You may recall that I have opined in the past about the problems I’ve discovered with the aggregate method, both several times in this blog, as well as in our newsletter; I also wrote an article on this topic.
Some individuals who have read my materials argue that the aggregate method is, in fact, the superior method. They find that the case, for example, where all the composite’s accounts have identical 4.00% returns, but where the composite has a different return, to be perfectly fine. In fact, that it is the correct return, and that the BMV+weighted cash flow approach to be the one in error (even though it matches the composite’s).
I must confess that I found this all quite perplexing and, to some degree, shocking. However, while corresponding with some folks on this topic I had yet another epiphany. I believe there is something more foundational / fundamental going on here, which requires some thought. There is a point which is very important to consider: What is the composite return supposed to represent? I suggest that you take a moment to reflect on this before continuing to read this post.
If you want to check the definition that is in the GIPS® (Global Investment Performance Standards) glossary, you’ll quickly discover something:
it’s not there! In spite of the vast importance of the composite return, there is no definition for it. Perhaps there was an expectation that “of course everyone knows what it means or represents,” but after some reflection, I don’t believe this is true.
In reality, there are two different answers, depending upon which formula you use to calculate it:
- if you use either the BMV or BMV+WCF approach, the composite return represents the asset-weighted average experience of the accounts that were present in the composite during the given time period. However,
- if you use the aggregate method, the composite return represents the return of the composite, as if it was an account itself.
Therefore, if you believe that the return should treat the composite as a single account, then of course you would believe that the aggregate method is correct; but if, like me, you think it should represent the average experience of REAL accounts, then you would find its result to be a bit confusing at times.
Space doesn’t permit me to go much further on this subject here, but I will comment at greater length later this month in our newsletter, so please stay tuned. I am of the firm believe that this is a fundamental issue with the standards, which has been overlooked by the GIPS Executive Committee, and its predecessor groups. I, too, hadn’t really given it much thought until recently. But when someone firmly says, in response to my criticisms, that “no, the aggregate method is the most accurate method, and the BMV+WCF is actually inferior,” I was forced to pause and reflect.
p.s., As you no doubt realize, the GIPS standards grew from the AIMR-PPS®. If you take a look at the first edition of the earlier standard you will only see one method to derive the composite return, and it is based solely on the beginning market value. The other two were added in the 1997 editions. I suspect that when this was done, no one on the AIMR-PPS Implementation Subcommittee realized that they were at that moment introducing a second definition or meaning for the composite’s return. But they were.