Factor Models
Ben Davis, Ph.D., MSCI and
Jose Menchero, Ph.D., CFA, MSCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 8
The sector-based Brinson model is widely used in the investment management community. In this paper, we show that the
Brinson model represents a special kind of factor model, which we term the Brinson-replicating factor model. We then
demonstrate how this factor model can be augmented with other factors, such as styles, to gain insight that would not be possible under the simple Brinson framework. We also discuss how to attribute risk to the same underlying set of decision variables.

Getting to the Heart of Investing - Financial Stewardship That Meets Client Objectives
Patrick Fowler, The Spaulding Group
and Stephen Campisi, CFA, Intuitive Performance Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 21
The purpose of this article is to introduce (or perhaps to reintroduce) a philosophy and structure of performance and financial
stewardship that puts the interests of the clients funding goals at the forefront of investment decisions. As our performance
metrics become more complex and we dive down deeper and deeper into the accuracy of returns, the availability of data, and
the automation of numbers, it is important to take a step back and reflect on what it is we are trying to accomplish. Each of
us has a fiduciary duty of loyalty, prudence, and diligence which we owe to the clients who entrust their financial assets to
our care.

The Journal Interview

Todd Jankowski, CFA, CFA Institute . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 31
An Analysis of the Aggregate Method to Calculate Composite Returns
David Spaulding, CIPM, The Spaulding Group. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Page 35
Any firm that claims compliance with the Global Investment Performance Standards (GIPS) is faced with the need to derive
returns for their composites. When the AIMR standards were being developed some suggested that equal-weighting would
be better, asset-weighting won out. I recently conducted some analysis of the aggregate method, one of the ways to derive
composite returns, and discovered that it is arguably inherently flawed. The purpose of this article is to provide you with background and supporting evidence as to the measures apparent inaccuracies.

New High Performance Computational Methods for Mortgages and Annuities

Yuri Shestopaloff, Ph.D., SegmentSoft Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 41
Generally, mortgage and annuity equations do not have analytical solutions for unknown interest rates, which have to be
found using numerical methods. Another issue is that these equations have multiple solutions. We discovered an interesting
property of mortgage and annuity functions that can be used for computing the interest rate. These functions have a single
minimum and one or no inflection point, while the value of interest rate that corresponds to the minimum is equal to approximately one-half of the value of the correct solution.

Tailoring Manager Allocation to Market Conditions Using Alpha Optimization: Part 2

Eric A. Stubbs, Ph.D., RBC Wealth Management and
Enrique Jaen, Ph.D., RBC Wealth Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 55
In Part 2, we extend our analysis further to solve a practical problem in manager allocation, which is how to make optimal
use of new information on manager performance and market outcomes to reallocate to investment managers. We show that
the specific performance outcome of a group of managers can be separated into (1) manager performance, (2) allocation
performance, and (3) environmental expectations.

This article has been reprinted with the permission of The Journal of Performance Measurement.
Winter 2011. For more information on this publication or to become a subscriber, visit
www.SpauldingGrp.com or contact Christopher Spaulding at
(732)873-5700 or CSpaulding@SpauldingGrp.com.
With offices in the New York City and Los Angeles metropolitan areas, The Spaulding Group, Inc is the
leader in investment performance measurement products and services. TSG offers consulting services;
publishes The Journal of Performance Measurement, a quarterly publication we launched in 1996; and
hosts the Performance Measurement Forum. The firm also sponsors the annual Performance Measurement, Attribution and Risk (PMAR) conference and PMAR Europe which have come to be recognized
as the leading performance measurement conferences in the industry. TSGs Institute of Performance
Measurement offers performance measurement training, including a fundamentals course on performance
measurement, a course on performance attribution, and two CIPM exam preparation courses. Additional
details about TSGs services may be found on our website www.SpauldingGrp.com.

