Annual Performance Reporting, CRM2, CRM2 Performance Reporting Workshops, CRM2Plus, CRM2Plus Software

CRM 2 and IRR

On June 14, 2012, the Canadian Securities Administrators (CSA) published for comment a second version of amendments to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) with respect to the second phase of the Client Relationship Model initiative (CRM II). New regulations under CRM 2 affect registrants under both IIROC and the MFDA.

CRM 2 is a new set of financial rules that have been implemented to ensure investors receive standardized information about the cost and performance of their investments.  Since July 15th, 2014, firms have been required to disclose charges and compensation from trades.  By July 15th, 2016, it will be mandatory for advisors to provide investment performance information to clients.  This will entail an annual account performance report, which will include the annualized total percentage return for the client’s account, with text, tables, charts, explanatory notes and a definition of total percentage return.

A key mandate of CRM 2 is that registered dealers must disclose to clients costs and compensation as well as provide meaningful reporting of investment performance.  The money weighted internal rate of return (or net present value internal rate of return) is one of the pieces of data that will be given to clients.  Using the above explanations, it should be clear to a client that a money weighted internal rate of return is simply the annualized rate of return that takes into account cash inflows and outflows.

A client who has been provided a rate of return as well as fees has some information at their disposal, but may lack context.  Was the performance good or bad?  Were the fees too high, or were they fairly low?  Is this an aggressive portfolio facing a temporary slump?  Did an advisor’s advice prevent returns from being taxed away?  Was their portfolio liquid enough to meet unexpected withdrawals?

From Advisor.ca:

WHAT DOES A PORTFOLIO’S PERFORMANCE DEPEND ON?

Over the long term, the performance of a portfolio depends on the following factors:

  1. the performance of the market as a whole;
  2. the skill of the portfolio advisor; and
  3. the actions of the investor

Influence of the Market

Most portfolios do well when the market does well. A common saying is that a rising tide lifts all boats. On the other hand, when the market is experiencing a correction, the advisor would have to be either very skilful or very lucky to generate a positive return for the portfolio.

Influence of the Portfolio Advisor

The composition of an actively managed portfolio is usually different from that of the market portfolio. Portfolio advisors add value by using their analytical skills and knowledge of companies to identify stocks they believe will outperform the market. The additional return, after allowing for risk, is sometimes referred to as alpha, as opposed to beta, which is the return from simply tracking the market. Of course, it is possible for portfolio advisors to make mistakes and choose stocks that end up underperforming. In this case, the alpha is negative.

 

Influence of the Investor

Most investors probably think that, having entrusted their portfolio to an advisor, they are entitled to hold him or her fully responsible for its performance. This is incorrect. The client’s own actions also have a major impact on the portfolio’s performance, for better or worse.

Most of the time, it’s for worse. Investors contribute to their portfolio’s performance through their decisions to add more money to the portfolio or withdraw money from it. Studies have shown that investors’ actions reduce the annual return on their portfolio by approximately 1.5 percentage points. Think of it as a kind of negative alpha attributable to the investor. The negative alpha is truly enormous, especially when compounded over time. It can make the difference between a comfortable and a frugal retirement.

Investors’ alpha is negative because their decisions are often driven by emotion. Suppose they inject new money. This may be at a time when the market is overvalued and good investment opportunities are scarce. The portfolio advisor will then have to decide whether to buy investments for the portfolio at inflated prices or keep the money in cash—a choice between the devil and the deep blue sea.

Alternatively, suppose investors decide to withdraw money from their portfolios. Perhaps they have been spooked by a recent drop in the market. This is actually the worst time to withdraw money. In order to satisfy the client, the portfolio advisor will need to sell some investments at depressed prices.

The sad reality is that investors consistently choose the wrong timing. They tend to inject new money after a run-up in stock prices, when everything has become expensive, and withdraw from the market after a large drop in stock prices, when everything has become a bargain.

PERFORMANCE REPORTS UNDER CRM 2

When developing CRM II, the concern of the securities regulators was to enable investors to figure out how they are progressing towards their investment objectives. Quite rightly in the view of this author, the return that CRM II requires dealers and portfolio advisors to provide to their clients is the money-weighted return.

The money-weighted return is a personal rate of return. It is most unlikely that two investors will have the same personal rate of return even if they happen to use the services of the same portfolio advisor. This is because the money-weighted return takes into account all the factors that affect the return on a portfolio, including the investor’s decisions. It is most unlikely that two investors will add money to or withdraw money from their respective portfolios at precisely the same time.

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