You may recall that the only major controversy regarding the AIMR Performance Presentation Standards (AIMR-PPS(R)) was the use of asset-weighted returns, rather than equal-weighted. Two groups in particular, the Investment Management Consultant’s Association (IMCA) and the Investment Counsel Association of America (ICAA) (now the Investment Adviser Association), opposed asset-weighting, partly because they felt that larger accounts would have greater influence on the return, which could cause “special handling” of these accounts. The reason for the asset-weighted approach was to have the composite look like an account. Not surprisingly the GIPS(R) standards adopted asset-weighting, too. Until today I hadn’t given this much thought.
However, I recently did a GIPS (Global Investment Performance Standards) verification for a client who has a couple composites which are dominated by very large mutual funds. For example, one has a fund of roughly $250 million and individual accounts of around $500,000; suffice it to say, the composite return usually approximates or equals the fund return, even though the individual accounts may differ by several basis points (e.g., -2.38 vs. -2.11, the composite matches the fund (-2.38); 8.46 vs. 6.56; the composite matches the fund (6.56)). Granted, this is a very extreme example, but it does cause me to wonder if the asset-weighted approach truly is better.
What is the composite return supposed to represent? Clearly some sort of average, right? And so we have asset-weighting, but does this always make sense? While I understand the idea of the composite looking like a portfolio, in reality no one is managing the composite; the accounts are being managed. Something to ponder, perhaps?