Getting to the Heart of Investing Financial Stewardship That Meets Client Objectives
It takes a strong man to stand up for himself, a stronger man to stand up for others.
Excerpt from the movie Barnyard
The purpose of this article is to introduce (or perhaps to reintroduce) a philosophy and structure of performance
and financial stewardship that puts the interests of the clients funding goals at the forefront of investment decisions.
As our performance metrics become more complex and we dive down deeper and deeper into the accuracy of returns, the availability of data, and the automation of numbers, it is important to take a step back and reflect on
what it is we are trying to accomplish. Each of us has a fiduciary duty of loyalty, prudence, and diligence which
we owe to the clients who entrust their financial assets to our care. This is true for both investment managers and
performance measurement staff. The focus of performance professionals has traditionally been on individual products and funds. We receive very little training in the total portfolio and relatively little training in methods to evaluate our success in meeting our clients financial goals. We are advocating that performance professionals develop
a broader perspective than just the individual products. This may not fall on one performance professionals shoulders but the collective team to be aware of the ultimate client goals.
Patrick Fowler
is the Chief Operating Officer for The Spaulding Group, where he has been for the past twelve years. Patrick oversees the firms research efforts, training programs and conferences, the Performance Measurement Forum, as well
as other operational areas. Mr. Fowler is also the Director of PerformanceJobs.com, a career resource for investment performance professionals, is Managing Editor of The Journal of Performance Measurement, and is a partner
with Edge Financial Group. Patrick received his Bachelors Degree in Communication from Cook College, Rutgers
University in 1998. He also completed the Rutgers Mini MBA Program for Business Essentials in 2004.
Stephen Campisi, CFA
is a practicing portfolio manager for endowments, foundations, and pension plans and serves as a consultant to
institutional portfolio managers in the areas of asset allocation, risk management, manager selection, and performance measurement. He is also Principal of Intuitive Performance Solutions, a consulting firm specializing in
performance analysis and investment education. He has over twenty-five years of investment experience including
eight years as a bond portfolio manager within the insurance industry. He spent fifteen years as Adjunct Professor
of Finance for the Graduate School of Business of Western New England College, and for more than the past
decade he has taught CFA Review classes for the Hartford CFA Society, for which he is a past president. He is a
frequent speaker at investment conferences and a current participant in the CFA Institutes Speaker Retainer Program, addressing CFA Societies throughout the United States. He is a member of the Advisory Board of The Journal
of Performance Measurement, which published several of his articles including Primer on Fixed Income Performance Attribution and Long Term Risk Adjusted Performance Attribution which won the Peter Dietz award.
He holds an MBA from the University of Connecticut and an MA in Music from Montclair State University.
INTRODUCTION
Performance professionals have been called the geeks
in the corner, back-office number crunchers, and
performance nerds. But the title we need to hold above
all others is fiduciary. This is a steward with responsi-

Winter 2010/2011

bility to act at all times in the clients best interest to

analyze, to educate, and to guide our clients to the mutual benefit of all. This is by no means a feel good
paper. Rather it is a reflection on experiences and interpretations of best practices that will serve as a road map
for performance professionals and the finance industry

-21-

The Journal of Performance Measurement

as a whole to consider for the collective benefit of all.

How does this relate to performance measurement and
the world in which we work? For that we turn to the
work done by Stephen Campisi and draw on the information provided by Ron Ryan. In Stephen Campisi, we
find a visionary who has helped shape and reshape the
way we think about performance and attribution. His
real life approach and practical mentality lend themselves to creating concepts that are understandable, easy
to use, and readily applied to all financial houses. Recently, through his presentation at last years Performance Measurement, Attribution and Risk (PMAR)
conference, Stephen enlightened me to this concept of
managing money as stewards with fiduciary responsibility; providing practical and useful ways to measure
performance while meeting the real goals of our
clients creating wealth for spending, while preserving
principal.
Giving, guiding, and mentoring are ideas we can all embrace to make our industry and our lives richer. This explores how we should be moving toward examining total
portfolio performance and its influence on the ultimate
client, while avoiding the pretense of precision. We accomplish this by looking at case studies and examples
from the pension, charitable, and personal client worlds.
Stewardship can be broken into three duties of fiduciaries who hold a position of trust: loyalty, prudence, and
diligence. Loyalty is based on understanding to whom a
fiduciary duty is owed. As the CFA Institutes ethical
guidelines explain, that duty is owed first and foremost
to our client, then to our employer, followed by our profession, and finally ourselves. Therefore, stewardship
and our own ethical responsibilities are one and the
same. Our goal is simply to look out for our clients; putting our firm, our profession, and ourselves behind what
is in the best interest of our clients. Are we doing this
today? The answer, in many cases, is no.
EMPHASIS ON MEETING CLIENT GOALS
Comparisons to asset benchmarks are useful for answering the question, Did the implementation of the strategy
add value? But we first have to answer the question, is
the strategy alone likely to meet the clients financial
goals? We are asking the question, do we have the right
strategy and are we succeeding? All clients have similar

The Journal of Performance Measurement

goals: they invest to do something with their money.

