Most Popular ArticlesNovember 3, 2009
For our first example, let’s take an IRA investor who contributes $2,000 a year (adjusted for inflation) to the New Perspective (NP) fund starting in 1999. By the end of 2008, she would have $24,200. By contrast, if she had invested in the EAFE index, she would have $22,000 – $2,200 less.
Now let’s examine a period of saving and spending with the impact of taxes. Suppose a grandparent sets up a college fund for his grandchild who plans to start college in eight years. In 1999 he begins investing $2,000 (adjusted for inflation) each year into the NP fund in a taxable account starting in 1999. In years 2007 and 2008, the student takes $5,000 and $5,150 to help with college expenses. Under this scenario, the college fund in NP would be worth $10,900 in 2008, while the EAFE index would be worth $11,700. The timing of cash flows and taxes adversely impacted this individual’s wealth performance, while the performance reported by NP did not change. The timing of when over and under-performance occurs has significant impact on real world situations; whether that impact is positive or negative is simply a matter of luck.
An example of bad luck is what happened to investors of the Legg Mason Value Trust over the last three years. Bill Miller grew famous by besting the S&P’s performance for 17 consecutive years. He accomplished this feat by concentrating his stock selections in companies and industries he felt would outperform the broader market – the S&P 500. Unfortunately for him and his investors, his string was interrupted starting in 2006 by three years of significant underperformance – 10%, 12%, then 18%. His outsized bets on the US financial sector worked against him. What impact would these results have under our earlier lifelike scenarios?
In the case of our saver, an investor starting in 1999 saving $2,000 each year for ten years (increased each year to keep pace with inflation) would have $42,000 in Miller’s fund at the end of 2008. Our index investor would have $51,300. Under our save-and-spend example, the Legg Mason Value investor would have $19,200 in 2008, well short of the index investor’s $24,100. That’s an avoidable 20% reduction in lifestyle.
What’s going on when a fund can outperform the market, yet in many cases fail to deliver superior results for real investors?
As stated earlier, the uncertainty associated with the timing of a fund’s relative performance can have beneficial or detrimental impact on an individual’s investment plan, depending upon how his or her cash flows (saving, spending, or holding) line up with the fund’s results. It is this degree of risk that an active manager adds beyond market performance that often goes unconsidered.
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