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Stephen Campisi, CFA Director of Institutional Investments Bank of America Merrill Lynch Hartford, Connecticut
Successful portfolio management is often determined and presented according to detailed and sophisticated performance measurement methods. Clients financial goals, however, are more straightforward: generate money to spend and preserve principal. Presenting performance in a manner that addresses clients true goals can strengthen the managerclient relationship and benefit both parties.
y goal is to challenge you to look at performance from a new perspective, one that can benefit you as well as your team, your firm, and most importantly, your clients. For performance professionals, this approach is an opportunity to become a meaningful partner in the investment process. I will demonstrate how to use clients goals to determine the investment process and how to communicate success to clients. The emphasis needs to be taken off of us, our firms, and our products and put on our clients and their goals. Instead of focusing on returns and the complexities and details of calculating returns, we should emphasize the income that the portfolio will provide to the clients for their goals. Additionally, clients are more likely to value you when your product is presented as an integral part of their overall portfolio strategy and not simply as an isolated product.
of living expenses, savings for their childrens college tuition or for retirement, or an inheritance or a charitable donation. Institutional clients include insurance companies, pension funds, and charitable organizations. Insurance companies collect premiums, invest them in a portfolio, and then spend money from that portfolio to pay benefits or annuities. Pension funds withdraw money regularly and pay it to the retirees who are living on that money. Charitable clients include endowments and foundations. Endowments tend to be not-for-profit organizations with a pool of money devoted to one beneficiary, such as a hospital or college. They spend routinely from the portfolio to help cover operating expenses. Foundations are not-for-profit organizations that make grants. They withdraw money from their portfolios and use it to fund such worthy causes as education and health care. These clients are vastly different from one another, but they have one thing in common: They all spend money from their portfolio. Benjamin Franklin once said, The value of money is its usefulness. Portfolios are not ends in themselves but means to an end. Our job is to help accomplish that end with our clients through our investment practices. Although cash distribution is a primary focus for clients, standard financial theory assumes that money is never taken out of a portfolio and that all proceeds are reinvested in the portfolio. Financial theory assumes a single, long-term holding period, and meanvariance optimization relies on this assumption. But correlations do not remain constant, variance does not stay the same, and clients do withdraw money from their portfolios, period over period. That spending changes everything for portfolio managers. Cash flows are usually viewed as having a negative effect when evaluating portfolio performance. For clients, however, the portfolio exists to meet their first goal, which is the ability to withdraw cash and
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use it purposefully. Portfolio spending can be viewed as a liability, a stream of payments that may be estimated in terms of amount and timing. Additionally, portfolio spending must keep up with inflation. The second client goal is that the portfolio continues to perform well, year after year, generation after generation. Meeting this goal means that at a minimum, the original principal value should be preserved net of spending and inflation. Endowments, foundations, and other institutions generally have a perpetual time horizon. Individuals can also have long investment horizons; income beneficiaries rely on spending from the portfolio, and heirs or remainder beneficiaries rely on principal preservation or growth.
