In his fantastic book ‘The Little Book of Common Sense Investing’ John Bogle, the founder of the Vanguard investment group, highlights the importance of truly understanding the numbers when fund management groups publish their fund performance figures.
Bogle refers to investment companies’ habit of presenting time-weighted returns based purely on the change in the asset value of each fund and points out that the returns actually earned by the average fund investor is often much lower. To get a true reflection of the returns achieved by an investor, consideration must also be given to the money-weighted return which takes into account the flow of capital in and out of the fund by investors putting money in and taking money out. (As you may know already – money tends to flow into most funds after good performance has already been achieved and goes out when mediocre performance follows.)
To illustrate his point Bogle undertook a review of returns achieved by the S&P 500 Index (an index comprised on the 500 leading companies from industries in the US economy) covering the period from 1980 to 2005. The research showed that during these 25 years an S&P Index fund provided an annual return of 12.3% whilst the average equity fund achieved an annual return of only 10%. To make matters worse, after money-weighted returns are calculated, the average investor received only 7.3% a year.
The figures show that $10,000 invested in the index fund during these 25 years would’ve grown to $170,800 whereas the average equity fund achieved only $98,200. However, the average investor faired worst of all, receiving just $48,200 – a paltry 28% of the return of the index fund. So the investor provides 100% of the money and takes100% of the risk and receives just 28% of the index value. Does this sound like a fair deal to you?
Please don’t be fooled into thinking these principles only apply in the US. Lukas Schneider of Dimensional Fund Advisors specifically researched this issue in the UK with similar findings to Bogle. The research covering 1992 to 2003 showed that the FTSE All Share Index (an index representing approximately 98% of the market value of UK companies) delivered an annual return of 8.99% whilst the average fund active in this sector returned 6.93%. When money-weighted returns are factored in the results are even more alarming with the average investor receiving just 4.91% over the same period.
Putting these figures into context reveals the staggering gap between the performance figures reported and the returns actually achieved by investors. Assuming an investment of £200,000 in 1992 the index would have grown to around £562,000 by 2003 whereas the money-weighted return would have provided the average investor with a figure of around £356,000 – an astonishing deficit of £206,000 over the same period. How many years will it take to catch up? How many years will this postpone your ideal lifestyle?
So, the next time you’re given performance figures make sure you’re told if the investment returns are time-weighted or money-weighted. It pays to know the difference!