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Historical View of Compound Returns May Miss Red Flags


Software Settings Allow Clubs to Track Ownership Records



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Both Club Accounting 3 and the online myICLUB.com have club settings that affect the way compound annual return for indi­vidual securities is calculated. The first setting is Include Earlier Ownership. This setting is found in both versions of the club accounting program. The second setting is Merger/Spinoff Return Basis. This setting is found only in the online version. I’ll discuss the consequences of these options, starting with Include Earlier Ownership in this article and Merger/Spinoff Return Basis next issue.

The Include Earlier Ownership setting is included to cover situations in which a club owned a company, sold all shares, then made another investment in the same company. When this choice is selected, the program will use all transactions related to the company during the entire history of the club to calculate the returns to display on the Valuation Statement.
   
The advantage to this choice is that the investment club can see how its total investment in this company has performed during the club’s entire history. This indicates whether the club has employed reasonable entry and exit points for this company.
   
Like most things in life, this choice also has a disadvantage. In this case, past performance can mask the perfor­mance of the current holding. The magnitude of this distortion will vary and depends on the relative size of the new and old holdings and the difference in their performance. This doesn’t mean the return figures are inaccurate; they just cover different situations when different settings are chosen.
   
Here’s a quick example of how this works: A club pur­chases shares of Company XY on Jan. 1, 2004, costing $6,000. On Dec. 31, 2006, all shares are sold for total proceeds of $12,000. The compound annual return for this investment is 26 percent. On Jan. 1, 2008, the club purchases shares costing $3,000. On Dec. 31, 2011, the value of the shares from the Dec. 1, 2008, purchase are now worth $1,500.
This is a return of negative 15.9 percent per year for these shares.
   
But the club chose Include Earlier Ownership in its settings page. In this case, the program includes the cash flows from the earlier 2004 purchase. On the club’s Valuation Statement dated Dec. 31, 2011, the return figures for XY read 19 percent. (You can use the XIRR function in Microsoft Excel to confirm this scenario.) The much better perfor­mance of the earlier purchase has significantly masked the poor performance of the most recent purchase. If the club didn’t know what was being measured, the members may think the new purchase was performing well.
   
The default setting for the software doesn’t include pre­­vious ownership. To include earlier ownership, the change can be made by going to Tools > Settings in the desktop software and Utilities > Update club settings in myICLUB.com.


Russell Malley is the Club Accounting Adviser for ICLUBcentral.


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