Gallery:Step 10|Nest Egg Retirement

Understanding Your IFA Index Portfolio Return

Gallery:Step 10|Nest Egg Retirement

If you are a client of Index Fund Advisors, you may have recently received a quarterly performance report. If you are not a client, here is a sample quarterly performance report of an actual client, with a fake name. The intent of this article is to help you better understand the numbers on that report.

The first thing that you may notice is that we report two separate performance numbers—the time-weighted return and the dollar-weighted return (also known as the internal rate of return). Here is an easy way to understand the difference: The time-weighted return is the return received on the first dollar invested in the portfolio, while the dollar-weighted return can be thought of as the average return received by all dollars invested in the portfolio. If you never have any deposits or withdrawals to your portfolio, then the two returns would be equal. It is the time-weighted return that should be compared to a relevant benchmark. While the dollar-weighted return is a better reflection of the experience that you have received as an investor, it should not be used as a basis for judging the performance of your investment because only you have control over your cash flows. Our advice is that if you have cash to invest, you should invest all of it immediatley, because every price is a fair price and every day has the same expected return.

One number that you may have noticed is not included in the report is your total number of dollars gained (or lost) divided by your net cash flows. We have been asked several times why we do not report this overall percentage gain or loss for your portfolio. The answer is quite simple—showing that number could create a distorted view of your investment experience, especially if you have had more than one cash flow. To understand why this is true, please consider the following two hypothetical examples.

Suppose that Joe initially invests $100,000 into his portfolio, and nine years later he invests an additional $900,000. At the end of the tenth year, he cashes out with $1.2 million. His net gain divided by his net flows is 20%, and his annualized dollar-weighted return is 8.41%.

Now let’s look at Sue who is investing in a different portfolio, and her investments are the opposite of Joe’s. She initially invests $900,000, and nine years later she invests an additional $100,000. At the end of the tenth year, she also cashes out with $1.2 million. Like Joe, Sue’s gain divided by her net flows is 20%, but her investment experience was very different from Joe’s. Her annualized dollar-weighted return is only 2.01%. The table below summarizes Joe’s and Sue’s investments.

The obvious conclusion is that showing net gains divided by net flows could be misleading to IFA’s clients (or the clients of any investment firm) because it tells us essentially nothing about the investment experience that the client received.

The returns that we show on the report for the IFA Index Portfolios and the S&P 500 Index merit further explanation. The IFA Index Portfolio returns are net of a 0.90% advisory fee, which is the highest fee charged by IFA. If your fee is lower than 0.9%, then your return will be higher than what it would have been at 0.9% by about the same amount as the difference. Furthermore, the IFA Index Portfolio returns assume that the portfolios begin the year in perfect balance. To the extent that your portfolio allocation differed from the target on January 1st, your return will differ from the return shown for the closest IFA Index Portfolio. Also, even if your portfolio started the year in perfect balance, it could still differ from the IFA Index Portfolio in the middle of the year if you had a deposit or a withdrawal that was used as a rebalance opportunity.

The real world implementations of the portfolios differ from the IFA Index Portfolio models. For taxable accounts, tax-managed funds are used in five specific asset classes that make up 70% of the equity allocation. It is IFA’s expectation that while these funds may have slightly lower returns than the non-tax-managed funds on a pre-tax basis, they should have slightly higher returns on an after-tax basis. All the returns shown on the report are on a pre-tax basis. For tax-deferred and tax-free accounts, IFA utilizes the DFA U.S. Micro Cap Fund in place of the DFA U.S. Small Cap Fund, and IFA utilizes the DFA U.S. Small Cap Value Fund in place of the DFA U.S. Targeted Value Fund. For the New IFA Index portfolios, these two funds comprise 40% of the equity allocation. If you have a combination of taxable, tax-deferred and tax-free accounts, we advise clients to asset allocate a combination of the above funds and spread out the funds among the various accounts. If you are in one of the non-standard IFA Index Portfolios, such as the Original, Socially Responsible, Sustainable, Core, or Global IFA Index Portfolios, your return will differ from the returns shown for the IFA Index Portfolios. Consequently, there are many implementation variations from the IFA Index Portfolio returns shown on the performance reports, on the IFA Index Calculator and on the Index Portfolio pages

For the data series used as benchmarks in the performance reports for clients who are in the New IFA Index Portfolios, the monthly returns of the Original IFA Index Portfolios (with the same equity percentage allocations) are used through 8/31/2013, and the monthly returns for the New IFA Index Portfolios are used after 8/31/2013. For example, the data for Benchmark IFA Index Portfolio 60 uses the Original Index Portfolio 50 data through 8/31/2013 and the New IFA Index Portfolio 60 data thereafter. Since all the full equity original IFA Index Portfolios from 90 to 99 have been replaced with the Original Index Portfolio 100, the returns used for Benchmark IFA Index Portfolio 100 start with Original Index Portfolio 90 through 8/31/2013. Thus, the benchmark return shown for Index Portfolio 100 will differ from the return seen in IFA's Index Calculator

The returns shown on the performance report for the IFA Index Portfolios when the starting date occurs in the middle of a month are estimated as follows. The return for a partial month is calculated as the return for the whole month multiplied by the number of days covered in the month divided by the total number of days in the month. While this may differ substantially from the actual return over that partial month period, the impact of this difference will become less important over time.

We know this is confusing, but we hope that this explanation has been helpful to you. Just imagine how hard it is to properly track and benchmark an active managers portfolio.  If you have any further questions about the returns shown on your performance report, please contact your IFA Wealth Advisor.