Every year, the Brown Brothers Harriman (BBH) investment team speaks with hundreds of investment managers, ranging from take-public activists who focus on Israeli military startups to hyperconcentrated mega-cap investors who own just three companies. Given the immense diversity of background, philosophy and personality across this spectrum, it is tempting to think we have heard it all. However, one recent manager meeting concluded with something we do not often encounter: a bet.
The manager in question – a grizzled, successful emerging markets veteran – pointed to his two-pronged track record, which exhibited both time-weighted and capital-weighted returns. Notably, his fund’s average capital-weighted return since inception had beaten its time-weighted return by 1 or 2 basis points. Few other managers could claim that kind of parity, he said. In fact, he doubted whether more than one in five would even disclose such numbers, if they kept them at all. If we could prove him wrong, he promised, he would buy us dinner at a New York restaurant of our choice.
Why All the Fuss About a Simple Return Calculation?
Capital-weighted returns – also called money-weighted, dollar-weighted or investor returns – are significant for the added insight they offer into a manager’s performance, but also for the broader discussion about capacity and investor behavior they tend to provoke. Put simply, capital-weighted returns are a form of internal rate of return (IRR): They measure the dollar return generated on each dollar invested in a portfolio.
By contrast, the majority of investment managers prefer to quote their total time-weighted return, which reflects the average compound rate of return of the portfolio as a whole – that is, the position-weighted appreciation of a portfolio’s underlying holdings – regardless of when or how much capital has been invested or redeemed over the life of the portfolio.
This distinction is best portrayed using an example. Imagine an individual investor who invests $100 in a fund at time (t) zero. The fund returns 20% in its first year, increasing the value of the investor’s original investment to $120 at t=1. Encouraged by these early results, the investor allocates another $500 to the fund. In year two, however, the fund loses 10%, bringing the dollar value of the investor’s total cumulative investment to $558 at t=2.1 The investor then liquidates her investment.
In this case, the fund’s time-weighted return is 3.9%,2 since the portfolio’s value appreciated 20% in period one before declining 10% in period two. But notice the timing of the fund’s returns: The investor had only $100 invested during the fund’s “up year,” but $620 invested (the original $100, grown 20%, plus the capital infusion of $500) during the fund’s “down year.” As a result, the capital- and time-weighted returns are different. When calculating the investor’s IRR based on the $100 outflow at t=0, $500 outflow at t=1 and $558 inflow at t=2, her capital-weighted return is -6.1%, a far worse outcome. Put another way, capital-weighted returns reflect the returns an investor (or, if aggregated and averaged, all investors) earns from a given fund, whereas time-weighted returns depict performance from the perspective of the fund itself.3
Why Does This Distinction Matter?
The distinction between time- and capital-weighted returns can be viewed through two separate lenses, each of which suggests an important lesson about investing.
The first is one of capacity. Consider the typical trajectory of a successful investment management firm: In the first few years following inception, prior to generating a long track record, a portfolio manager is only responsible for investing a limited amount of assets. As a result, she is able to concentrate the portfolio on her best ideas, deeply researching each and generating solid returns.
Over time, however, this impressive performance will likely attract more capital – and at a certain point, the portfolio manager can no longer deploy that additional capital to her existing, well-researched, high-upside investment ideas. However, eager to absorb more assets (and the fees she will earn on them) from new investors, the portfolio manager might choose to add additional positions to her book, and her 10 best ideas will become 15; 15 will become 20; 20 will become 30 – and so on.
If one’s intuition suggests this steady overdiversification (or a foray into larger, more efficiently traded companies) will actually decrease performance as the portfolio begins to include progressively worse, less rigorously researched ideas, that intuition is correct. Numerous academic studies indicate that investment firms suffer from material diseconomies of scale.4 In his 1995 shareholder letter, Warren Buffett himself admitted:
The giant disadvantage we face is size: In the early years, we needed only good ideas, but now we need good big ideas. Unfortunately, the difficulty of finding these grows in direct proportion to our financial success, a problem that increasingly erodes our strengths.5
Later, in 2005, Buffett was even more direct about the limitations of managing large sums of capital, reportedly telling a group of students from the University of Kansas:
The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.6
In other words, as the well-known adage goes, size is the enemy of performance. Put in the context of our earlier example, it is possible the manager portrayed had enough good ideas to put the investor’s original $100 investment to work, but the additional $500 invested at t=1 “forced” the fund to expand into new, lower-quality names that dragged on performance.
