Rolling with the punches

PORTFOLIO POINT: Measuring performance has become more difficult in these volatile times, but there is a reliable method. Here’s how.

At this time of year investment return data for the last calendar year starts to filter out to investors, and analysis appears in mainstream press. Although it is useful to track how your investments performed, this current batch of returns in particular could lead you to making the wrong decisions about how to invest for the future. Let me explain why and offer some alternative ideas.

The below is a typical performance table summarising returns to December 31, 2011, for many common asset classes and combinations of them. If you haven’t already seen this, you will soon, along with comments about how unrewarding investing is and how superannuation is broken.

-Typical returns to December 31, 2011 (%)
Asset	1 month	3 months	1 year	3 years	5 years	10 years
Cash	4.7	4.8	5	4.4	5.5	5.4
Australian Bonds	11.4	7.7	11.4	6.3	7.4	6.3
Australian Shares	-27.1	8.2	-11	7.7	-2.4	6.1
International Shares	2.4	8	-5.3	-2.6	-7.6	-3.5
AREIT Listed Commercial Property	30.6	45	-1.6	2.3	-15.2	0.6
Australian Residential Property	1.3	1	-0.1			8.6
x
Conservative	4.2	7.9	2.8	5.8	3.5	5.9
Balanced	2.4	9.1	0.2	6	1.3	5.8
Growth	0.1	10.3	-2.5	6.2	-0.5	5.8
High Growth	-5.3	10.9	-6	5.6	-3.1	5.2

Find here hard to read acronym-rich assumptions and limitations,
quoting unfamiliar sources and complex benchmarks

Monthly and quarterly returns are meaningless

Returns from investments over the last month and quarter make worthless reading most of the time. This is especially so during periods of high volatility like now. To make this point this I have “annualised” the monthly (x12) and quarterly (x4) returns in the above table so that a shocking -27% return from equities sits next to a fabulous 30% for listed property.

To borrow terms from the electronics industry, this reflects noise, not signal. You could easily have had the reverse of these for the previous month and still arrive at the same annual return. The only information gatherable over this time period is evidence of the decline in returns from price-stable cash as interest rates fall. If elsewhere you see funds and managers ranked on monthly or quarterly performance, then all you can learn from that is to not expect to read anything insightful from that journalist or provider.

Even annual returns are date sensitive

Even over a longer 12-month period, returns data can be misleading. The -11% earned from Australian shares (Accumulation index) for 2011 will disappoint many. However, as shown below, since mid-January 2009 the broader Australian sharemarket has essentially gone sideways in price, bounded between a high of 5000, when all looks bright in the world, and 4000, when the end of the financial world seems near.

It just so happens that 2011 was a year that started optimistically and finished pessimistically. If Australian shares remain within this paradigm, it really isn’t a brave call from analysts to divine that this will be a good year for share investors.

Of course there are some useful signals here, including affirmation that a well-diversified portfolio of quality bonds increases in value to counteract shares that fall in value. Perhaps also the in-between result for listed commercial property suggests many of the problems with that asset class have been addressed.

Don’t forget income

Most investment-market returns, including the ones tabulated here, incorporate both price change and income (which together give a “total return” measure of performance). Over short periods price changes can overwhelm and mask the important return from income. In the current environment, income is the main game and fortunately many assets, including currency-hedged International investments, are paying you about 5–7%. For now this makes Australian investors some of the luckiest in the world, as I pointed out recently (see Asset allocation: What you must know).

Shane Oliver provides a nice summary of income from investing in many different asset classes that perhaps you can bank on. If you dig deep enough you can usually find a break down between income return and price change reported by fund managers. Your cash statement might also show this but not if you automatically reinvest income.

Many investment charts and graphs exclude reinvested income. Also, many in the media comment on price indices, not income-inclusive “accumulation indices”. This can lead to overly pessimistic views about sharemarket investing and wrongful comparisons with returns from cash and bonds.

Bond returns include both income and price change and as a consequence can easily mislead the novice bond investor to what return is on offer for the period ahead. Australian bonds of various types yielded on average about 7% at the beginning of 2011. Their impressive 11% total return includes this paid income plus a capital gain of 4% available if those bonds were sold today.

Unfortunately, due to this price appreciation, expect from January 1, 2012, to now earn a lesser 6% yield on current or new monies before any uncertain future capital gain or loss (or 4% yield from highly “appreciated” Commonwealth government bonds if you’re as nervous as some overseas institutional investors are now).

Sadly, residential property returns are a landmine of complexity. Most sources report price change thus understating total investment return. It would be wrong to count the gross rental return from property of, say, 4–5% as income is often depleted by repairs, agent’s fees, land taxes, rates and other imposts. Price change is also fraught with reporting issues, composition differences and is overstated by the value of capital improvements. In the table above, I’ve used price returns from Residex for houses, increased by 2% to reflect net rental income and capital improvement.

Hedge your bets

When comparing returns from international shares it is important to look at both where the effects of currency movements have been taken out (hedged) or not (unhedged). In a typical table, like the one above, only one side of the story is being told – here unhedged.

If appreciation in the Australian dollar during the year is taken out through hedging, last year’s returns from international shares were –2%, not –5%, and were 2 not -2% for international listed property. Over the last three years, as the Australian sharemarket went sideways, international markets performed better after correcting for currency change. Over 10 years, the –3% shown for investing offshore is actually 4% after hedging – a return that trails Australia by only 2% annually. You’ll need resource companies (which returned a boom 14% pa for the last 10 years) and banks to keep firing to repeat that going forward.

You, your shares and bonds aren’t average!

