Evaluating Performance Measurement

Executive Summary

There are generally two ways of calculating investment returns. Mutual funds, pension plans, and investors with total return objectives predominantly use the market value based method. Money market funds, cash portfolios, insurance accounts and investors seeking income stability tend to rely on book value based returns.
Sometimes, an investor may use a type of return methodology inconsistent with the portfolio’s investment goals. Furthermore, complaints about apples-to-oranges return comparisons of different managers often involve a mismatch of the two types of return measurement.
Market value performance measures a portfolio’s estimated liquidation value, and it may not be appropriate for certain “buy-and-hold” portfolios as it tends to introduce market volatility and offers less informational value for income projections.
The book value return method removes unrealized gains and losses by using “adjusted book value” in return calculations. This method is based on the predictive nature of a non-defaulted bond’s price at maturity; i.e. its par value ($100).
Book value return may be a preferred performance measurement method for cash portfolios with a primary objective of capital preservation and with a short-duration portfolio structure. Specifically, returns tend to be less volatile and income estimates tend to be more accurate when the book value method is utilized.
Clear identification of investment goals should be a crucial step in performance measurement selection. Without the alignment of performance methodology with investment objectives, return numbers may be of little value.

Introduction

At first glance, the task of measuring investment returns of corporate cash portfolios seems relatively straightforward, since they most typically invest only in “plain vanilla” securities and have a limited number of transactions. Treasury practitioners, however, often tell a different tale of performance measurement. One frequent complaint involves apples-to-oranges performance comparisons between money managers. Another involves the difficulty of estimating coupon yields. And still others complain about the lack of appropriate benchmarks for buy-and-hold portfolios.
This state of confusion often comes from the fact that there are both apples and oranges in the investment performance world, otherwise known as market value returns and book value returns. While investors often have some understanding of the former since it is the way most stock and bond portfolios are measured, the concept of returns based on adjusted book value is typically known only in such limited circles as money market managers, government pooled investors, and insurance companies. Until one understands the different concepts and their proper applications, meaningful interpretation of performance records can be difficult. This research paper attempts to help investors gain a glimpse of the extremely complex world of performance measurement with a brief overview of the two types of return methodologies and their applications to cash portfolios.
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