Phalippou et al Flashcards
The Hazards of Using IRR to Measure Performance
Key Issues - Reinvestment Assumption
IRR assumes that intermediate cash flows are reinvested at the same high rate, which is often unrealistic. This overstates actual returns for top-performing funds and understates returns for poorly performing ones.
Key Issues - Volatility Distortion
IRR exaggerates performance differences between top and bottom quartile funds, making performance appear more dispersed than it is
Key Issues - Aggregation Problem
Average IRR across multiple funds does not represent the actual return of combined cash flows. This can mislead investors about fund performance.
Key Issues - Incentive Misalignment
IRR incentivizes fund managers to manipulate cash flows:
- early exits: may exit successful investments prematurely to boost IRR
- large dividends: borrowing funds to pay dividends inflates IRR but destroys value
- fund grouping: combining funds hides underperformance by reporting inflated aggregate IRR
Key Issues - Endogenous Cash Flows
Managers can time cash flows strategically to improve reported IRR, potentially misrepresenting true investment outcomes.
Key Issues - Unfair Penalization of Long-Duration Investments
IRR biases against long-duration investments, which may have sound fundamentals but lower IRR due to extended timelines.
What is the proposed solution?
Modified IRR (MIRR)
- adjusts for IRR’s flaws by assuming that intermediate cash flows are reinvested at a more realistic rate, such as hurdle rate or market return (e.g. S&P 500)
- calculate MIRR at both the investment and fund level
- use a fixed re-investment rate (e.g. 8% or market index return) for all funds to improve compatibility
What are the advantages of the MIRR?
- aligns incentives between fund managers and investors
- provides a more accurate and fair measure of performance
- avoids unrealistic assumptions about reinvestment rates