Market indices represent the returns from the broader market and especially for big companies and borrowers. In Australia, our sharemarket is uniquely dominated by three major constituents: resource companies, banks and “the rest”. For instance, the returns from resource companies (read BHP and Rio Tinto) in 2011 were a disappointing –25%. If you thought, as many other investors clearly did, that the resources boom was coming to an end, you would have earned instead a better –3% from other shares.

Small companies that did so well the previous year, retreated in 2011 earning -21% – a common pattern of downmarket performance. The best downmarket performer last year was hedged global listed infrastructure, which returned 5%.

Calendar 2011 also showed that not all bonds are alike. You would have been especially rewarded if you chose to invest in high credit quality and long duration bonds – earning 13% in 2011 for Australian government bonds and 18% for Australian inflation-linked bonds, the latter, which I introduced to readers earlier (see Inflation-friendly bonds). Corporate bonds and lower credit quality “high yield” bonds didn’t perform as well, bringing down the average to 11%.

The long run is never long enough

Academics such as Eugene Fama and Kenneth French are fond of saying they won’t be able to draw a conclusion about an asset’s performance until they have studied 30 years of its history. As we are still working our way through a once-in-100-year financial storm, it is not surprising that returns data, even up to 10 years, can send out misleading signals. For instance:

• An annualised three-year return of 8% suggests all is well investing in Australian shares, however this is based solely on the fact that the starting point is January 1, 2009, near to when the market bottomed (see chart below).

• Conversely, five-year return data suggests share investing is a fool’s game. This message will be getting stronger each month until we reach November 2012 when the starting point for this measure is the market peak. Imagine the headlines then!

• Looking at 10-year data and the returns from different multi-sector funds, you could conclude asset allocation doesn’t matter. Regardless of whether you were a conservative, balanced, growth or aggressive investor, you earned about 5.5% annually (with apologises as these are closer to nine-year annual returns borrowed from Vanguard’s multi-sector index funds from their inception in November 2002). This is just coincidence. However as the standard deviation of returns (see The silent killer of retirement savings) from these funds are quite different, if you are a pension phase investor you have a lot more to live off had you picked the conservative option.

• Earlier we reported (see We’ve been here before) an ultra-long term annualised return for the Australian sharemarket of 11%. Had I started that series in 1900 instead of 1880, and finished it in 2000 or 2007 not 2010, I could have suggested the long-term returns from shares were a much higher 13%. So next time you see someone report a return with two decimal places (eg, 7.86%), just smile knowing someone is enjoying a false sense of certainty.

Incidentally, the long run is not kind to speculative investments such as gold, which provide nil income and rely on temporary price fluctuation to add value. This is a reminder that your return from speculating in precious metals is entirely dependent on your personal entry and exit price and is not reflected in a published figure.

Did you invest all your money on just one day?

Underlying these simple performance measures is the wrong assumption that you invested all of your money on one day and sell everything today! I don’t recommend either. Most invest and divest progressively over decades so your returns earned won’t mimic these measures at all. It probably won’t be appreciated until next decade that these are good times to be an under 50 auto-investing accumulator investor.

This market is instead harmful really only to the pre and recent retiree who has or had too much in undiversified equities (and probably unlisted illiquid property and mortgage trusts) AND who is drawing more than 5% from their portfolio as income.

Such is the power of performance figures that many investors use them as a rallying call to invest in what went up and divest what went down. In the US, Morningstar has begun publishing, in addition to fund returns, “Investor Returns” which take into account investment flows. On average, returns earned by the average investor lags fund returns by a painful 1.5%.

Don’t drive by looking in the rear view mirror

It is important to remember that historic returns describe what has already happened, and not what will happen. In fact, there is probably more chance the reverse of last period’s performance will happen next period. Often bad times in the sharemarket are followed by good ones, which statisticians call “mean reversion”. There is no promise that good returns follow bad, it’s just that quite often shares are oversold or overbought owing to behavioural reasons.

This is true also of the bond market, although often the driver is falling and rising interest rates. In the following chart of rolling annual returns you may see the cautious bond investor in January 2008 earned a whopping 20% return by December of that year, while the new bond investor in January 2009 suffered a small negative return by the end of the year as interest rates were forecast to rise back. I don’t believe we are through this financial storm yet, and that there is still a role for nominal fixed-interest rate bonds in your portfolio despite their previous gain.

Rolling annual returns from investing in various Australian bonds (Commonwealth, State, Corporate), cash and shares, all including reinvested income, to end date shown. Source: S&P

Repeat after me: “Rolling relative real returns”

The previous chart reminds that starting and end dates for performance measurement are critical. To avoid being duped I would encourage you to look at rolling return charts like the above or simply study a record of annual returns (either or both, calendar or financial year). Instead of letting the calendar demark returns, you could look at returns by event, such as the GFC peak, during the fall, in the recovery and over the past two-and-a-half flat years. This would help you divine your or another’s performance in rising, falling, recovering and flat markets respectively. For instance, industry superfunds’ substantial use of unlisted non-market priced assets, often see them outperform in a falling market but underperform in a recovering market.

Especially when comparing performance, it is good to look at relative returns – the difference in performance versus an appropriate index or peer group. By looking at rolling relative returns, it is easier to spot periods of outperformance and underperformance.

Sometimes you find, when comparing trumpeted long-term returns from professional fund managers, just one decision made a few years ago helped that fund outperform their peers for the next several years. New investors since didn’t or don’t benefit.

Finally, it would also be useful to look at real returns after adjusting for inflation; however, I think that might make for too many rolling relative real returns. As mentioned earlier (see Invest like the very rich), it is also important to invest for after-tax returns.

It is important to track returns as part of a disciplined portfolio management process, but be careful what you divine from it, including about the future ahead during these unusual times.

Doug Turek is the Principal Adviser of independently owned advisory and money management firm Professional Wealth.