May 23, 2007
HARD FACTS & NET RESULTS
Investment performance is often less than it appears. The top-line number may impress, but after adjusting for real-world frictions, the net result may disappoint.
Everyone knows this and, for the most part, everyone ignores it. Maintaining a sunny disposition is essential when it comes to deploying capital, and so who wants to let reality muck up the fun?
Meanwhile, even for those who demand nothing less than the unadulterated truth, it's unclear how to adjust top-line returns to calculate something closer to reality. Although it's easy to generalize for everyone, the final numbers may be applicable to no one. So it goes with investing when you move from paper to reality.
That said, in those rare instances when someone takes the time to estimate the damage, the reality burst can be shocking, even if it's not precisely accurate. One example was dispensed yesterday, deep within the walls of New York's celebrated 21 Club, where Garrett Thornburg, CEO of Thornburg Investment Management, spoke to a room of journalists (including yours truly) on the hard facts of net results.
Consider the S&P 500, for instance. According to Thornburg, the 11.7% annualized total return for the index over past 20 years through 2006's close fades considerably after deducting for a variety of monetary abrasions that cut into investors' take.
Indeed, the annualized 11.7% for the S&P 500 falls to 6.5% after investment management fees, dividend and capital gains taxes and inflation, according to Thornburg. The dynamic is at work in other asset classes too. Again using Thornburg's numbers, we're told that annualized total returns over 20 years are smaller than they appear. In particular,
* small cap stocks (as per the Russell 2000) fade to 5.9% from 10.9%
* foreign stocks (MSCI EAFE) drop to 3.5% from 8.4%
* long term government bonds (20 year Treasuries) slip to 2.1% from 8.3%
* commodities end up with a negative 0.9% from a nominal 3.1%.
Perhaps the most astonishing evolution is the one assigned to single family homes. The nominal 4.8% return posted over the 20 years through the end of last was sliced to a measly real return of 1.2% after taxes, fees and inflation, according to Thornburg.
Among the conclusions the analysis inspires: "Taxable fixed-income securities only make sense for the tax-exempt of tax-deferred investor....", according to the handout that accompanied yesterday's chat. Meanwhile, "...a 3% real return is a fair objective. More volatile stocks should aim for more than 3%. Less volatile bonds might aim for less than 3% (although, high-grade, tax-free bonds have actually exceeded that over the past 20 years)."
Of course, the past is only a guide, and perhaps a poor one at that. There's also some play in how one might estimate taxes, fees and inflation. Meanwhile, an investor's expectations about the future will dominate strategic design in the here and now. On that note, we might move the debate along by asking if readers think inflation, taxes and nominal returns over the next 20 years will be a) higher, b) lower, or c) about the same? Take your time. This, after all, is a trick question.
Posted by jp at May 23, 2007 10:39 AM
It would be interesting to see what this analysis showed for alternative investments such as private equity and hedge fund returns.
For hedge funds, the high turnover rate of investments would probably have a significant impact on taxes as little may be regarded as capital gains.
For private equity, I remember reading somewhere that a leveraged investment in say an S&P 500 index fund would produce better returns than a private equity investment.
Just something to think about I guess.
Furthermore the 2/20 management/performance fee arrangement may have a significant impact on returns over a long period of time. I haven't seen this analysis done, but I am sure it exists or that someone, somewhere is working on compiling it.
Posted by: Wall Street Insider at May 26, 2007 4:00 PM