Whether our clients are individuals, pension funds, endowments or charities, their goal is to make money, do
something useful with that money, and preserve that
money with minimal risk. As such, we need to consider
the impact of inflation, fees, and taxes as It is not what
you make, its the value of what you keep.1 We need to
set reasonable expectations for our clients, since wealth
creation and capital preservation do not happen
overnight. What is a reasonable time frame to evaluate
our success in meeting our clients goals? And what is
the best way to measure success? We begin to see that
our emphasis needs to be about money, not simply about
returns and certainly not about beating benchmarks or
peer groups. The focus needs to be on the whole portfolio and not simply on the individual components. Our
performance numbers, analysis, and interpretation need
to take into account the entire portfolio and then to
measure success against our clients goals within time
frames that reflect these goals.
OUR PENSION FUND CLIENTS AND THE
PENSION CRISIS
At last years PMAR conference, Ron Ryan of Ryan
ALM gave a presentation titled, The Pension Crisis:
The Biggest Financial Fiasco Since the Great Depression. Ron explains the situation as it stands today: If
we were to mark-to-market the public pension funds of
America, according to the experts, they would have a
deficit of over $2 trillion. Ron went on to say: In the
1990s, pension funds were winners. Most of them had
funded ratios that had surpluses maybe as high as 150
percent. Then we had the decade of 2000s. By the end
of 2008, most funded ratios were about 50 percent. Wow.
What happened?
Ron hits the nail on the head here: what did happen?
One-hundred and fifty percent funded in the 1990s and
50% funded in 2008. The underfunding of government
plans is partly driven by politicians granting greater pension benefits than the assets can sustain. But that is only
part of the reason for the underfunding; the other source
is a mismatch of assets and liabilities. At a time of market stress when equities decline and interest rates decrease, we have a perfect storm of negative events,
where the assets decline and the liabilities increase.
Thats the economic reason. The investment manager
cant control the decisions of the politicians, but he can

-22-

Winter 2010/2011

adjust the strategy to reflect the new liability picture to

reduce the risk exposure for the client. Corporate plans
have been less susceptible, but still experienced an underfunding of liabilities.
This begs the question: Where was the stewardship, the
loyalty, the clients best interest? Why did we continue
to subject our clients to unnecessary risks when they
were funded at 150 percent? Can we blame this outcome
on bad markets? Bad timing? Bad benchmarks? Bad
information? Bad accounting rules? The simple answer
to all these questions is Yes, we can blame these
things, but it doesnt fix anything. What should we have
done differently and what can we do moving forward to
manage these assets to accomplish the goals of our
clients while generating surpluses to sustain us through
down markets?
Given the current underfunding of pensions, many plan
sponsors are choosing to move to a liability driven investment strategy, or LDI. This straightforward and effective approach involves matching the interest rate
sensitivity of the bond assets with that of the liabilities,
by matching the bond duration to the liability duration.
This immunizes the bond portfolio since changes in
liability value due to yield changes will be matched by
equivalent changes in the bond portfolio. Along with
the bond allocation, an investment in equities should
supply the growth needed to help address the underfunding of the plan. Over time, as the portfolio value grows,
an increasing proportion of assets can be invested in
bonds, further reducing the risk of a mismatch in the
value of the assets and the liabilities. The ultimate goal
is to fully fund the liabilities with bonds so that the plans
funded status remains secure, even though interest rates
remain volatile and unpredictable. In essence, the plan
is de-risked over time until its assets are essentially
risk free, not in terms of market volatility, but in terms
of their matching price volatility relative to their true
benchmark, the plans liabilities. We note that this Liability Driven Investment approach is often implemented
by simply matching duration. However, some advocate
a more precise method which involves cash matching
each liability payment with a corresponding bond payment. How is this done? The answer is to manage from
a liability-based perspective and to benchmark against
a custom liability index (as all liabilities are different)
and adjust those liabilities to reflect the ever- changing

