PART THREE:

Investment performance from the client’s perspective: Focusing on money and funding success

Our fiduciary, client-focused approach to investing began by recognizing the organization’s responsibility to their beneficiaries to fund the mission for generation after generation. This is a challenging task, given the ups and downs of the investment markets, and so we applied a holistic approach that matched a robust spending policy to a diversified asset allocation that minimizes market risk, and then we evaluated our expected results by looking at risk from the perspective of the beneficiaries.

In this final installment, we examine actual investment results using true goals-based performance measurement and evaluation methodologies. What makes this different from the traditional approach? It’s simple: we focus on monetary results, rather than statistics. We also recognize that the true benchmark for measuring investment success is the “liability” of the organization: enough money to “pay the bills” while retaining real portfolio value to keep going in perpetuity. Do we include the standard asset benchmark and performance statistics in our analysis? We certainly do. But we will also demonstrate how our monetary measures of investment success are much more understandable, intuitive and relevant than standard performance measurement statistics. This is “performance from the client’s perspective.”

INTRODUCING THE PLAYERS: SPENDING POLICY, ASSET ALLOCATION AND INVESTMENT SELECTION

Our spending policy sets a 5% annual withdrawal rate that is applied to the prior five years (i.e., 60 months) of portfolio values. Our earlier articles noted that this “smoothing” of portfolio value provides several key benefits:

• Smaller variations in withdrawal amounts (less sensitivity to market volatility)
• Delayed withdrawal response to market downturns
• Increasing financial support when markets decline (and when needs may be greatest)
• Higher portfolio values from “saving for a rainy day” during strong investment markets

The portfolio’s asset allocation was a 70-30 mix of US equities and US bonds:

We invested across a set of 13 actively-managed mutual funds with between 2 – 4 funds in each segment. Allocations ranged from 2% to 10% (consistent with the weighting to each asset segment.)

TRADITIONAL INVESTMENT RESULTS

Our performance analysis covers the 20-year period between 1992 and 2011, which included two historic market cycles with substantial market appreciation, followed by devastating declines. The first of these declines occurred in 2000-2002, and the second was an even more severe market decline in a single year (2008) that has been called “The Global Financial Crisis.” These two market cycles demonstrate the value of our holistic approach and our emphasis on monetary measures of investment success, giving us the opportunity to “stress test” our approach and its implementation.

We see that this was a good time to take market risk, with a 5% reward (500 bps) for investing in our strategy instead of holding cash. An investment earning the market return of about 8.25% grew by nearly 5 times over this period, while holding cash barely doubled (earning only a bit over inflation.)

Our portfolio outperformed its asset benchmark by 42 bps with lower volatility risk (10.4% vs 11.1%) and less market risk (Beta of 0.92.) After adjusting for its lower risk, its outperformance doubles to 84 bps. Its risk-adjusted performance is also reflected in a higher Sharpe Ratio (risk premium vs volatility) of 0.53 vs 0.46 (a 15% relative improvement.) Given its high correlation to the benchmark, we infer that 96% of the portfolio’s return pattern is driven by benchmark factors.

How does any of this analysis inform the organization’s fiduciaries as to their success in fulfilling the mission that was entrusted to them? The sad reality is that it does not, because it provides no useful information regarding a) delivering adequate financial support to the beneficiaries or b) maintaining the real value of the portfolio for the next generation or c) the risks, severities and occurrences of failure during the performance measurement period. These informational inadequacies come from the emphasis on the portfolio as an investment product, instead of its true purpose as a means to a specific end, with that end (financial support for the mission) expressed in terms of money, rather than statistics.

SHIFTING FROM STATISTICS TO MONEY

We begin by applying our spending discipline to the series of monthly market returns for the portfolio and its asset benchmark, investing an equal initial amount in each. We also created a “liability benchmark” of the client goals: withdrawals that increase with inflation, and preserving the real value of the initial portfolio over this 20-year period.

The first set of investment results shows accumulated withdrawals and ending portfolio value for our initial $10 million portfolio, along with the asset benchmark. Our success is measured relative to the goals. (As noted earlier, beating the asset benchmark is still considered failure if we do not meet or exceed the organization’s monetary goals.)

The goal was to spend about 118% of the portfolio’s initial value over 20 years and to grow its value by about 63% to preserve its true (inflation-adjusted) value. This is the amount needed to continue to support the mission going forward. Taken together, the goal was to generate a “multiple” of the initial investment of about 2.8x in “Total Value Earned.”

It’s immediately clear that the benchmark and the portfolio outperformed both of these monetary goals. It’s also obvious that the majority of this outperformance was due to the investment strategy. This confirms the sensibility of our fundamental belief that coordinating spending policy and asset allocation is key to financial success. This also confirms the expectation that actively managing the assets may be part of this success, but that its effects are typically smaller than the positive effects of the strategy. This “modest, but meaningful” active effect is demonstrated in the following attribution analysis.

MONETARY PERFORMANCE ATTRIBUTION: THE CLIENT’S VIEW

Our initial investment of $10 million produced nearly $10 million of excess value over the goals. We also note that this excess value was almost equally split between the twin goals of withdrawals and portfolio value. A high-level attribution of excess monetary value above the goals allocates about 75% to the chosen strategy and 25% to active effects.

We believe that these monetary results are much more meaningful than simply stating that the portfolio outperformed the asset benchmark by 42 basis points!

And what about returns? The traditional, product-oriented, time-weighted returns (“TWR”) for the benchmark and the portfolio were 8.27% and 8.70% respectively. These simply measure the return on a static amount of capital over 20 years. That is nothing like our portfolio and the mission of the organization. Can we compare these static returns to the organization’s monetary goals? We think not. At best, TWR offers some insight into the returns on the investment products held in the portfolio (assuming that no funds ever leave the portfolio.)

