Last fall, we offered a Q&A overview of Canada’s Client Relationship Model, Phase 2 (CRM2), when the model was still squishy – molded but not yet gelled. As of June, CRM2’s new regulations aimed at establishing more uniform financial performance reports went into effect. For many investors, the results won’t be apparent until they receive their year-end reports in early 2017, but it’s worth being aware of what to make of the required format when it arrives.
You and Your Performance Reports
When you’re considering how your investments are playing out in real life, it can be hard to know what to make of the numbers. Are negative returns bad? Are positive returns good? Overall, are you “winning” or “losing”? What is a “win,” anyway?
Correct answers call for correct context. As we discussed in “Stop worrying about missing out,” your financial success does NOT depend on how your neighbor (or anyone else) has been doing, nor on what hindsight has to say about recent market trends. Useful performance measures should answer two key questions:
- How near or far are you from your personal financial goals? Adjustments may be warranted if you’re under- or overshooting them, or if the goals themselves have changed. Individual investment progress is typically best measured by your Internal Rate of Return (IRR) – also referred to as Dollar-Weighted or Money-Weighted Rate of Return.
- How have your investments stacked up against their closest benchmarks? Don’t expect perfection here; there are rarely spot-on comparisons to be made. But if a return comparison varies widely when in theory it should not, it’s worth asking why. Relative investment progress is typically best measured by your Time-Weighted Rate of Return (TWR).
CRM2: IRR vs. TWR
As of June, CRM2 calls for your performance reports to include your IRR, which represents a shift from the more typical TWR reporting. Which is “better”? Again, it depends on the context.
Your IRR – factors in the timing of your cash inflows and outflows, which means that your IRR can vary from that same fund’s published rate of return, for better or for worse. Understanding the variation can help you best assess how you’re doing in reaching your personal goals.
Your TWR – is typically the best figure for comparing your portfolio’s returns with the returns of its closest available benchmarks, regardless of your inflows and outflows of cash.
In other words, IRR and TWR can both be meaningful, depending on what you’re measuring. As you review your future performance reports, it’s worth being aware of the differences, and why there’s not much value in comparing your IRR – or personal rate of return – to a standard market benchmark or to other investors’ returns.
Making the Grade: A Helpful Analogy
To offer an analogy, imagine your child comes home with an A– grade point average on her report card. She complains that all of her friends had solid A’s. What should you do?
At first, you might think her “underperformance” warrants a change. But now let’s factor in an important detail: Unlike her friends, your daughter recently shifted into a more challenging program, to improve her chance of being accepted into the college of her choice. In that context, her grades are not only on track with her goals, she’s actually increased her odds of acceptance.
In short, not all comparisons that can be made should be made. When it comes to your IRR, remember that your personal goals are your best “benchmark.”