Winter 2010/2011

landscape. Evaluate the pension funds overall liabilities, along with its funding and operational requirements. Begin with these amounts and then match them
with risk-free bonds (i.e., Treasury zeros). By defeasing
these liabilities you have successfully eliminated risk
from the portfolio, ensuring a return that meets this
funds objectives. We manage the assets to increase the
certainty of meeting the clients objectives; in this case,
to fund the pension liabilities. Now take the surpluses
and manage them actively, providing your portable
alpha2 (transfer of excess return above the objectives
(read liabilities)). The alpha portfolio is invested in
higher-returning equities, and the beta portfolio is invested in bonds which match the liabilities. The job of
the alpha portfolio is to beat liabilities and to grow a
surplus of money, not to beat a benchmark return. Returns dont matter in respect to a benchmark; the only
thing that matters is generating alpha in excess of the liabilities. As Ron explains: The person that wins the
game is not the person that beats the benchmark; you
can beat the benchmark and still lose the game because
you are not meeting your liabilities. For example, we
observed a manager investing in a typical 70% equity
and 30% bond portfolio for a pension plan. He outperformed his asset benchmark by 300 bps in 2008, losing
only 22% instead of 25 percent. However, the pension
liabilities declined by only 8% over that time period.
So, was the manager 300 bps ahead or 1,400 bps behind? In this case, managing to the benchmark rather
than to the clients goals (the liabilities) produced a 14%
funding deficit for the pension plans beneficiaries.
Managing to the wrong objectives is not stewardship,
and no one benefits.
PROOF IS IN THE PUDDING
Some recent research by SEI suggests that pension
funds are moving in this direction of Liability Driven
Investing (LDI.) Their November 2009 Quick Poll
shows that the percentage of pensions employing a Liability Driven Investing strategy has nearly tripled over
the past three years from 20% in 2007 to 54% in 2009.
The poll also revealed that 90% of respondents felt that
controlling year-to-year volatility of funded status is
the primary objective of LDI. Absolute return seems to
also be on the decline as the benchmark of choice, as
the poll stated that in 2007 absolute return was the
highest ranked benchmark by 28% of poll participants.

-23-

The Journal of Performance Measurement

This year, only 15% of the poll participants identified

this as the primary success metric.
A TALE OF TWO MANAGERS:
THE BENCHMARK BEATER AND THE
STEWARD
Our example begins in early January 2000. After enormous equity gains from 1995-1999, many corporate
pension plans were operating at a 50% surplus to their
liability value. In walk two portfolio managers. The first
is called The Benchmark Beater. He is a typical in-

vestment manager for pension plans: he focuses on total

return, and his aim is to beat the asset benchmark. He
invests his clients assets in a 70/30 equity/bond portfolio. The second is called The Steward. She is a loyal
fiduciary; a risk manager first with a keen focus on the
clients needs. She invests her clients money in zero
coupon Treasury bonds to match the next 30 years of
pension payments (the Beta portfolio). She invests the
surplus in S&P 500 for long-term growth (the Alpha
portfolio).
The client is a pension plan with scheduled payments

Figure 1: Projected Pension Liabilities

$43.3 Million

The Journal of Performance Measurement

-24-

Winter 2010/2011

Figure 2: Yield Curves at Beginning and End of Evaluation Period

for the next 80-plus years reflecting a 12-year average

duration. The interest rates for 12-year bonds are currently at 6.5 percent. The current value of liabilities is
$28.8 million, and each portfolio value is $43.3 million.
Fast forward 10 years after the market events from 20002009 and we have interest rates falling from 6.5% to 3.2
percent. The S&P 500 lost 9% over these ten years. The
70/30 strategy only gained 25% over this time period
while paying liabilities, with the remaining liabilities
nearly doubled as a result of lower interest rates. Liability-matched bonds increased in value lockstep with liabilities.
So how did our two managers fare? The Benchmark
Beater paid out $20.8 million in benefits and ended with
a portfolio value of $30.5 million, a liabilities value of
$34.6 million, and a deficit of $4.1 million or 12 percent.
The Stewards portfolio also paid out $20.8 million in
benefits (from liability-matched bonds) and ended with
a portfolio value of $44.7 million, a liabilities value of
$34.6 million and a surplus of $10.1 million or 29 percent. Quite a difference.
Looking forward, our Benchmark Beater is hoping the
equity market will recover enough to provide the additional growth needed to make up the deficit, so that he
can one day finance the liabilities. The percentage of liabilities at risk remains at 100 percent. Meanwhile, the

