Flaw in time-weighting return

Many pension funds are still trying to recover from the devastation they've suffered as a result of the market downturn (“CalPERS goes with new risk-based allocation,” Pensions & Investments, Dec. 27). And many are seeing that using market indexes are the inappropriate metric to perform against, substituting absolute and/or liability-related benchmarks. But how many also see that the return they're using is inappropriate?

Most pension funds, I would guess, only use time-weighting to measure performance. And why? Probably for a few reasons: because that's the way they've always done it; because that's what the GIPS, or Global Investment Performance Standards, require; because that's the measure their consultants use and recommend.

They fail to recall that time-weighting was developed in the 1960s as a way to measure the performance of their managers, not their performance. The Bank Administration Institute, on the heels of Peter Dietz's landmark thesis, put forward the first standard on performance measurement in 1968. This was followed in 1971 by the Investment Council Association of America's standard. Both promulgated time-weighted measures, which eliminate, or reduce, the impact of cash flows. And why would they do this? Because managers don't control the flows, their clients do.

So great, if you want to know how your managers are doing, use time-weighting. But when it comes to wanting to know how the fund itself is doing, why on earth are you going to eliminate the very cash flows which you control? To utilize time-weighting makes absolutely no sense. Money-weighting is the measure to be using. Yes, this means you'll be calculating returns two ways, but that's because you're asking two different questions: How is our manager doing? And how are we doing?

We have had increasing success at convincing firms of their error and are hopeful that more will see the light, have an epiphany, or simply recognize what has been known for nearly 50 years. If a pension fund stops using the wrong benchmark, they're only half the way to properly assessing their performance; they also need to measure it properly.

David Spaulding

President, The Spaulding Group Inc.

Somerset, N.J.