The portfolio is now worth $65. Although it seems a return of about 50 percent is needed to break even, two years of inflation must be factored in to recoup the original portfolio value in real terms. A return of 63 percentalmost twice as much as in the original exampleis actually needed when accounting for spending and inflation. The Order of Returns. Spending is also significantly affected by the order in which portfolio gains and losses occur. Consider three annual returns of plus 10 percent and three annual returns of minus 10 percent, and factor in spending of 5 percent each year. In Scenario A, the positive returns come first and are followed by the negative returns. In Scenario B, the negative returns come first, followed by the positive returns. In both cases, $100, net of spending, becomes $70. But in Scenario B, spending is 25 percent less than in Scenario A. The order of returns does not matter when money is not spent from a portfolio, but it does matter when spending is the goal. Performance Analysis. Performance measurement began with simple absolute return methods. It evolved into relative return analysis when portfolio returns were compared with market benchmarks, peer groups, or style-based benchmarks. Today, returns are often adjusted for various types of risk, such as volatility risk, market risk, or more complicated risk measures (e.g., downside risk relative to a target return of the client). Attribution analysis details why a portfolio outperformed its benchmark. Following is a review of a portfolio using some traditional methods of performance analysis. Table 1 presents the return results of a real portfolio according to traditional quantitative performance analysis. The benchmark returned an annualized 7.98 percent. The portfolio earned 8.05 percentan excess return of 7 bps with slightly lower volatility. The portfolio and market returns are highly correlated at 0.97, and the beta of the portfolio is 0.93, which means the portfolio has 7 percent less market risk than the benchmark portfolio. Adjusting Table 1. Quantitative Performance Analysis for 19922009 of the Sample Portfolio vs. a Benchmark
Portfolio 8.05 10.82 0.97 0.93 0.38 0.40 0.38 Benchmark 7.98 11.26
Measures Traditional (time-weighted return) Risk Correlation with benchmark Beta to benchmark Alpha Sharpe ratio
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the alpha for market risk gives 38 bps of riskadjusted excess return. The Sharpe ratio confirms a better payoff for the risk assumed. This state-of-the-art performance analysis suggests that the portfolios performance has been adequate. Yet, when performance is viewed in terms of the clients spending and principal preservation goals, this portfolio performed exceptionally well. The reason for this disconnect is because traditional analysis fails to measure the clients goals or consider the clients definition of risk. Performance Returns. Two types of performance methods are generally used to measure client returns: the time-weighted return and the internal rate of return (IRR). The time-weighted return, often considered the gold standard in performance returns, measures the return on a single sum invested for the entire performance period. It does not account for cash contributions or distributions; it simply links returns together, whether the returns were based on a large asset base or a small one. It is the perfect method for measuring the return on an individual product, but it is not good for measuring the return on a portfolio with a spending objective. The internal rate of return, or money-weighted return, reconciles the beginning portfolio value and any cash flows with the ending portfolio value. It is useful for measuring an actual portfolio return, but it is still incomplete because it does not measure how much money the portfolio generated relative to how much money the client needed.
of 8.04 percent. The portfolio had 1 bp of excess return. But the portfolio did not simply meet its goal; it actually exceeded its goal. By examining the cumulative amount of spending planned versus the actual amount of spending achieved, the result is that for every $100 the client hoped to spend, it spent $113. And the principal grew by more than 5 percent. The 1 bp of outperformance shown by the time-weighted return ignores the spending success. Figure 1 shows the rolling seven-year returns of the foundations portfolio. The dotted line that hovers around 8 percent is the target return, which is the amount needed to cover annual inflation as measured by the Consumer Price Index (CPI) plus 5 percent spending. The black line is the portfolios returns. From mid-2002 through 2009, there was no period in which the portfolio came anywhere close to meeting its target return, yet this period is when the portfolio had its greatest success as measured by the amount of spending. Table 2 shows the portfolios returns on an annual basis. Years 19921999 are what I call the fat years, in which the returns are generally substantially higher than the target returns. Years 2000 2009 are what I call the lean years, in which the returns are devastatingly below the target returns. For 20002002, the cumulative return of the target was nearly 27 percent; during this period, the portfolio lost 7 percent. In 2008, portfolio performance was even worse and lagged the target by more than 3,400 bps. How was the great success possible during this time period? Goal-Based Results. During those fat years, the portfolio was generating extra money that was reinvested in the portfolio to expand the asset base and earn even higher returns. By the time the leanyear period began, the portfolio had a surplus of 50 percent in dollars accumulated that sustained portfolio spending through periods of great stress. To review the methodology behind this performance, the target portfolio begins with $1 million and grows with inflation. The spending target is 5 percent, growing with inflation. The portfolio begins with $1 million as well. In each period, the portfolio and the target will generate a return and use it to spend from, and the remaining value will earn the next periods return. Any contributions or excess spending by the client is ignored so success can be evaluated based only on the ability of the initial capital to meet the stated goals. Figures 2 and 3 show the results.
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Figure 1.
