PART ONE MARKETS, RETURN, AND RISK
Chapter 7 Sense and Nonsense about Pro Forma Statistics
Pro forma is a most unfortunate and confusing term in the sense that it is used in virtually opposite contexts. Pro forma results are based on presumed representative returns as opposed to actual returns and are used when actual returns are unavailable or are considered to be in need of modification. In practice, however, pro forma returns can range from unrepresentative and misleading to more representative than so-called actual returns.
As one example of the misleading uses of pro forma numbers, consider a new fund of funds that employs a track record based on how the portfolio would have performed in the years prior to the fund’s inception based on the actual track records of the funds selected for the portfolio. It’s easy for investors to be fooled into believing that such pro forma results are representative because, after all, they are based on actual track records. The catch, however, is that only funds with good past performances will be selected, and the knowledge of which funds would have experienced superior performance would not have been known prior to the achievement of their outperformance. There is, in fact, no reason to assume that a largely similar portfolio, let alone the same portfolio, would have been chosen at the start of the pro forma period and subsequently maintained throughout the period without changes. Thus such pro forma results will be highly biased because, although the portfolio results are constructed from actual return data for the underlying funds, the composition of the portfolio itself is hypothetical.
Another example of misleading pro forma numbers would be a manager who after trading a diversified portfolio decides to create a new specialized program that trades only one sector in the portfolio. One can safely assume that such a carve-out portfolio will be based on a market sector subset of the whole portfolio that has done particularly well. Once again, the pro forma results are based on actual returns, a factor that seems to lend credibility. What the investor may fail to realize, however, is that the returns represent a cherry-picked subset of a broader portfolio. There will always be some portions of the portfolio that will do better than others (e.g., better- performing market sectors). There is, however, no reason to assume that the subset chosen to be a new stand-alone program will continue to do better in the future.
It is tempting to conclude that pro forma results are categorically misleading and should be dismissed, and in fact that is exactly what many investors do. This presumption, too, however, is a mistake since pro forma results can sometimes be more representative than so-called actual results. Consider, for example, a manager who launches a fund that will trade the same strategy previously utilized for a proprietary account that was not charged any fees. In this instance, the actual past returns would overstate performance potential (even assuming future returns are
equivalent to those realized in the past) because they fail to reflect the fees that will be charged to investors in the fund. Clearly, the correct representation of results will be one that reduces the prior actual track record returns by amounts equivalent to the fees that investors will be charged in the new fund. Not only is there no problem with the use of pro forma results in such a situation, but the pro forma returns are unquestionably more meaningful than the actual returns.
As these contrasting examples should make clear, pro forma results can range from misleading to more representative than actual results. To lump all pro forma results together in the same derogatory context is itself misleading.
There are two key questions regarding any pro forma result:
1. Does the pro forma result embed any hindsight?
2. Is a pro forma result more representative than the actual results?
The answers to these questions determine the legitimacy or lack thereof of a pro forma return series. In the first example cited—a new fund of funds using a pro forma track record based on the prior actual track records of the underlying funds selected for the portfolio—the fund of funds manager has the benefit of hindsight in picking the funds in the portfolio. No fund of funds manager will construct a portfolio of funds that have done poorly in the past. Thus the actual results of funds in the portfolio for the period prior to their selection will be a misleading indicator of the portfolio’s potential future performance. Similarly, in the example of a new fund product formed as an extraction from a broader portfolio, the choice of the subset benefits from hindsight. In contrast, where the adjustment is made to more accurately reflect the way a fund will be traded without any hindsight distortion at all—for example, a pro forma adjustment to reflect fees that new investors will be charged but that are not reflected in the track record—the pro forma returns can be more accurate and representative than the so-called actual returns.
Investment Misconceptions
Investment Misconception 21: Pro forma results provide a reasonable approximation of actual performance.
Reality: Although this assumption is true sometimes, pro forma results can be wildly misleading if they are derived with the benefit of hindsight.
Investment Misconception 22: Pro forma results are highly distorted and should never be used as a proxy for actual performance.
Reality: Although this assumption is often true, sometimes pro forma returns can provide a more appropriate performance representation for the investor than actual returns—as would be the case if the past actual returns were achieved with a lower fee structure. Generally speaking, pro forma returns are preferable to actual returns if they only adjust past fees to more closely represent fees paid by current investors and do not make any adjustments that benefit from hindsight.
Investment Insights
There is a great deal of confusion regarding pro forma results due to the term’s use in nearly opposite contexts. Pro forma results are both used when they shouldn’t be and dismissed when they are entirely appropriate. The key is whether pro forma results embed hindsight—a consideration that makes all the difference.
Chapter 8