Most performance analysts have heard it said that we should never annualize returns of less than one year. Some may also be aware that GIPS provision I.5.A.4 (2010 edition of GIPS) forbids compliant firms from annualizing returns for periods of less than a year?
But why shouldn’t this be done? Certainly, we could do it mathematically. The formula for annualized return (from the CIPM Expert Level curriculum) is:
where each r(i) is an annual return and N is the number of annual periods. Or, more generically:
where R(ann) is the annualized return, R(cum) is the cumulative return and d is the number of days in the evaluation period.
There are two reasons why we don’t annualize periods of less than a year. The first reason is ethical. The second reason is conceptual.
The ethical reason is that it is not considered best practice to take a return that is for a period of less than a year, and project such a return to an annual time frame. For example, let’s assume a manager has a return of 11% for the month of January. We can certainly use the above formula to extend (i.e., project) the return to an annual timeframe: