We should pay more attention to the gap between what a fund earns and what an investor makes. Dr Benjamin Holdsworth on why percentages are important.
In the investing world, there are some quirky mathematical outcomes that are worth remembering.
The first is that if an investment goes up 100%, it only has to go down 50% to get back to where it started.
And the second is that if an investment goes down 50% it has to go back up 100% to get back to where it started. It may seem obvious but it is useful to keep in mind.
The past two years have given us quite a few live examples of this maths in action, including Cathie Woods’ innovative technology fund ARKK, an actively managed Exchange Traded Fund (ETF).
ARKK posted a stellar return of around 200% from the start of 2020 to February 2021. Cathie Woods quickly became the darling of US financial media and TV shows.
A bit disappointed
If we compare that to a more typical robust, diversified portfolio comprising 60% in global equities and 40% in higher quality bonds, which returned in the region of 8% over the same period, we may feel a bit disappointed.
Yet 8% is actually a good outcome, given that in the first quarter of 2020 the markets fell substantially on the back of the pandemic. (See figure 1 below)
If we roll on from the ‘peak’ of ARKK to 12 March 2022, we can see the asymmetry in percentage returns in action. ARKK has lost over 60% and is now almost back to where it started the period, despite its 200% rise. (See figure 2 below)
Over the whole period, ARKK is up 13% and the global balanced portfolio is up 9% (nine), so not much to choose between the two, or is there?
As we have counselled before, there are two sides to the investment coin. One is return and the other is risk. Over the whole period, the ARKK fund is almost four times more volatile than the global balanced fund, which makes it inherently harder to live with.
The other useful lesson to take from this example is that most of the stellar performance occurred when the ARKK fund was relatively small. The 200% performance quoted above assumes that a lump sum was invested on 1 January 2020 and held for the period under review.
Yet the fund only became popular once the bulk of the rise had already happened. A large component of investors’ money was invested at or near ‘peak’ ARKK and has suffered the bulk of the subsequent fall.
Morningstar – a reputable, independent fund research house – has estimated that in the three years to 31 December 2021, the total return (relating to a lump sum invested at the start of the period, otherwise known as a time-weighted return) was around 35% a year in US$ terms.
On the other hand, if fund flows are accounted for, the average investor generated a return somewhere in the region of 10% a year, known as the investor or money-weighted return.
This 25% or so annual difference between what the investment returned and what the average investor gets back, is sometimes referred to as the ‘behaviour gap’.
Sometimes the ‘tortoise’ investor can feel left behind, but the diversified nature of their portfolio across markets, sectors, companies and other asset classes such as bonds, results in a much smoother journey to their destination.
The highs may not be so high but the lows take less recovering from, reining in the ‘hare’ investor.
This should encourage tortoise investors to stay invested. The mathematics of percentages in investment returns may be quirky, but it is important.
Dr Benjamin Holdsworth (right) is a director of Cavendish Medical, specialist financial planners helping consultants in private practice and the NHS
The content of this article is for information only and must not be considered as financial advice. Cavendish Medical always recommends that you seek independent financial advice before making any financial decisions.
Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. The value of investments and the income from them can fluctuate and investors may get back less than the amount invested.