Misleading Returns: How Ignoring Cash Flows Can Result in Performance Measurement Errors

Abstract

This article discusses how the traditional approach of measuring performance using time-weighted compounded returns can lead to grossly misleading conclusions in the context of two examples of practical interest. First, the authors show how measuring tail-risk hedging performance using only compounded returns, rather than both returns and timing of cash flows in the context of the underlying portfolio, can lead to erroneous conclusions about the value added by such hedges. Second, they show how measuring performance using compounded returns alone and ignoring timing and size of investment flows can result in contradictory conclusions about the long-term profitability of such investments, using the ARKK exchange-traded fund as an example. They conclude that a more complete approach to performance measurement is essential for investors to not be misled by oversimplified metrics, such as compounded returns.