Investors should set objectives and measure investment success using their level of wealth rather than total returns, the 300 Club believes.
A paper written by 300 Club chairman and Coal Pension Trustees Investment CIO, Stefan Dunatov, has argued that focusing on the total amount of return rather than the effect of compounding on wealth, will compromise how successfully an investor achieves their investment objective.According to Dunatov
(pictured), it is crucial to consider the path that investment returns take because one path might experience strong returns at the start while another might experience them towards the end. This means although the average returns are the same across both scenarios, the total wealth they each generate is quite different because of compounding, he added
(see chart inset – click to enlarge).Dunatov explained: “A scenario where returns are poor to begin with will have less assets to grow once a period of strong returns arrives. The compounding effect is therefore less powerful than it would be for a fund that enjoys strong returns at the start of the period.”The paper referred to the example of a closed £1bn defined benefit scheme which needs an average real required rate of return of 2% a year to pay pensions over the next 10 years.“Assuming the fund has the same annual outflow over the next 10 years, there will be exactly the right amount of money to meet all its payments,” Dunatov wrote. “Poor performance early on may result in the fund not being able to make the pension payments towards the end of its expected life as the strong performance years will be working on a smaller pot of assets. Strong returns early on may, by contrast, result in the fund having more money than it needed.”He added: “The message is that total returns are insufficient for the purposes of achieving the right objective and measuring how we meet that final objective. Overall wealth is a key metric for success, not just the amount of returns.”However, Dunatov said returns do still matter because they are what will deliver the required levels of wealth – and are used to judge the extent of the risk being taken in achieving an objective.He said: “Investment returns provide valuable information, but they do need to be seen within the context of a wider framework.”Dunatov
first told portfolio institutional about this idea of using wealth to set investment objectives in September last year.The 300 Club is a group of leading investment professionals from across the globe with a mandate to challenge the investment industry and investing practices.