Successful managers therefore face an essential decision: cap asset growth, stay concentrated, prioritize investment returns and serve all investors equally well over the long term – or gather assets and get rich from management fees at the expense of performance and newer partners. In our experience, the predictably lucrative benefits of “Option B” are too much for many to resist.
Unsurprisingly, a 2009 study published by researchers at Emory University’s Goizueta Business School and the University of Michigan’s Ross School of Business analyzed returns from 11,000 hedge funds from 1980 to 2008 and found that annualized dollar-weighted returns typically lagged their time-weighted counterparts by between 3% and 7%.7 This is especially important to remember when gauging the eye-popping since-inception returns displayed by many famous hedge funds, which have ballooned in size and quietly altered the composition of their portfolios to accommodate new assets – not to mention the host of potential behavioral pitfalls that often follow investment success. While the fund managers will have benefited from exceptional results over the lifespan of the fund, their limited partners’ returns may look very different.
The other useful way to view time- and capital-weighted returns is through the lens of conviction and timing.
In general, BBH believes that attempting to time the market is a fool’s errand – a philosophy that applies equally to security selection and manager selection. When first underwriting a talented new manager, our investment team does not attempt to wait out a high-priced market (such as the one currently underway) before making an initial allocation. While short-term returns may suffer as a result, we aim to partner with managers for multiple decades and expect strong absolute performance from them over a full market cycle, regardless of starting point.
That said, in the same way we would seek to add to positions in high-quality businesses during periods of irrational price depression, we should also possess the conviction to allocate additional capital to our investment partners when their portfolios have sold off. Doing so allows us to capture higher capital-weighted returns as more of our dollars are invested at low prices.
By the same token, managers with savvy, high-conviction investors who allocate rather than redeem during down markets will exhibit high average capital-weighted returns. This outcome can vary even among capacity-conscious funds that have been closed to new investors for years: Those confident enough in their theses to reopen and pursue additional capital during temporary sell-offs will, provided they are correct, generate higher capital-weighted returns than peer managers who remained closed through market weakness, even with identical portfolios and identical time-weighted returns.
Put in the context of the earlier example, imagine that the fund’s 10% loss between t=1 and t=2 was simply due to short-term market volatility and that the investor, still confident in her manager, decided not to redeem her capital at the end of year two. Also imagine the fund rebounds and appreciates 30% in the subsequent year. If the investor chose to keep her $558 in the fund at t=2, by t=3 she would have roughly $725,8 a time-weighted return of 12%9 and a capital-weighted return of 9%.
If, on the other hand, the investor chose to allocate an additional $500 at t=2, bringing her total value invested in the fund to $1,058, by t=3 she would have $1,37510 – still a time-weighted return of 12%, but a better capital-weighted return of 14%.
Clearly, long-term capital-weighted returns provide a useful additional data point, allowing prospective investors to compare the since-inception track record of a prospective manager with the actual investment outcomes experienced by clients and partners over time. A combination of strong time-weighted returns and low average capital-weighted returns suggests that a manager’s performance has suffered as assets have grown, or as investors have cut and run after downturns and failed to participate in any subsequent upside.
A manager with higher capital-weighted returns, meanwhile – like the one who made us the dinner bet – has delivered client returns that better align with overall fund performance. While the driver of this parity varies by manager, the most common causes include thoughtful capacity constraints, the rare ability to invest skillfully at scale11 and a roster of sophisticated partners who have added rather than withdrawn capital during temporary downturns, often at the fund manager’s direction.
What Is BBH’s View?
Identifying managers who are willing to sacrifice the “easy money” of asset gathering in order to outperform and deliver client returns that match their own results is a key tenet of our investment process. This criterion is part and parcel of our preference for highly concentrated, high-conviction managers who mitigate risk and outperform not through overdiversification, but by making a handful of excellent, extensively researched investments.