Winter 2010/2011

Steward takes some of his surplus (invested in equities)

to purchase additional bonds for the current years 21
30 (the original years 31-40.) In this risk-based rebalancing the manager changes the allocation between the
beta and alpha portfolios to 75% bonds and 25%
equity, effectively de-risking even more of the liabilities. This lowers the percentage of liabilities at risk to
less than 3 percent. We see that the Stewards portfolio
moved from a funding ratio of 1.5x to 1.29x thereby
maintaining a smaller surplus throughout a down market, while the funding ratio for the Benchmark Beater
portfolio went from 1.5x to .88x in effect going from
surplus to deficit. This deficit is now a senior liability
of the corporation, and the financial health of the company is now diminished.
What began as an investment problem has now become
a corporate finance problem, leaving the pension beneficiaries, the firms clients, and its stockholders at
greater risk. This leads to the question of whether the
performance measurement function should be focused
on returns or money; whether it should be focused on
benchmarks or client goals. We believe that the right answer is the former rather than the latter. If we were to
look at this clients investment performance from a total
return perspective, it would not tell the right story. The
immunized strategy of the Steward gave us a return
of 3.13% while the Benchmark Beaters portfolio provided a 10-year return of 2.26 percent. Does 87 bps

-25-

The Journal of Performance Measurement

really give you the full picture here of the story of surplus (29%) versus a deficit (12%)? The story of a $14
million difference in portfolio values? The story of gaining 3% net of payments versus losing 30 percent? What
about the story of risks? Would it guide you as to where
you would want your money invested?
Charities and Public Foundations
As performance professionals, we have to know the right
questions to ask in order to give the client the information relevant to them. In almost every meeting, conference, or forum we have attended, someone has brought
up the issue of educating the client or something to the
fact that I put all these reports together and have to explain them each time to the client. In the argument for
time-weighted return vs. money-weighted returns it is
often claimed that it doesnt matter as it is too complicated to explain the difference to the client. Why is
this the case? Are we reporting the right information
based on the clients requirements? We know in the case
of endowments and charitable organizations that their
goals (liabilities/objectives) are to fund their operational
expenses or to spend 5% a year giving back to the communities in which they serve, while making enough to
keep up with inflation. The goal for these organizations
is not to beat a benchmark; it is to sustain their existence
(maintaining principal adjusted for inflation) and provide
a service in both good times and bad. In short, these organizations exist to spend money, and their performance metric should not be a return comparison to a
benchmark or peer group. Instead, it should be the assurance to their constituents that they continue to support
their mission, especially in down markets and poor
economies when the need is greatest. In Steve Campisis
presentation at PMAR VII on Goal Centered Performance Analysis, he commented:
What is wrong with the traditional approach is that it
has nothing to do with measuring our ability to meet the
clients goals of spending adequacy and principal
preservation. And, they are not considering the clients
view of risk, which is a shortfall of spending and losing
principal value. That is what risk means to your client
in real terms. Standard performance techniques are
measuring the wrong things. They are doing it with great
precision, I will give them that, but I think that answering
the wrong questions precisely is not accuracy; it is precise, but precisely wrong. In the end, people dont want

