On equity markets, long-term decision making and performance metrics

The 2012 Kay Review of UK Equity Markets and Long-term Decision Making confirmed that short-termism was a problem. Identifying asset managers as the dominant players in the investment chain, Mr Kay concluded that their appointment and monitoring was too often based on short-term relative performance and recommended an examination of the metrics employed. Using as conceptual framework the Keynes–Graham schema proposed by Woods in 2013, we demonstrate that the most commonly employed measure, the time-weighted rate of return, is inappropriate and inaccurate as a performance metric and should be replaced by the familiar, but generally ignored, money-weighted rate of return. Hitherto there have been three strands to the economics and finance literature on portfolio management, namely with reference to the efficient markets hypothesis, the selection of optimal portfolios in a mean–variance context using quadratic optimisation techniques and principal–agent issues that exist between portfolio managers and their clients. In this article, we initiate a new strand in the literature by focusing on the metric used to measure the performance of a portfolio manager, incidentally showing that our approach has immediate implications for the three existing strands.