Measuring Investment Performance

(January 2010)

 

There’s an old saying that success has a thousand fathers. Sure to follow the pleasant rise in stocks for 2009 will be a “thousand investment managers” touting their robust investment returns for the year. Investors will do well to view these success claims with a skeptical eye.

In the first place, the year 2009 isn’t the whole story. Talking about 2009, when the S&P 500 returned 26.5% (including dividends), must be put into context with 2008, when the index (including dividends) fell 37.0%. In other words, an investor with $1.00 thusly invested at the beginning of 2008 would have only $0.80 two years later. So investors should consider the two-year period when comparing mutual funds and other investments that did well in 2009. It’s unfortunate, but the fact is that some of the best returns for 2009 followed the worst performances in 2008, expanding the S&P 500 pattern. (A mutual fund that declines 50% one year and soars 60% the following year leaves its investors with only $0.80 for each $1.00 invested.)

In the second place, with the exception of one-year performance figures, the mutual fund industry reports its annual returns as averages. Investors may have seen, for example, performance reports for three-year and five-year “average, annual returns.” Due to the effects of compounding, “average” returns can distort what actually happens to the money. A more accurate, yet simple, method of measuring a mutual fund’s performance is to calculate the value of $1.00 invested at the beginning of the period, recalculating it for each time period. Table I shows the value of $1.00 for the S&P 500 index calculated in this manner for the past three years (dividends reinvested).

TABLE I

Year S&P 500 3-Year Return Value of $1.00 Average Return Value of $1.00 Invested at Average Return
2007 5.5% $1.06 -1.7% $0.98
2008 -37.0% $0.66 -1.7% $0.97
2009 26.5% $0.84 -1.7% $0.95
-1.7% -1.7%

As shown, investors in the S&P 500 for the last three years actually ended up with $0.84 on the dollar compared to their “average, annual return,” which implies they ended up with $0.95. Five-year returns contain the same distortion. As shown in Table II, an average return from 2005-2009 for the S&P 500 index implies that investors wound up with $1.16 for the period, when the actual experience shows they ended up with only $1.02.

TABLE II

Year S&P 500 5-Year Return Value of $1.00 Average Return $1.00 Invested at Average Return
2005 4.9% $1.05 3.1% $1.03
2006 15.8% $1.21 3.1% $1.06
2007 5.5% $1.28 3.1% $1.10
2008 -37.0% $0.81 3.1% $1.13
2009 26.5% $1.02 3.1% $1.16
3.1% 3.1%

During the past decade, investment models have been subjected to at least two severe stress tests. Most investors would agree that many, if not most of these models, failed to perform as advertised. Portfolios managed by the “smart people,” such as Harvard, as well as those managed by individuals, all experienced painful losses. There are many opinions about what went wrong, and the investment community will be promoting new investment models and tuning up their pie charts for years to come. These efforts would be enhanced by more transparency in reporting performance.

Meanwhile, investors can develop their own measure of performance by calculating the value of $1.00 over relevant time periods, and then applying the extensions to reflect their own circumstances. For instance, $100,000 invested in the S&P 500 index at the beginning of 2007 was worth just $66,000 at the end of 2008, and only recovered to $84,000 by the end of 2009, dividends included. (See Table I)

It doesn’t take long before averages begin to distort actual results. As almost all investors know by now, the S&P 500 finished the decade 24.1% below its beginning price of 1,469.25 on December 31, 1999. Add in dividends, and the results are still disappointing: $1.00 invested 10 years ago is only worth $0.91 today. However, if one uses “average annual returns” to describe the past 10 years, the impression is that investors finished the decade with $1.13 for each $1.00 invested. As Table III shows, the “average annual return” is not an accurate picture of what happened.

TABLE III

Year S&P 500 Returns Value of $1.00 Average Return Value of $1.00 Invested at Average Return
2000 -9.1% $0.91 1.2% $1.01
2001 -11.9% $0.80 1.2% $1.02
2002 -22.1% $0.62 1.2% $1.04
2003 28.7% $0.80 1.2% $1.05
2004 10.9% $0.89 1.2% $1.06
2005 4.9% $0.93 1.2% $1.07
2006 15.8% $1.08 1.2% $1.09
2007 5.5% $1.14 1.2% $1.10
2008 -37.0% $0.2 1.2% $1.11
2009 26.5% $0.91 1.2% $1.13
Average Return 1.2% 1.2%

Using the hypothetical investor above, with $100,000 invested at the beginning of last decade, “average” return shows a value at the end of the decade of $113,000. But looking at what actually happened to the value of $1.00, it is clear that the investor’s $100,000 investment actually declined to $91,000, a $22,000 discrepancy, or distortion, from using “average, annual return.”

Prepared by:

Sam Dreher
H.S. Dreher Capital Management, LLC
275 SE Broad St
Southern Pines, NC 28388

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