The Journal of Performance Measurement

to hear about basis points; they want to hear about

whether they have enough money to meet their financial
goals. We need to change our reports to reflect the realworld goals of our clients.
Let us take a step back and think, why are we measuring
performance? Is it to report returns or to evaluate the
success of the client? How are the clients goals expressed? The answer: money terms. Their prior success
was the ability to get spending out the door. Their future
success is based on how much money they have for future spending. Using a money-oriented approach, let us
look at a case study of a community foundation whose
mission is to spend 5% on grant making while preserving its real portfolio value for future generations. In Figures 3 and 4, we examine their results for the years 1992
2009 based on $1 million of portfolio value. (We note
that the foundations initial spending rate was 5.5%
from 1992 2003, with spending adjusted to 5% from
2003 2009.)
From this example you will see that this portfolio was
able to provide the greatest grant-making benefit even
during the lean years of declining market values (the
vertical lines in Figures 3 and 4, 2000 2002, and 2008)
and in spite of these market fluctuations they stayed
ahead of their goal of preserving real principal value.
This shows us that investing for clients is really about
surplus management rather than beating benchmarks.
The goal is to earn more than we spend, and to reinvest
this excess money in the years of strong market returns.
This builds a safety cushion or rainy day fund of
surplus value that is spent during the years of market
declines. Clearly, the portfolio will see negative returns
during weak markets, but this money-based approach
helps us to understand the difference between spending
a surplus that preserves minimum required capital as
opposed to spending from an underwater portfolio.
An approach based simply on returns cannot answer
these critical questions. So, the relevant question is not
so much about long-term time weighted returns, but
rather it is about whether the portfolio is at a surplus or
not. The devastating market declines of 2000 - 2002
and 2008 were not devastating events for portfolios that
had wisely built a surplus and were aware of the amount
of capital they needed to support their money goals. It
is this stewardship message expressed graphically in
Figures 3 and 4 that tells a success story, not of a brilliant fund manager but of an organization that was able

-26-

Winter 2010/2011

Figure 3: Spending for Grant Making vs. Planned (Target) Spending

Portfolio Spending vs. Target

1992 - 2009

At the time of greatest need, we are able to spend the most.

Figure 4: Portfolio Value Net of Spending vs.
Initial Portfolio Value Adjusted for Inflation
Portfolio Value vs. Benchmark and Target
1992 - 2009

Winter 2010/2011

-27-

The Journal of Performance Measurement

to provide adequate benefits when they were needed.

This is a powerful message of true value that the investment portfolio brings to the client. We believe that this
approach will help you to retain a client and also to attract and sign new clients.
Its important to note that a traditional time-weighted return analysis would have suggested that the portfolio
only met its target, since the return of the portfolio was
only one basis point ahead of the inflation plus spending rate return of the target; the portfolio earned an annualized return of 8.05% vs. the target return of 8.04
percent. However, as these simple money-based charts
suggest, the portfolio not only met but exceeded both
goals: its cumulative spending was 13.7% greater than
the target, and it increased its real portfolio value by 5.4
percent. Clearly, the time-weighted return cannot evaluate the clients success because it ignores the spending
cashflows that represent the clients mission. By using
a money-weighted return we incorporate both client
goals: spending and principal preservation. As expected
from the evidence of the charts, the portfolios internal
rate of return (IRR) of 8.86% exceeded the target IRR
of 8.08 percent. By understanding the clients real world
needs, tailoring a strategy to meet those needs and implementing it with skill and dedication, we present to
our clients our role as faithful stewards and active participants in managing the investment portfolio to meet
their organizations objectives. We become true partners
in helping to meet their financial goals and their mission.

By presenting the returns in money terms, you remove

the confusion and the walls that people put up around
complicated mathematics and procedures. This is especially relevant when looking at the entire portfolio and
not simply at its components.
YOU, ME AND THE PEOPLE WE
LEAVE BEHIND
By now you may have noticed a theme: identify the
clients needs and liabilities, match the liabilities against
an appropriate investment portfolio, and actively manage surpluses to generate alpha. Is this approach appropriate for personal accounts? Yes! This also applies to
managing personal assets, as all clients have financial
goals that may be seen as financial liabilities. Whether
it is little Juniors college tuition in 15 years, an investment property we are saving to purchase, or our retirement - we figure out how much money we need and
when we need it, and then we develop an investment
portfolio to help us to meet these goals. All along the
way we measure performance relative to the goals we
set at the beginning - not by comparing our returns
against an asset benchmark. The problem with how we
report performance to individual investors today is that
the information is presented before fees, taxes, and inflation have taken their toll, and so our clients dont receive a true picture of how their wealth has changed.
Using long-term historical returns from 1928 2003 we
analyzed the impact of inflation and taxes on the returns

Figure 5: Efficient Frontier of Investments Before and After Inflation

Effect of Inflation on Investment Returns

Return

Before Inflation

After Inflation

Risk

The Journal of Performance Measurement

-28-

Winter 2010/2011

Figure 6: Efficient Frontier of Investments Before and After Tax

Effect of Taxes on Investment Returns

Return

Before Taxes

After Taxes

Risk

Figure 7: Efficient Frontier of Investments Before and

After Inflation and Taxes
Effect of Taxes and Inflation on Investment Returns
What you are told you made.