This approach to investing and the edge it provides is simply not possible at large asset sizes. While we prefer to receive more rather than less capacity when we find a truly exceptional manager, we fully expect our partners to close their funds well before asset growth necessitates a deterioration in strategy, behavior or investment outcomes. In fact, we make a point of determining our managers’ maximum capacity goals during underwriting and assess any post-investment deviations with great scrutiny.
To meet the challenge of our bookmaker, we looked inward to assess the capital-weighted returns of BBH’s internal and external portfolio managers. In general, we discovered positive results, with capital-weighted returns exceeding time-weighted returns – but felt that in many cases this comparison was a bit unfair, no matter how favorable to BBH. Because we invest in several emerging managers and have been an early anchor investor in seven of our nine external long-only strategies, our multihundred-million-dollar investments heavily skew our managers’ dollar-weighted returns toward the recent past – a timeframe in which the S&P 500 has almost quadrupled since its financial crisis trough. While we fully expect our managers to continue this trend over a full market cycle, citing their current capital-to-time-weighted delta therefore seemed slightly disingenuous.
In the spirit of competition, however, we identified and compared the track records of two long-only equity managers – one we previously considered as a partner and another that successfully became (and remains) a material portion of client portfolios.
Manager A is an international equity investor we researched and monitored for several years. Unfortunately, during our due diligence process, we observed the same common problems described earlier: Assets fluctuated as short-term partners entered and left the fund in parallel with performance, the portfolio suffered from overdiversification (it “de-worsified”), and we concluded that the analyst team did not know what it owned as thoroughly as we expect from our managers. In the end, we passed.
Unsurprisingly, Manager A’s 10-year time-weighted annual return as of April 30, 2018, was 3.43%, with a capital-weighted return of just 1.29% – a difference of -2.14%, consistent with the underperformance predicted of mutual funds in the 2009 study referenced earlier.
Manager B, meanwhile, is a largely domestic equity investor that has also grown assets over time – but has done so thoughtfully, with little change to portfolio diversification, and closed to new investors five years ago. As a result, the manager’s 10-year time-weighted return over the same period is 8.68%, compared with a capital-weighted return of 9.79% – a +1.11% differential.
While we should not compare these managers in terms of absolute returns – after all, they operate in different markets – the gap between their fund performance over time and the returns delivered to their actual investors is meaningful and clear. Naturally, the task of finding new high-quality managers as each of our existing strategies gradually close is a challenging one, but we believe the alignment and performance benefits of investing with high-integrity, capacity-conscious partners is well worth the effort.
We’ll take that free dinner now.
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© Brown Brothers Harriman & Co. 2018. All rights reserved. 2018.
1 (120+500)*(.90) = 558
2 [(1.2*.9)^(1/2)]-1 = .039
3 Or, technically, from the perspective of a passive from-inception investor who has never added to or withdrawn any portion of his capital.
4 Teo, Melvyn. “Diseconomies of Scale in the Hedge Fund Industry.” Hedge Fund Insights. December 2012.; Yin, Chengdong. “The Optimal Size of Hedge Funds: Conflict Between Investors and Fund Managers.” The Journal of Finance 71, no. 4 (2016).; Shawky, Hany A., and Ying Wang. “Can Liquidity Risk Explain Diseconomies of Scale in Hedge Funds.” Quarterly Journal of Finance 07, no. 2 (2017).
5 Berkshire Hathaway 1995 Annual Letter.
6 The Motley Fool. Buffett/Jayhawk Q&A. 2005.
7 The study also observed capital-weighted underperformance of 1.5% for mutual funds and, interestingly, even broad stock indices. Source: Dichev, Ilia D., and Gwen Yu. “Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn.” SSRN Electronic Journal, 2009.
8 (558)*(1.30) = 725.40
9 [(1.2*0.9*1.3)^(1/3)-1] = .12
10 (1,058)*(1.30) = 1,375.40
11 Buffett is an example of this, though even Berkshire Hathaway’s returns pale in comparison to his early track record. Source: Berkshire Hathaway 2014 Annual Letter; Buffett Partnership Ltd. 1968 Annual Letter.