The measurement and reporting of investment returns is an important facet of receiving financial advice, yet it is one of the most misunderstood concepts in finance. Most people think about returns in simple terms, that their capital should be worth more at the beginning of the period than at the end. This is obviously important, but it does not accurately measure how your portfolio is performing because it excludes such important factors as pension payments, franking credit refunds, taxation and both additions and withdrawals from your portfolio.
In order to more accurately reflect the performance of portfolios Wattle Partners, and in fact all major super funds, report performance as an ‘internal rate of return’ more commonly known as an IRR. An IRR differs from the simple approach to measuring returns in that it measures only the performance of the investments you hold. What this means is that the contribution of funds to your portfolio is not seen as a positive return as it would be in a ‘simple’ calculation, whilst withdrawals from your portfolio do not negatively impact on performance. As most readers will appreciate, if you draw 5% of your capital from your portfolio in a year in which your capital has grown by 7%, your simple return would be reduced to just 2% when looking at the balances alone.
The IRR is a more accurate and comparable approach to measuring returns over the long-term. For those with engineering or investment experience, the IRR reflects the discount rate that makes the initial value of your portfolio equal to the final value, including the impact and timing of any income that is received. That means it is time and money weighted. Your withdrawals will not directly impact on returns, only the performance of the investments sold to fund them.
The IRR is used throughout the investment world, including for the calculation of benchmark returns, like industry super fund and other benchmarks. This is due to the fact that it removes the impact of all non-investment related matters from performance. As a global industry standard, it is the primary measure available to us to report performance and is calculating automatically via our XPLAN system.
There are a number of reasons that an IRR is more accurate and useful for investors, but particularly those who are drawing an income from their portfolios.
Franking Credits – One of the biggest reasons is due to Australia’s imputation system. If your portfolio holds ASX shares each dividend will be received with franking credits attached, yet you do not actually receive these in cash at the time of payment. For those in a zero-tax environment, you only receive these franking credit refunds when you lodge your tax return, which can be as late as the following financial year. Therefore, relying on the simple rate of return of reviewing the start and end balance of your portfolio excludes the impact and value of these franking credits which can be 2-3% on an annual basis.
Taxation – Similarly to the treatment of franking credits, the simple rate of return gives no consideration to taxation rates or benefits. The alternative to the franking credit exclusion, is the tax reduction that these and other deductions provide to you. For instance, if franking credits from your personal share portfolio are used to reduce your tax, you are receiving substantially more benefit than a simple rate of return is able to measure. The use of an IRR includes the impact of franking credits when they are received, ensuring their value is not excluded from your performance.
Spending – One often overlooked matter when it comes to measuring performance is the inclusion and exclusion of personal bank accounts. If your personal bank account is included at one time and excluded at another, the result would be a substantially lower simple rate of return. By using an IRR, the inclusion or exclusion of these accounts has substantially less impact on your return.
One final important fact to consider is the different manner in which index, industry fund and benchmark returns are measured. Each of the major benchmarks and industry super funds report accumulation returns, assuming every dollar of return generated by your portfolio is reinvested immediately upon receipt. This means the returns benefit from daily compounding. This makes direct comparison with accumulation indices more difficult, as they most investors withdraw or spend the income they receive, rather than reinvested it into their portfolio.