TIME VS. MONEY

Morningstar, that online bastion of financial research, has committed to start publishing dollar-weighted returns on its site by the end of the year. They will also include a ratio that represents the percentage of the total return captured by the dollar-weighted number. The announcement is causing a bit of a stir, but what does that mean exactly? And how, if at all, will it affect investors?

In the past, published returns have been time-weighted, meaning they are calculated by comparing the price say, when the fund began, to the present-day price (a point-to-point measurement, if you will). This method is faulty, however, in that it assumes investors bought in on the first day and are still holding the investment now. As anyone familiar with investing, especially active management, can tell you, that’s not typically the case.

Dollar-weighted returns, on the other hand, figure return by taking into consideration the performance over the life of the investment, but by also factoring in the cash flow in and out of a fund. Returns achieved when more money was in the fund carry more weight than returns achieved when fewer investor dollars were present. Losses are treated the same way, weighted more heavily if more money is present.

Not surprisingly, dollar-weighted returns tend to be lower than time-weighted returns, but “come closer to capturing the cumulative investor experience,” says Morningstar Managing Director Don Phillips. The differences are most evident in funds that use hedge strategies. As part of its research, Morningstar considered 80 such funds. For the 10-year period ending December 31, 2005, the total annualized return (the time-weighted return) was 3.41%. The dollar-weighted return? 0.48%. That’s a big difference in terms of investor success.

Morningstar also applied its success ratio to several fund families. The highest percentage (109%) went to Dimensional Funds, a company whose dollar-weighted returns are actually higher than its time-weighted returns, clearly indicating its investors are very disciplined and therefore achieve better results than most. Other fund families didn’t fare as well. For example, Dodge & Cox, Fidelity and Vanguard all scored above 85%, but Putnam scored only 67% and Janus, only 25%.

While the dollar-weighted numbers aren’t likely to be the active management antidote the industry needs, they will certainly give investors a clearer picture of a fund’s performance.

 

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