Why top of the table returns don’t always deliver the best results for investors

Why top investment returns don't always put your clients in first place

Albert Einstein once called compound interest the eighth wonder of the world: those who understand it, earn it... those who don't... pay it. The financial services industry understands it, but the way it presents investment returns often ignores it.

The result is investors lose out.

Investment performance tables often present returns by adding total annual returns and dividing by the number of years to produce an average annual return.

It fails to show the impact of volatility and capital losses and how they erode the power of compound interest (which occurs when earning interest on top of interest), leading to lower long-term investment returns.

Consider the performance of two hypothetical portfolios over five years in Figure 1 below. Each portfolio produces an average return of 4% a year.

However, the compound annual growth rate (CAGR) of Portfolio B and the final account balance are both higher despite Portfolio B underperforming in four of the five positive years in the table below. Sacrificing some upside participation in order to manage negative environments delivers the better outcome in the long run. 
 


 

Figure 1: Average investment returns ignore compound interest

 
  Return Value
  Portfolio A Portfolio B Portfolio A Portfolio B
Year 0     $100.0 $100.0
Year 1 10% 8% $110.0 $108.0
Year 2 -20% -12% $88.0 $95.0
Year 3 10% 8% $96.8 $102.6
Year 4 10% 8% $106.5 $110.9
Year 5 10% 8% $117.1 $119.7
  Average Return Compound Return
Over 5yrs 4.0% 4.0% 3.2% 3.7%

Source: Milliman.
 

Portfolio B’s lower volatility and lower maximum drawdowns through time allows the power of compound interest to work its magic on the final result. 

As markets turn into negative territory, a portfolio that retains most of its account balance is best poised to benefit from the market rebound. By avoiding the worst of the market downturn and volatility, investors have less need to capture the maximum return when markets are strong.

It underscores the irrelevance of looking at one-year investment returns or average returns that don’t take into account compounding.
 


Managing volatility and drawdown are the keys to meeting long-term goals


Long-term investment returns should reflect risk but, in the real world, timing is everything.

Over the six-month period from September 2008 to February 2009, the median superannuation balanced option fell 18.5% while the median growth option experienced a drawdown of 23.2%, according to SuperRatings.

By way of contrast, average net annual return delivered by most large super funds over the 20 years to 2016 was 5.7% – a figure which hides the impact of major drawdowns and volatility. However, managing these factors is crucial to maximising real-world goals.

For investors in or near retirement and beginning to replace their salary with their life savings and investment returns, these market events create significant changes to their quality of life. Without the ability to add to their savings when markets fall and simultaneously reducing their account balance to fund living expenses – the power of compounding has been severely diminished.

Diversification through owning a broad range of assets across stocks, bonds, and alternative investments – provides some protection. But the behaviour of many assets become correlated during severe stressed periods, such as the GFC; providing fewer benefits than many investors expect.

In some cases diversification also lowers compound returns by lowering exposure to growth assets, such as equities. Further, investing in strategies with higher management costs and added complexity to diversify may not improve long-term outcomes. At a minimum, added complexity may only serve to increase unpredictable outcomes.

Finally, traditional defensive investments represented by historically low global risk-free real rates of return continue to challenge investment managers and investors alike. While equity valuations have seemed high in recent times, many an active manager has looked foolish by de-allocating from risky assets over the past 2-3 years.

Investment performance tables shouldn’t be the only performance metric for investors who want to generate the strongest retirement incomes because they rarely reflect real-world experience.

Rather, a focus on managing volatility and drawdowns will lead to better retirement outcomes.

 

This article was supplied by Milliman

 
 

Disclaimers

This document has been prepared by Milliman Pty Ltd ABN 51 093 828 418 AFSL 340679 (Milliman AU) for provision to Australian financial services (AFS) licensees and their representatives, [and for other persons who are wholesale clients under section 761G of the Corporations Act].
 
To the extent that this document may contain financial product advice, it is general advice only as it does not take into account the objectives, financial situation or needs of any particular person. Further, any such general advice does not relate to any particular financial product and is not intended to influence any person in making a decision in relation to a particular financial product. No remuneration (including a commission) or other benefit is received by Milliman AU or its associates in relation to any advice in this document apart from that which it would receive without giving such advice. No recommendation, opinion, offer, solicitation or advertisement to buy or sell any financial products or acquire any services of the type referred to or to adopt any particular investment strategy is made in this document to any person.

The information in relation to the types of financial products or services referred to in this document reflects the opinions of Milliman AU at the time the information is prepared and may not be representative of the views of Milliman, Inc., Milliman Financial Risk Management LLC, or any other company in the Milliman group (Milliman group). If AFS licensees or their representatives give any advice to their clients based on the information in this document they must take full responsibility for that advice having satisfied themselves as to the accuracy of the information and opinions expressed and must not expressly or impliedly attribute the advice or any part of it to Milliman AU or any other company in the Milliman group. Further, any person making an investment decision taking into account the information in this document must satisfy themselves as to the accuracy of the information and opinions expressed. Many of the types of products and services described or referred to in this document involve significant risks and may not be suitable for all investors. No advice in relation to products or services of the type referred to should be given or any decision made or transaction entered into based on the information in this document. Any disclosure document for particular financial products should be obtained from the provider of those products and read and all relevant risks must be fully understood and an independent determination made, after obtaining any required professional advice, that such financial products, services or transactions are appropriate having regard to the investor's objectives, financial situation or needs.

All investment involves risks. Any discussion of risks contained in this document with respect to any type of product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. There are also risks associated with futures contracts. Futures contract positions may not provide an effective hedge because changes in futures contract prices may not track those of the securities they are intended to hedge. Futures create leverage, which can magnify the potential for gain or loss and, therefore, amplify the effects of market, which can significantly impact performance.

An investment in an underlying portfolio, whether with or without Milliman Managed Risk Strategy (MMRS) is subject to market and other risks and no guarantee or assurance is given by Milliman AU or any company in the Milliman group that the use of MMRS in connection with an underlying portfolio will not give rise to losses or that the performance of the MMRS in relation to the underlying portfolio will remove volatility completely or to the extent depicted in an illustration or fully replace losses in the underlying portfolio or to the extent depicted.  While generally assets used in connection with the MMRS are liquid, this may not be the case in all circumstances.  Further, during periods of sustained market growth, the return to clients from the combination of an underlying portfolio and MMRS should be less than if a client had no MMRS.

Past performance information provided in this document is not indicative of future results and the illustrations are not intended to project or predict future investment returns.