Sometimes it is a good idea to stand back from the day to day joys and fears of the markets and remind ourselves what we as investors are trying to do.
Pension fund clients are wanting to pay future pensions, without facing a large extra bill to top up the fund. Charity clients want to pay future wages for their charity, and to command more resources in the years ahead than they can afford today, so they can maintain and preferably expand their charitable work. Rich individuals want to pass on a fund which has grown in real terms. They may want an income from their investment that rises by more than prices over their lifetimes.
That is why, if asked, we suggest clients look at the returns we help them achieve against a real return index. If your fund, taking one year with another, is growing by 3-5% real, that means your fund is growing faster than wages. If you can sustain returns like that the pension fund will be able to pay the pensions, the charity will be able to do more and the rich individual will be able to live well and pass on a good inheritance to the next generation.
In practise many clients want to feel they are doing better than this when markets are strong and rising, whilst many investment managers will want to warn clients that in bad years in markets they might have a negative return as many managers do not try to protect capital in a downturn. This has led to both sides often using measurement of an investment fund related to how markets are doing rather than to what is happening to the liabilities the fund is designed to meet.
This year may prove to be a stiff challenge to both client and investment manager. We are not expecting large gains in most markets this year. The headwinds of rising interest rates, worries about inflation, damaged banks, the need to rein in monetary excess and the rolling sovereign debt crisis are likely to limit the upside. Returns on client funds are fast approaching the 3% real level for the whole year in just the first three months. I doubt, however, that clients would welcome locking the gains in and parking all the money in cash, as there is enough optimism around to want to stay invested. Last year we could have locked in a 5% real return well before the year end, but clients are doubtless glad we did not, as markets made rapid progress thereafter.
The best advice I can offer on performance measurement is to keep in mind all the time the absolute rate of return you need to keep your fund ahead of its liabilities, and to be realistic about how high a rate of return you can earn. In the end rates of return are related to the growth rates of the underlying economies. We look at income levels and growth in income. Worldwide shares are currently offering under 2% by way of an initial income, which does not give you a lot of protection as interest rates and inflation rises. Rates of return in the credit boom of 2002-7 are not likely to be repeated in western debt laden economies. Eastern faster growing economies should produce higher rates of dividend growth, which is crucial to justifying current low share yields. Property income levels still seem to us to offer a better prospect, with a higher initial yield and reasonable growth prospects in many centres of the world.
By all means look too at how well the managers run the portfolios against market indices and other benchmarks, but remember that outperforming by losing less than the market does not pay future bills.