Bridging the Gap: Why Actual Returns May Deviate from Model Returns

As investment advisors, ensuring that your clients' portfolios closely align with model portfolios is critical. However, discrepancies between actual returns and model published returns are common. Understanding the factors that cause these variations is crucial for setting realistic expectations and optimizing portfolio performance. Here, we delve into the primary reasons behind these differences: trading costs, discontinuous trading, missed trades, timing of management fees, substituted securities and the assumption of equal weighting.

Trading Costs

One of the most significant factors affecting returns is trading costs, particularly ticket charges. These are the fees charged by brokers for executing each trade. Unlike model portfolios, which often assume no trading costs, real portfolios must account for these expenses. Frequent trading can accumulate substantial ticket charges, significantly reducing overall returns.

Discontinuous Trading

Discontinuous trading occurs when there is a delay between the time a model suggests a trade and when the trade is executed in the actual portfolio. This delay can lead to differences in the price at which securities are bought or sold, causing variations in returns. iQUANT, for example, assumes trades are executed on the first day of the applicable month and uses an "average trading price" that averages the day's high, low, close, and open prices.

Missed Trades

Missed trades happen when a recommended trade is not executed at all, often due to operational errors, liquidity issues, or restrictions on trading certain securities. Missing key trades can lead to significant deviations from model returns.

Timing of Management Fees (for portfolios)

The timing of when management fees are charged can affect the reported returns of a portfolio. Model portfolios typically do not account for these fees, leading to higher reported returns compared to actual client portfolios where fees are deducted periodically.

Assumption of Equal Weighting

Many model portfolios assume equal weighting of assets, but in practice, portfolios may deviate from this due to constraints like minimum position sizes, rounding, or client-specific requirements. These deviations can lead to variations in performance.

Substituted Securities

Models often rely on specific securities to achieve the desired performance. However, investment advisors may not always be able to buy those specific securities due to internal restrictions. In such cases, the advisor may substitute a similar security. While the substitute may track the target security closely, its performance won't be identical, leading to potential deviations from modeled returns.

Conclusion

Understanding the factors that cause variations between actual returns and model published returns is essential for investment advisors. By recognizing the impact of trading costs, particularly ticket charges, discontinuous trading, missed trades, timing of management fees, and the assumption of equal weighting, you can better manage client expectations and optimize portfolio performance. While these factors should not have a material impact, they may result in either higher or lower returns compared to what is published.

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