Before Taxes and Inflation

Return

What you really made.

After Taxes and Inflation

Risk

available to investors and found that these impacts were

so significant that they are impossible to ignore. The
nominal, pre-tax returns available to investors were between 3.75% and 10.42% (Figure 6), depending on investment strategy (from all cash to all equity). After
inflation, the real returns declined to between 0.7% and
7.4 percent (Figure 5).
This affects both taxable and tax-exempt clients. The effect of taxes was also significant, lowering returns to between 2.12% and 8.05 percent. The combined effect of
both inflation and taxes lowered returns to between 0.89% and 4.87 percent (Figure 7). It is important to
note that while returns declined dramatically, the risk of

Winter 2010/2011

these strategies was unaffected, so that clients were still

taking the same risk but were not being paid what they
may have expected. While these effects are dramatic,
they are probably understated, as they do not consider
the additional declines in return due to investment fees
and taxes from the realized gains from active trading.
Given the significance of what we have observed on the
impact of taxes, inflation, and fees on investment returns, there can be no question that we must include
these effects in developing investment strategies and in
reporting performance to our clients.
When we look at a fully taxable multi-asset class portfolio that has an expected long-term return of 8% and

-29-

The Journal of Performance Measurement

then subtract the expected effects of inflation (3%), fees

(2-3%), and taxes (2%), we see that the client is taking
all the risk and may be getting no true increase in wealth.
Are we doing our clients an injustice by providing them
with misleading or missing information? It appears that
we are. As stewards, we are called to present performance returns that consider the impact of inflation, fees,
and taxes (where applicable) so that the stated returns
will reconcile to the changes in money values that represent our clients financial goals. As fiduciaries, we are
obligated to report under the ethical guidelines of fair
representation and full disclosure that are the fundamental principles that uphold both the CFA/CIPM Code
of Ethics and the GIPS performance standards.
Shouldnt we report this information?

success must be stated relative to those financial goals.

The client has financial goals; that is their obligation.
The client invests to satisfy those financial obligations.
Effective performance, from the clients perspective,
must be relative to their financial goals, not simply to a
benchmark. Benchmarks are not their goal.
Zig Ziglar said, You can get all that you want out of
life by helping others get what they want. That maxim
holds true for sales, and it holds true for most aspects
of life, including investing. Take care of your clients and
they will take care of you.
ENDNOTES
1

Taken from Stephen Campisis 2010 presentation at The

Spaulding Groups Performance Measurement, Attribution
and Risk (PMAR) Conference.

SUMMARY
As performance professionals, our presence in the financial organization has increased considerably over the
past two decades. The performance and investment function go hand-in-hand when telling a story to a client.
That story must show our clients how their investment
portfolio performed (did they or didnt they meet their
goals/liabilities/minimum funding requirements), where
they came from, and where they are headed. We cannot
continue to present misleading or confusing information
to clients. We must manage to their goals. As an industry,
we are marred by a damaging public relations black eye.
As an industry, as a community, as a country, and as a
global village, we owe it to ourselves to change the way
we manage money (invest to meet client goals), the way
we benchmark results (adapt custom liability indexes
and money based benchmarks), and the way we report
results (use money values and internal rate of return to
complement time-weighted returns). We need to incorporate a stewardship mindset that truly puts our client
first.

Taken from Ron Ryans 2010 presentation at The

Spaulding Groups Performance Measurement, Attribution
and Risk (PMAR) Conference.

What does that mean? What could we do better?

Changes to consider include IRR returns and timeweighted returns equally displayed to the client, total
portfolio attribution, and showing the true return that
nets out taxes, fees, and inflation to provide a more clear
and concise picture of the total portfolio. Not only is it
the right thing to do, it will provide us with an opportunity to prove our value to our clients, to our firms, and
to ourselves. We all serve the client in meeting their ultimate financial goals and performance as a yardstick of

The Journal of Performance Measurement

-30-

Winter 2010/2011