Alternative Assets & Performance
The use of alternative assets in client investments has grown substantially in the past decade. The uniqueness of these assets presents several challenges to firms trying to measure and report performance to their clients. In recent discussions regarding alternatives, our conversation inevitably leads to pricing issues and time vs. money weighted performance.
To Backdate or Not to Backdate Pricing, That is the Question!
Most of our clients have chosen to align the delayed pricing of alternative assets with accounting statements. This means that if the year-end price for a private equity position is not distributed until 90 days until after year-end, December, January, and February positions would then reflect the “old” price on monthly statements AND performance reporting. The benefit of this approach is that performance reporting matches accounting statements and provides consistency, in addition, it minimizes the recalculation of historical performance and manual processes to reprice history. The downside is that the performance doesn’t reflect the (delayed) price updates, which creates a lag in performance. Additionally, the portfolio performance may not align well to market benchmarks, which generally restate their performance as prices are updated.
A growing minority of our clients have chosen to update the First Rate system back to the date the price is effective and recalculate performance. This process can be executed by an analyst with administrator privileges or through automation of the nightly data load and processing. The benefit is that the performance reflects the actual pricing (while delayed in posting) and also aligns with various market benchmarks, which have delayed price updates (HFRI and others). The downside is that accounting statements no longer match the performance reporting and can lead to confusion when comparing reports. In addition, any time historical performance is recalculated, there is a risk of introducing a change that is not anticipated.
Money-Weighted or Time-Weighted?
Most of our clients choose a calculation methodology per portfolio (either time-weighted or money-weighted) that is consistent for the entire portfolio. While GIPS governs the calculation, presentation, and processes involved in reporting performance to prospects, it is generally up to the manager to determine how to report performance to existing customers. Investment managers tend to prefer time-weighted calculations to minimize the impact of contribution/distributions on performance. Time-weighted calculations are generally preferred if most of the investments’ contribution/distribution timing decisions are made by the client. In doing this, the performance of the manager shouldn’t be positively or negatively impacted based on when the client decided to contribute or call for a distribution from the portfolio. However, in the case of many alternative investments, the investment managers (or the third party alternative managers) determine the timing of capital calls, and therefore a money-weighted calculation is preferred. The benefit of this approach is that a single weighting methodology is used, reducing confusion and complexity. The downside is that the performance of alternative assets is shown using a methodology that doesn’t reflect the managers’ control over cash flow timing. For more on this topic, check out this blog and debate via the comments in The Spaulding Group Blog.
A growing minority of our customers are choosing to show both the time-weighted and money-weighted performance of a portfolio with a mix of traditional public securities and alternative investments. As a result of this demand, First Rate is introducing the option of showing the performance of underlying assets classes and sectors (i.e. Equity, Fixed Income, Alternatives, Cash, etc.) as either time-weighted or money-weighted. The benefit of this approach is using the best practice calculation with the underlying assets involved. The downside is that when multiple weighting approaches are used, performance results may be difficult for wealth managers and clients to understand. In addition, attribution or contribution analysis will become difficult in a portfolio utilizing multiple methodologies.
My recommendation is to carefully consider the implications of both choices and make a decision that best aligns with your firm’s capabilities and client communication standards. In the years ahead, I expect the pricing issue will continue to be split between backdating pricing and freezing historical changes. First Rate is working to make the automated “back loading” of these delayed prices easier, but due to the various ways data is sent to our system, it will be difficult to fully automate this process. However, I believe more firms will also restate performance as this process improves. My prediction is that the blended reporting of time-weighted and money-weighted performance will continue to increase.