Instead, we provide the return on the portfolio in the context of its goals of making regular withdrawals and growing its principal value. We need a goals-based return that reconciles beginning capital, withdrawals and ending portfolio value. That return is the Internal Rate of Return or IRR. The IRR of the benchmark and the portfolio are 8.78% and 9.08% respectively. These exceed the TWR of the portfolio and its benchmark. These also exceed the 7.74 IRR derived from the cashflow goals.

EVALUATING MONEY OVER THE INVESTMENT HORIZON

The most exciting monetary results are observed over time. These illustrations show the combined effects of our coordinated spending policy, asset strategy and active implementation, relative to the client’s goals.

We begin with the primary fiduciary responsibility of preserving portfolio value, net of withdrawals. After an initial three years, we see the effect of the “virtuous cycle” taking place, as our “spend less than you make” approach created a substantial surplus value that sustained ongoing spending throughout the market cycle. This was followed by a three-year market decline starting in 2000, along with spending at five percent that produced a decline of 24 percent in net portfolio value.

Using the traditional performance measurement approach, many money managers were wringing their hands over the “loss” of portfolio value relative to the “high water mark” following an extraordinary equity market runup. Their focus on this short-term loss led to many calling into question their strategy, and even wondering whether a 5% spending rate was a reasonable expectation for the future. This is the result of evaluating the portfolio in isolation, rather than viewing its current valuation relative to the goal of preserving enough value to support future support to the beneficiaries.

By taking a goals-based, monetary approach, we clearly see that even with this 24% loss in value, the portfolio remained in a strong surplus position, with more than enough to continue its planned financial support. The portfolio then built this surplus to a level that even allowed it to face a 42% decline in 2008. This “worst case” scenario saw the portfolio once again maintain its required value and then quickly rebound into another surplus. What a strong confirmation of the benefits of this holistic, goals-based approach to investing!

THE RELATIONSHIP BETWEEN SPENDING AND PORTFOLIO VALUE

The strong surplus that built up in the first few years led to a sustained level of spending that remained substantially higher than the goal, in spite of dramatic downturns in the investment markets. We also observed that the pattern of spending remained stable, with minimal year-to-year differences (other than steady increases.) The first half of the evaluation period reflected slight underperformance of the portfolio’s withdrawal results relative to its benchmark, followed by more substantial outperformance by the portfolio in subsequent years.

A closer examination shows that portfolio withdrawals continued to increase, even during the market downturn of 2000-2002, and then stabilized for a few years, until they increased once again. Even after the severe downturn of 2008, the withdrawals only declined by about 5% on a relative basis over the final three years. The larger message of success is that withdrawals remained substantially above their goal for the entire 20-year period.

BRINGING SPENDING AND PORTFOLIO GROWTH TOGETHER

The smoothing method prevents “overspending” at times of extraordinary portfolio growth, using the unspent funds to create a reserve that supports withdrawals during times of market declines. We see this clearly in the 3-year downturn that began in 2000. During that time, withdrawals continued to increase, and then stabilized until they could increase again. This pattern of behavior follows the “Virtuous Cycle” of portfolio growth, creating a sustainable dynamic between surplus and sustained withdrawals during times of market stress. What a different message than what is typically discussed when only return statistics are the basis for evaluating success. As we have said: “It’s about money, not returns.”

Total value Earned is the sum of current portfolio value and total withdrawals to date. This single number brings together both components of the mission: ongoing financial support and portfolio preservation. When we examine the total value goal against the results of the benchmark and the portfolio, we see persistent outperformance. The only variability was how much excess value was provided from time to time. The accumulated withdrawals provide a stabilizing component to this performance measure, with the effect of cutting the declines in outperformance substantially (as compared to the decline in portfolio value alone during periods of extreme market stress.) We can also see the cyclical nature of relative investment performance, with the benchmark having a slight edge in the first half, followed by a more substantial portfolio advantage.

SUMMARY AND INSIGHTS

Clients invest so that they can meet their financial responsibilities and goals. These goals are expressed in terms of money, rather than the statistics that dominate investment management and performance evaluation. Besides being complex, these statistics do not express success in terms that are relevant or even understandable to clients. We suggest that statistics have their place in evaluating investment products, but are at best incomplete when it comes to evaluating client success.

We used investment returns as the starting point to a goals-based performance evaluation that relates directly to the fiduciary responsibilities of boards, investment committees and OCIO firms that help organizations to meet their objectives of providing ongoing financial support while preserving the portfolio for future generations.

The integration of a robust spending policy with an appropriate asset allocation and an effective implementation of the investment plan are key to every client’s success. We measured this success in terms of traditional performance and risk metrics, and then we added the monetary results for withdrawals and portfolio value. By examining these results over time, we created accurate and effective visuals that demonstrate clearly the true risk clients face: mission failure. In our case study, we saw that what appeared at first to be slightly-impressive statistical results (using traditional performance metrics) was actually superb monetary results that demonstrated very low mission risk, even at times of historic market stress.

WHAT’S NEXT?

Our next series addresses the forward-looking process of asset allocation and diversification as a way to manage and moderate market volatility in the investment portfolio. Using a forecast of market returns, risks and asset correlations, we tackle the problem of achieving portfolio efficiency while seeking the best pathway to the client’s required return. Our analysis would not be complete without adding an innovation: adding risk attribution to the performance forecast!

Written in partnership with Stephen Campisi