If you’re like most clients, when it comes to measuring the growth of an investment, you really have only one question: How much did I invest and what is it worth?
One could be easily forgiven if they mistakenly thought the answer could be gleaned from their account statement. The statement is, after all, the official record of one’s portfolio. But it doesn’t necessarily answer that key question. In this brief piece, we explain why that is, and what to do about it.
Before we jump into that, however, we first want to share some good news and express some gratitude. Last week, at the Canadian Wealth Professional Awards, we won the award for Best Advisor (in the country!) with Expertise in Alternative Investments. The independent judging panel, which included the CEOs of the CFA Society, Advocis, and the Responsible Investing Association, chose us from a wide field, acknowledging our particular experience, knowledge and expertise. Being recognized in such a fashion is a great, humbling honour, for which we are very grateful. The award highlights our ongoing commitment to continuing education, ethics, thought leadership, and our relentless pursuit of excellence in our field for the benefit of our clients. More information can be found here and here.
Now on to the subject at hand:
Account statements show two main things: Book Value, (aka Adjusted Cost Base (ACB)), and Market Value. Each are problematic.
Market Value reflects what the position/investment is worth today. For the most part, it answers the second part of our question, i.e. “what is it worth”. The issue with Market Value, however, is that it does not include any dividends or income that the investment has paid out in cash.
Implication: Imagine a position into which you invested $100, continues to be worth $100 one year later, but has also paid $10 in cash dividends or income into your account. In this case, your statement would show a Book Value of $100 and a Market Value of $100, leading one to believe that they had earned nothing from the investment. In reality, they have earned 10%, as their investment of $100 maintained its value and earned income of $10, totaling $110. As an investor, the important thing to know would be that you invested $100 and now have $110; an increase of 10%. While the value of your account will have increased by the $10, it is reflected in the “total account value” column, and not linked to the investment itself, so you don’t see that the investment is “worth” more to you than you paid for it. If that $10 dividend was automatically reinvested into the fund or stock, it would be reflected in the market value, since it is now back inside the position. So while market value technically answers the “what is it worth” question inasmuch as it represents what your position could ostensibly be sold for, it may or may not include dividends and income produced by the position, depending on whether they were paid in cash or reinvested.
Book Value, or Adjusted Cost Base (ACB), does not necessarily mean “Cost” as in “how much did I invest”, which may come as a surprise. I mean, it even has “Cost” in the name! But it is not simply an indication of what you originally paid. The issue is that Book Value/ACB is a tax term. It is a calculation used to determine the cost of an investment for tax purposes. The Canada Revenue Agency requires investors to use the ACB calculation when determining capital gains or losses for income tax purposes. And this “cost” for tax purposes can, and often does, differ from the first part of our question, “How much did I invest”. Certain events can either increase or decrease the ACB, moving it away from the original invested amount.
Implication: When a stock or fund pays dividends that are automatically reinvested back into that stock or fund, the amount of the dividend/income is added both to the ACB and to the market value. This inflates the ACB and creates the appearance on a statement that the investor paid more for the position than they originally did. As a result, the amount of the apparent gain is effectively reduced (because it looks like you paid more for something than you really did). Now, from a tax perspective, this is extremely helpful to an investor, because it narrows the gap between “cost” and “value”, so when the position is sold, there is “less” of a gain on which one has to pay taxes. So using ACB as a measure of “cost” is a good thing, because it can help the investor pay less tax. As a measure of performance, however, it is far less useful. (https://en.wikipedia.org/wiki/Adjusted_cost_base)
Using our original example, imagine a position into which you invested $100, continues to be worth $100 one year later, but has also paid $10 in dividends, which were reinvested into the same fund/stock. In this case, your statement would show a book value of $110 and a market value of $110, again leading one to believe that they had earned nothing from the investment. In reality, here too, they have earned 10%, as their initial investment of $100 is now worth $110. But the Book Value/ACB on your statement won’t show $100; it will show $110.
When the numbers are small, like $10, and over a short period such as one year, it is fairly easy to remember and mentally account for. But over many years, this can create quite the disparity between what one’s statement shows and one’s actual investment performance. Look, for example, at this client’s account:
Let’s use the first Fixed Income position—Canso Corporate Value—as our example. Reading the statement, the Book Value is $206,355 and the Market Value is $246,458. Looks like a gain of $40,102, or 19.43%. Not bad. And, for tax purposes, it’s accurate. But, the client did not invest $206,355 in this position. They only invested $125,000 (Actually, they invested $200,000 and subsequently sold $75,000, so their true net cost is $125,000, and the position is still worth $246,458). They have been reinvesting the income generated by that fund for a number of years, but their capital outlay was $125,000. So as an investor, the answer to their question of “What did I invest and how much is it worth”, is actually this: You invested $125,000 and it is worth $246,458, which is a gain of $121,154 or 97%. Now because, for a while, they had an additional $75,000 invested in the fund and it was producing income, the time-weighted return calculation works a bit differently, but this is beyond the scope of this piece. Effectively, the principle is true, although the actual calculation states that their return is about 73% on the dollars invested for the period they were invested. We would be happy to elaborate on this if you like; feel free to reach out to us.
This issue arises with many investments, particularly, but not exclusively, with fixed income funds. It can also happen when an investor reinvests their dividends into stocks or trust units, or when equity funds distribute gains to their unitholders. Further, when investments pay income classified as “return of capital”, it does not incur income tax and reduces the ACB, ultimately increasing the amount of capital gains tax due on disposition, but the scope of this piece does not allow for that to be covered in detail here.
In Summary: Looking at the statement does not necessarily provide the information an investor desires. In order to determine what their actual invested capital was, an investor would have to review all of the activity and history of the position to determine the amount of income generated and how much had been reinvested etc. This is not done to be misleading; and, as per CRA mandate, the information on the statement is “accurate”; just not particularly useful as a measure of performance.
What is an investor To Do: There are two key takeaways for investors. The first is that they should be aware of this; knowing is half the battle. Know that Book Value vs. Market Value is not a suitable way to evaluate performance. The second is that your Advisor can run performance reports for you that actually provide the information you desire—namely, “How much did I invest and what is it worth”. Here is one such example for the same client shown above:
Such reports can be generated on an ad-hoc basis, for any time period desired (e.g. since inception, over the last 3 years etc.). Ultimately, the performance of the overall portfolio (as opposed to each individual line item) is what matters, and the performance is only relevant in the context of the amount of risk taken, volatility experienced, and your objectives, (a subject of both previous and future blog entries), but, know there are better ways than one’s statement to answer the question “How Much Did I invest and What is it worth”. Ask your Advisor. Feel free to ask us. We’ll show you.
Fondly, and on behalf of Sean and Farialle,