LONDON, June 14, 2022 — The Thinking Ahead Institute (TAI) - an investment research and innovation members group sponsored by WTW - has released open-source computer code to empower institutional investors to think differently about investment performance and how to report it. The code is an implementation of TAI’s Fundamental Return Attribution (FRA) framework which is derived from its in-depth research into the separation of short-term and long-term return components of an investment strategy. The code is designed to make it easy for investment organisations to apply this framework to their own portfolios and develop more meaningful reporting tools, which if widely adopted by the industry would transform it.
Tim Hodgson, co-head of the TAI, said: “TAI research has identified a significant long-term investment premium - up to 1.5% pa - that can be harvested and shared with end beneficiaries. However, the industry has become accustomed to short-term performance measures, which are perpetuated by traditional reporting methods, resulting in many investment mandates being terminated for the wrong reasons and at the wrong time. Hopefully, this is about to change as institutional investors are equipped with new tools to help them think differently while shifting their focus towards asset managers’ decision-making abilities and the fundamental drivers of returns.”
“Institutional investors are equipped with new tools to help them think differently while shifting their focus towards asset managers’ decision-making abilities and the fundamental drivers of returns.”
Tim Hodgson | TAI
The TAI’s new open-source code, which is freely available on Github.com, is designed to break down a portfolio’s returns into three components: changes in market sentiment; growth in portfolio fundamentals; and changes in the portfolio’s holdings. This allows the evaluation of an investor’s decisions to be based not only on market-value returns, but also on changes in the fundamental attributes of the portfolio over time. This is intended to promote a longer-term outlook, and to enable an improved dialogue between asset owners and asset managers.
Tim Hodgson said: “In addition to thinking differently, we believe the widespread use of this approach will enable improved conversations, between asset managers and asset owners, about the long-term return drivers of an investment strategy, particularly during periods of underperformance. In addition, it should broaden the portfolio-review discussion away from an exclusive focus on short-term performance towards the quality of underlying decision-making and production of sustainable returns.”
This initiative to improve transparency and enhance accuracy in reporting in the industry has been long supported by TAI’s membership of institutional investors - especially WTW, Baillie Gifford, MFS and S&P Dow Jones Indices - who have helped develop and test the framework and methodology.
The FRA framework can be applied to all asset classes but, as with any single measurement methodology, it may be more applicable to some mandates than others. Currently, it has been applied to portfolios using company fundamentals, but there is potential to apply it to other characteristics that investors increasingly wish to monitor or manage in their portfolio.
Craig Baker, global CIO at WTW, said: “We are already making use of this methodology to assess equity managers beyond the traditional frameworks and expect to widen that to other asset classes. We have found it to be particularly helpful in understanding what has been driving performance when there has been a divergence in fundamentals and stock price performance in the wider market. In future, we think this methodology will also be able to support investors who seek to align their portfolios to ESG objectives but are struggling to identify if a portfolio’s decarbonisation is, for instance, due to underlying companies reducing emissions or the divestment of high-emission companies. We believe this framework, and an enhanced version of the tool, could provide much needed clarity into how ESG objectives are being managed and achieved.”
Aye Soe, Managing Director, Global Head of Core and Multi-Asset Product Management at S&P Dow Jones Indices (S&P DJI) said: “S&P Dow Jones Indices welcomes the opportunity to share its insights with the Thinking Ahead Institute on this research project. As the world’s leading index provider, our independent indices and benchmarks help promote increased understanding of global financial markets, which aligns with the goal of the FRA framework. Collaborating with organisations such as TAI helps S&P DJI continue educating market participants about the benefits of indexing and how transparent indices contribute to measuring market risks, returns and opportunities.”
Stuart Dunbar, Partner at Baillie Gifford, said: “We are delighted to have supported TAI in development of this open-sourced FRA framework. The methodology will allow asset owners and managers to better understand the drivers of return and encourage genuine long-term investment. Such investment is critical to the generation of wealth in the economy.”
The Thinking Ahead Institute’s Fundamental Return Attribution framework enables the separation of a portfolio’s returns into three main components. Returns arising from changes in market sentiment (multiple return), the growth of the portfolio’s fundamental characteristics (growth return) and the change in those fundamental characteristics due to changes in the portfolio’s holdings (activity return).
Decomposing returns into these three components enables a deeper understanding and assessment of how an investment strategy generates returns. Compared to more traditional attribution methods that focus on explaining returns by the performance of different groupings of securities this approach considers how the investment process generates returns in aggregate due to the current decisions of the asset manager or its past asset selection decision.
The approach separates out returns arising from changes in short-term market sentiment enabling a longer-term outlook by asset owners and asset managers when evaluating recent performance or setting future return expectations. For more detail read the research paper: Fundamental return attribution - separating returns due to short-term noise from intrinsic portfolio growth.
The Thinking Ahead Institute was established in January 2015 and is a global not-for-profit investment research and innovation member group made up of engaged institutional asset owners and asset managers committed to mobilising capital for a sustainable future. It has over 55 members around the world and is an outgrowth of WTW Investments’ Thinking Ahead Group which was set up in 2002. Learn more at Thinking ahead institute.
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