Rolling Seven-Year Returns of a 70/30 Portfolio vs. CPI plus Spending, December 1998December 2009
Percent 16 14 12 10 8 6 4 2 0 12/98 12/99 12/00 12/01 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 Target Return Portfolio Return
Table 2.
Year Fat years 1992 1993 1994 1995 1996 1997 1998 1999 Lean years 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Returns for the Sample Portfolio vs. the Target Returns, 19922009
Portfolio 12.00% 9.84 0.78 27.47 14.03 18.67 10.94 11.59 4.09% 1.15 9.77 22.60 12.42 6.51 12.88 9.97 29.2 27.24 Target 8.64% 8.48 8.40 8.26 9.08 7.39 7.29 8.41 9.14% 7.23 8.09 7.31 8.47 8.64 8.14 8.83 5.16 7.79
Figure 3 shows the growth over 18 years of the original $1 million principal value to about $1.5 million as a result of the effects of 2.5 percent inflation. The surplus grew, and then two market downturns occurred. The first was the bursting of the technology bubble. The second was the leverage-induced downturn of 2008. During the latter period, the portfolios value fell significantly below the target value for the first time. But at that point, I was able to meet with the foundation and show it that it could continue spending through the crisis and that it was likely to recover its losses in time. It was subsequently able to profit from the spectacular rally of 2009, which brought them back to a surplus state. The information I communicated to the client was meaningful, but it was not complex. The client saw that the portfolio was above the target values and that it was likely to stay above by continuing the cycle of building a surplus and spending it when necessary. The Virtuous Cycle. Several factors contributed to the portfolios outperformance: a solid investment strategy with reasonable return expectations, a reasonable spending policy that allowed for building a surplus, and the investment discipline to maintain the strategy. But the most important reason for the outperformance is that these combined factors allowed for the portfolio to be managed according to a virtuous cycle of building a surplus in the fat years to sustain the lean years. Figure 4 combines the portfolios spending success and principal preservation success into one chart. The black line represents the increase in portfolio value, and the gray line represents the increase in spending. From 1994 through 2000, portfolio value increased at a dramatic rate because
Note: Target return is CPI plus 5.5 percent from 19922002 and 5 percent thereafter.
The dotted line in Figure 2 is the target spending goal, growing with inflation. It shows when the client reduced spending from 5.5 percent to 5 percent. The black line is the actual spending results. Portfolio spending closely tracked target spending initially. Once the surplus is recognized, portfolio spending is persistently above target spending. The spending is also relatively smooth, despite the historic volatility in the markets during this time period.
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Figure 2.
Actual Spending vs. Target Spending for Sample Portfolio, March 1992December 2009
U.S. Dollars 25,000 Portfolio Spending 20,000 15,000 10,000 5,000 0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 Target Spending
Figure 3.
Actual Portfolio Value vs. the Target Value, December 1991 December 2009
2,000
Portfolio Value
1,500
1,000
Target Value
500
0 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
the market returns were so strong. But because spending is based on smoothing the market values over five years, spending increased at a much slower rate, allowing a surplus to build. Figure 4 also shows how the surplus sustained spending during the lean years. In 2000, the market value of the portfolio dropped but spending increased. An even more dramatic downturn occurred in 2008. Once again, portfolio spending was maintained and even grew during this period of economic weakness and greatest need. In the aftermath of 2008, many noteworthy endowments and foundations cut their spending
and fell short of their mission. The foundation in this case study was essentially aided in its fundraising efforts because it could demonstrate to potential donors that it is a responsible steward of contributions. It was able to show potential donors that even during extreme market conditions, the foundation has a proven track record of continuing to provide such community services as lunch programs for children or transportation for the disabled. This information is much more beneficial to clients than demonstrating that the portfolio outperformed its peer group or its benchmark.
