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I was recently talking with one of my students and he mentioned to me that he didn’t know how to measure his Fund’s Performance.
Return on Investment?
Average Annualized Return?
Compounding Annual Growth Rate?
Which one is best? Or none at all?
I said,
“Let’s start by figuring out how misleading some of these numbers can be and then go from there.”
Proper Historical Valuation
YEAR012345
RETURN–22%7%-28%15%17%
Let’s say the above table is your historical period of returns, which is pretty volatile.
What is the best way to measure this?
A financial advisor might come to you and say,
” Your Average Annualized Return for last year was 17%. The last 2 years it was 16%. 3 years was 1.3%. The last 4 years was 2.75%. And the last 5 years was 6.6%”
Now, as a fund manager which two years would you want to tell your investors?
Definitely the last year or two right?
But is that okay?
NO
This is why I like to call it the LIE OF AVERAGES because it is very easy to misconstrue what has actually happened.
AAR is out.
If you want to be successful in your fund you should never hide or give deceiving information
Using a CAGR with those same numbers gives about a 5.2% return…
However, CAGR is used more for a forward looking metric to assume returns, not necessarily for funds.
Return on investment is simply our (Current-Cost)/Cost. Which is 26%, but this does not account for Time Value of Money.
26% in 6 months vs. 26% in 5 years is WAY different to investors!
Not One, But Two
We will want to use IRR in our funds because IRR is good for understanding Time Value of Money…
But based on our returns it gives us only 4.8% Internal Rate of Return.
Did we make 4.8% over 5 years?
No, we made 26%.
This is still important to us, but in order to give the full picture we combine the IRR with our Cash-On-Cash return.
Cash on cash is a multiple based on money in, money out.
We put in $100, we get $126 out.
Thats a 26% percent return and coupled with the IRR this helps our investors understand what is happening with their money.
We also use Cash-on-Cash vs. ROI because it will help us understand dividends or property cashflows in our fund.
Conclusion
Make sure that you are transparent with your investors. Don’t finagle your way around and be misleading.
Not only is this wrong, but it is ILLEGAL.
If you had a bad month that’s okay! I have to tell my investors that we had a bad month or bad quarter often.
You also let them know that you will learn from your mistakes and that you take their money seriously so you will not let it happen again.
I go much deeper into this in my course and help you understand ways to not let these things happen in the first place.
What are some ways you hold yourself accountable to your investors?
Comment below!
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