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Rate of Return Differs by How It Is Measured

David Michels loves numbers. He’s an engineer. So when Michels heard that Fidelity Investments, the company that administers his Raytheon 401(k), would provide him with a “personal rate of return” for his overall retirement portfolio, he was ecstatic.

“I was just delighted they had done this for me,” Michels says. “Until I saw what it actually was.”

It wasn’t that the 58-year-old Encino resident was disappointed with how his portfolio performed, although he was. His 401(k) had grown just 2.5% in 1999, versus the 21% gain in the Standard & Poor’s 500 index of blue-chip stocks, according to his Fidelity statement.

Rather, Michels was surprised that Fidelity’s figures showed his account had grown at all. By his own estimation, his account lost money in 1999--about 1%.

The way Michels figures it, he started the year with $13,682.65. And during the year he contributed $13,656.24, which included both his contributions and his company’s match. That comes to $27,338.89. But by the end of the year, his balance was just $27,041.43--nearly $300 less.

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“Clearly, there is a problem,” Michels wrote in a letter to Fidelity officials. “Fidelity’s measure implies that I have earned money with my investments when, in fact, the opposite is true.”

Is it possible that the nation’s largest mutual fund company, with more than $660 billion in assets, is incorrectly calculating personal rates of return? Could Fidelity be pulling a “Beardstown Ladies”?

At first, Michels thought so. “The Beardstown Ladies didn’t take into account the contributions” they made in the form of club dues, Michels says. “Fidelity didn’t take into account the earnings or losses on [my] contributions.”

Fidelity officials agree with Michels’ assessment. Sort of.

They note that their personal-rate-of-return calculation does not take into account how one’s contributions perform during a period. Instead, Fidelity’s personal rate of return calculates only how the money one has at the start of the period performed.

But they say this is not a mistake.

“There are fundamentally two very different ways of measuring performance of an investment account,” notes Walter Tsui, senior vice president of Fidelity’s institutional retirement services.

The first is a “time-weighted” method. This is the method Fidelity uses to calculate personal rates of return for its 401(k) customers. The other, which Michels was using, is sometimes referred to as the “dollar-weighted” method.

The first measures how the pile of money at the start of a time period performs by the end of that period. The second measures the average return of all the dollars in the account during the period.

“For me, I want to compare how my money is growing compared to how it might grow in any other investment, like a simple savings account,” Michels says.

In other words, he wants to know how all of his money is growing--including money he had at the start of a quarter and the money he contributed to his account during the quarter.

Fidelity officials acknowledge Michels’ frustration, but argue that the time-weighted method is a fairer measure.

Let’s say you start the year with $100 in your account. Toward the end of the year, that money grows to $1,000--a stunning tenfold increase. But in the final week of the year, you roll over $100,000 from another account, and this money loses 1% of its value during that week. Under the dollar-weighted method, a one-week, one-time loss will mask the tenfold gain of your original $100, Fidelity officials say.

Also, when a mutual fund reports its own total returns in a quarter, it backs out the effects of new-cash inflow and outflow during the quarter.

“A fund manager shouldn’t get credit or be penalized by how much money is flowing into or out of his fund,” Tsui says. In this sense, Fidelity’s time-weighted method offers more of an apples-to-apples comparison with return figures that mutual funds report, Tsui says.

The dollar-weighted method is best-suited for determining if your market-timing decisions--in other words, the bets you made by contributing or withdrawing money at specific moments in time--were successful, argues Maria Crawford Scott, editor of the Chicago-based American Assn. of Individual Investors’ monthly newsletter.

“But in 401(k)s, you’re not market timing,” Tsui says. “You put money in based on payroll contributions.” And because of that, the dollar-weighted method may not be the most appropriate.

Confusion over which method(s) to use when calculating total portfolio returns has led some firms to hold off providing such information. “We have several reservations about such reporting,” says Vanguard Group spokesman John Woerth. “Among them: Personal returns and fund returns are likely to differ, and perhaps substantially, which could confuse--even mislead--investors.”

Also, “there are several techniques that may be utilized when calculating personal performance, and they may not produce the same results,” Woerth notes. “This could lead to still more investor confusion.”

Other firms get around this problem by simply publishing both numbers. For instance, though PaineWebber does not provide all retail clients with personal rates of return, it does provide these figures for high-net-worth and “managed account” customers. In those situations, customers are shown their rates of return based on both the time-weighted and dollar-weighted methods.

Fidelity tried that in a pilot program it initiated with some of its high-net-worth clients. But Tsui says publishing both numbers proved to be more confusing than enlightening.

Salomon Smith Barney uses different methods for different types of accounts. For instance, on discretionary “managed” accounts, it uses a time-weighted method. For basic self-directed brokerage accounts, it uses the dollar-weighted method.

So what’s the bottom line?

“The most important thing to understand is that one size does not fit all,” says Jeff Hack, chief administrative officer for Salomon Smith Barney’s private client services. “There are a lot of shades of gray” when it comes to measuring performance.

And before you go and rejigger your investments based on the personal rates of return you see on your 401(k) or brokerage statements, make sure you understand exactly what those figures are measuring. And which methods you should be using in specific situations.

As for Michels, he acknowledges now that “there is no single way to do this.” But, he adds, “I will completely ignore [Fidelity’s] figure. It means nothing to me.”

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Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.


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