The Hidden Risks of Disconnected Returns: Why Allocators Must Prioritize Accurate Data to Drive Better Investment Decisions
For asset owners it’s not uncommon to encounter situations where static reported returns (e.g., reported by a custodian, service provider, or fund manager) do not match the returns calculated from underlying cash flows and valuations. In isolation these disconnected returns are often viewed as innocuous, but when compounded across a portfolio, they can significantly compromise the data integrity of an allocators overall performance reporting and have far-reaching consequences.
But how can these reported returns become so disconnected from the underlying data?
Some of the most prevalent causes include:
1. Using accounting data
Most asset owners have some allocation to alternative investments in their portfolio. Alternatives by nature require constant updates to historical data as new information is received from the GP. Yet many asset owners calculate their performance monthly or even daily based on their accounting close process. The fundamental issue here isn’t limited to alternatives – the issue is that accounting-based information is being used to calculate returns, and as the performance book of record is updated the accounting book of record remains locked down.
2. Inconsistent calculation methodologies
While it’s logical to use different calculation methodologies when evaluating different investment types independently, storing performance calculated with a blend of different methodologies in the same historical record compromises data integrity. Furthermore, most performance systems don’t capture sufficient detail to show what methodologies were used, leading to disconnected returns with minimal context.
3. Manual data overrides
Asset owners occasionally encounter instances where they want to intentionally override a historical return. Reasons for doing so might include aligning with the manager reported return, minimizing the impact of large cash flows, or applying a methodology to suppress outsized or abnormal returns. On example is a “price return” which might be utilized anytime a large cash flow affects a commingled fund. In these scenarios the time-weighted return is overwritten by the price return of the fund to minimize the benchmark tracking error. If this methodology is applied across the portfolio for years, it can lead to a fundamental misrepresentation of their true earned performance and a plethora of disconnected returns.
There are several reasons why using disconnected returns for performance reporting can be a risk for asset owners:
Prone to inaccuracy
Disconnecting returns from the underlying cash flows and valuations results in inaccuracies that can misrepresent any asset owner’s performance, either positively or negatively. Inaccuracy in either direction can impact future investment decisions and potentially result in financial losses.
Difficulty tracking investment performance
When returns are disconnected from the underlying cash flows and valuations, it becomes difficult to track and reconcile investment performance over time, because each performance report is comprised of static point-in-time data. This can make it challenging to identify the root cause of performance discrepancies or changes in investment performance.
Limited flexibility in reporting
Using disconnected returns can limit the ability to generate flexible reports that are based on underlying cash flows and valuations. If the underlying data is not a reflection of reality, it can severely limit a client’s ability to gain deeper insights into investment performance and make informed investment decisions.
Asset owners today face many challenges when it comes to performance reporting, and they need to ensure their investment data is accurate, traceable, and flexible. However, many rely on legacy systems that were not designed to handle the complexities and granular detail of a modern asset owner’s portfolio.
To overcome these challenges, asset owners need a solution like Nasdaq Solovis that can calculate returns on-the-fly based on the underlying investment data. This way, asset owners can dynamically calculate returns at any level of detail (e.g. fund, asset class, strategy) for any time period - without relying on pre-aggregated or hardcoded data.
The result is a consistent, traceable, and flexible dataset, leading to better insights and ultimately – better portfolio decision-making.
Nasdaq for Asset Owners
Nasdaq
Delivering insights and intelligence for institutional investors
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Maz Asadi
Nasdaq
Maz is a Senior Implementation Manager for Nasdaq Solovis focused on multi-asset class portfolio management, analytics, and reporting solutions for institutional investors.
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