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Figure 4. Combined View of Portfolio Spending and Value vs. Target Spending and Value, December 1991December 2009
U.S. Dollars (thousands) 2,500 U.S. Dollars 25,000
2,000
20,000
1,500
15,000
1,000
10,000
500
5,000
0 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 Portfolio Value (left scale) Portfolio Spending (right scale) Target Value (left scale) Target Spending (right scale)
Communicating Results
To evaluate performance, the contributions from both active management and strategy need to be considered. Portfolio strategy provides the majority of good results, as Figure 5 demonstrates. The gray line is what the performance would have been if the portfolio from the foundation in the case study had simply been invested passively in benchmarks; the black line is the actual performance. Clearly, most of the success comes from strategy. The majority of communication to clients, however, is usually focused on the active effects. The opportunity for portfolio managers is to focus on the value that the portfolio strategy brings. Let me describe how results can be effectively and creatively communicated to clients using performance analysis that is based on clients goals. Money and Returns. Table 3 shows performance results in terms of dollars and returns for the foundations portfolio in the case study. The portfolio value at inception is $1 million, and the target value indexed for inflation is $1.56 million. If invested in the benchmark, the portfolio would have grown to $1.62 million. The portfolio actually grew to $1.65 million. The excess return over the target per million invested is about $84,000, of
which about $60,000 comes from the strategy and about $24,000 comes from active management. The spending objective was to begin with a $1 million portfolio in 1992 and spend a cumulative $1.2 million over the course of 18 years. The actual spending is $1.37 million, an excess of $165,000. The majority of this surplus, again, comes from the strategy. The combined principal and spending target is $2.76 million over 18 years. The portfolio value is $3 million, generating about $250,000 of cumulative excess per $1 million invested. This information is easily understandable as well as relevant and meaningful to the client. The concept of total return still has value, however, and Table 3 also shows the internal rate of return. This method is used because it recognizes the spending success as well as the principal growth. The portfolio achieved an annualized 8.86 percent internal rate of return compared with the 8.08 percent return of the target, an excess return of 77 bps. The 77 bps can be broken down into 62 bps from strategy and 16 bps from active implementation. The effect of the extra 77 bps on the clients goals is that about two-thirds of it went to spending and the remainder went to principal and growth. This approach links the returns to the initial capital and helps explain and attribute it in terms of source and benefit to the client.
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Figure 5.
Performance of the Portfolio, Benchmark Portfolio, and Target, December 1991December 2009
2,000
1,500
1,000
500
Table 3.
Nominal Values and IRR of the Sample Portfolio, Benchmark Portfolio, and Target for 19922009
Principal $1,562,327 1,623,123 1,646,722 84,395 60,796 23,599 IRR Cumulative Spending $1,205,825 1,343,335 1,371,362 165,536 137,510 28,026 Total $2,768,153 2,966,458 3,018,084 249,931 198,306 51,626
Portfolio Target Benchmark Portfolio Excess total From strategy From active
on a relative basis. Yet because of the surplus, the portfolio still spent above its target and the portfolio value remained 5 percent above target. Expressed in dollars, the excess over the target per $1 million for 20082009 was $70,000, most of which was in principal preservation. The dramatic plunge in the S&P 500 was an extreme event for the market, but it was not an extreme event for our client. It was reassured that even in extreme market conditions, its goals were being met and there was no need to alter its investment policy. Real Cumulative Dollar Results. Performance results based on a clients goals can also be shown in real dollar terms. The spending goal was $947,877, or about 95 percent, of the initial $1 million. The actual amount spent is 107 percent. The goal for the principal was to maintain $1 million in real terms; the actual amount is $1,054,019. These numbers can be shown as returns on a relative basis. They can also be shown in a cumulative attribution analysis relative to the target. The total excess over goal is 9.01 percent, 7.17 percent of which is from strategy and 1.85 percent of which is from active management. This percentage can be further broken down by benefit to the clients in terms of spending and principal. Current Values. Rather than showing the client all of these perspectives, I recommend reviewing the portfolio in terms of current values as shown in Table 4. The portfolio represented is worth $450 million; the target is worth $426 million. The $23 million of excess value contributed $1.2 million a
Real Annual Dollar Results. Another way to present these results is to compare the actual portfolio values and spending on an annual basis with the targeted values and spending. When viewed this way, the foundation portfolio outperformed almost 90 percent of the time, or 16 out of 18 years. On a total return basis compared with the benchmark or the target, the portfolio outperformed twothirds of the time. It is worth revisiting what happened to the portfolio during 2008, when the S&P 500 Index plummeted 37 percent. From 2008 through the end of 2009, the portfolio lost nearly a quarter of its value
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Table 4.
