When analyzing the performance of money managers, the industry standard assumes a single investment is made at the start of period and that no additional deposits or withdrawals are made. Cash flows in or out of an investment are assumed to be outside of the control of a portfolio manager, and therefore shouldn’t be used to judge the effectiveness of a portfolio manager’s investment skills. This methodology is known as time weighted returns.
However, when analyzing the suitability of an investment for an actual individual, how realistic is it to assume that the investor makes no contributions or withdrawals over a span of five, ten, or twenty years? In the real world, most investors are either in the accumulation or distribution stages, where contributions or withdrawals are indeed occurring. How much can cash flows impact the financial well-being of an investor?
Tackling the Distribution Challenge
In this example we will consider an investor with a starting portfolio value of $1 million and invested between January 1st, 1998 and December 31st, 2014. We explore three investments alternatives, namely:
- The broad U.S. equity market, as represented by the S&P 500 Index
- The average target date fund positioned for the time frame of 2000-2010. Such a portfolio is designed for an investor at or near retirement during the time frame analyzed
- The Swan Defined Risk Strategy Select Composite.
In the first case, we assume a single investment with no cash flows; the standard, sterilized time-weighted return analysis.
Source: Zephyr StyleADVISOR, Swan Global Investments
In the above case, because all have positive average annual returns over the 17 years and no withdrawals are taken, the ending value of the investment is significantly higher than the initial investment.
Withdrawing Income Changes the Picture
But what if the investor is retired and in the distribution stage? What if the investor takes out $50,000 at the end of every year and grows that by 3% a year to account for inflation? What impact would that have on the investment?