A Sample Portfolios Current Values, Surplus Value, and Surplus Annual Spending
Value $450,000,000 443,551,036 426,937,370
Conclusion
Presenting portfolio results in a goal-based manner can help reshape a clients perspective from focusing on individual investments and market fluctuations to evaluating the success of the entire portfolio on a long-term basis. The client is free to concentrate on being a steward of the assets instead of micromanaging the investment process and the manager. Reviewing portfolio results in this context also helps reshape the investment process. Our portfolio managers at Bank of America Merrill Lynch are focusing on being good risk managers in the context of the client. We have become goal-based managers instead of benchmark-driven managers. As a result, we are gathering more assets, managing them more effectively, and retaining more clients. It is my strong belief that performance analysis based on clients goals provides an exceptional opportunity for differentiation and a competitive advantage for investment firms.
This article qualifies for 0.5 CE credits.
Items Current values Portfolio Benchmark Target Surplus value From policy From active Total Surplus annual spending From benchmark From active
$830,683 322,448
year to additional grant making. The value of active management is $6 million more than if the portfolio had been managed passively. That difference supports more than $300,000 in additional grants. Which results would you prefer to communicate to a client: these results, or one extra basis point of time-weighted return?
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Q&A: Campisi
are able to understand these concepts because they are common sense. Most people understand that spending less than they earn allows them to save for the unexpected. Question: How can firms meet the goal of foundations that are looking for real returns of inflation plus 5 percent? Campisi: There are three ways to meet that goal over time. The first is with the right asset allocation; a simple U.S.-only, 60/40 strategy is not likely to work. The consensus view on U.S. returns in the future is that they will be more modest than historical returns. As an example, compound returns to U.S. large-cap equity were previously around 10 percent but are now forecast to be around 8 percent200 bps lower. So, consider asset classes that have higher returns and the possibility of better diversification to lower volatility, such as small caps and emerging market equity. An investor who can bear the illiquidity of private equity might earn 5 percentage points over large-cap equities to compensate for increased risk and illiquidity. The second way is through active management, which should be viewed as a risk management
tool. The real risk is not earning enough return to support spending. Increasing the active return provides another potential source of return enhancement and safety. The third way is to spend at a reasonable rate and smooth the market values over a multiyear period. The difference between smoothing for three years and five years is equivalent to about a 10 bp adjustment in the effective spending rate. The longer the time period that is smoothed, the more effectively is spending lowered. It actually produces more cumulative spending because a bigger surplus is being built. Those are three strategies to meet the goal: allocate appropriately, take active positions that you believe will help, and spend the right amount based on smoothed market values. Question: Should clients be presented with time-weighted return and internal rate of return measures or just internal rate of return along with the methodology you presented? Campisi: Both are necessary. Measuring by internal rate of return answers the question of how the portfolio capital gained or lost value. Measuring by timeweighted return answers the ques-
tion of whether the individual managers are really adding value. Question: Do you think clients will show loyalty to firms that demonstrate ethics, integrity, fair representation, and full disclosure? Campisi: I do. The essence of a fiduciary relationship is trust, and trust is rooted in ethical behavior. Striving to be ethical begins with the fiduciary duty of loyalty, which encourages managers to seek to meet clients goals and build a relationship with them that puts clients first. The question is, Will you retain clients longer when they truly understand the value you provide? I believe the answer is yes. If I were able to tell my clients that I not only met their goals but also exceeded their goals in all types of markets, rather than telling them that I outperformed by 1 bp, I believe they would choose to stay with me. Fewer reasons exist to leave this type of result because clients can see the big picture in the context of their goals. More reasons exist to leave if a manager looks just as good as everyone else based on his or her product in isolation.
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