Portfolio Versus Manager PerformanceThe purpose of this section is to explain the factors influencing the return on investment and to provide a reference to our clients in order for them to passs judgement on the return for a given period. Return on investment functionThe return of an investment portfolio is the rate by which it has grown over a given period. A portfolio of $100,000 on January 1st that increases to $112,000 on December 31st yields a 12% return. A portfolio of $100,000 on January 1st that grows to $104,000 on June 30th has risen by 4% over six months, equivalent to an annually compounded rate of return of 8.2% (i.e. a rate of return of 4% compounded over two periods). Return on investment is meant to increase the value of the investor's holdings. However, this gain is only real if it exceeds two factors that diminish its effect: inflation and taxes. InflationOver time, the cost of the goods and services that a portfolio is eventually intended to purchase rises. The average inflation rate in Canada over the past 15 years has been around 3%. Simply put, something that cost $100 fifteen years ago costs $156 today. Therefore, a $100,000 portfolio invested 15 years ago, which is now worth $156,000 fifteen years later, represents no real gain as the capital available today would not purchase any more goods or services than it would have 15 years ago. As a result, in order to verify the success of a nominal return on an investment portfolio, one must first obtain the corresponding inflation rate over the period in question. For instance, an annual return of 11% obtained in the 1990s by our typical client would be compared to an average annual inflation rate of 2%, a variance of 9%. This premium is exceptionally high considering that, in the last fifty year, the annual real return has usually been in the order of 3% to 4%. Our clients' portfolios have grown at a very satisfactory pace, allowing for significant wealth creation. In other words, it is preferable to obtain a 7% return when inflation is at 3% (a net return of 4%) than it is to obtain 12% when inflation is at 10% (net return of 2%). Income TaxesThe two levels of government are privileged partners in our clients' success, often reaping almost 50% of the profits made on portfolios. Because only the after-tax portion of the return is available for consumption or wealth creation, it is important to fully understand the impact of income tax on return. As the majority of our clients are already aware, interest income, dividends and capital gains are not all taxed at the same level. For example, only 50% of capital gains are taxed compared to 100% of interest income. Therefore, a portfolio composed uniquely of interest-bearing securities that yielded a 10% annual return would have performed worse than a portfolio achieving the same return, but of which 50% was made up of common shares. Inflation and Income TaxThe following example illustrates the remarkable effect that inflation and income tax can have on the overall potential of a portfolio to generate real wealth for an investor.
After five years, the real increase in wealth, net of taxes and inflation, was only 6%, 12% after 10 years, and 27% after 20 years. Therefore, even with a real return on investment of 5.0% (a 7.5% gross return minus 2.5% inflation), which is higher than the standard for the last fifty years, the purchasing power of the portfolio has only risen by 1.25% per year. Factors influencing returnThe return on an investment portfolio over a set period depends upon two considerations: (1) the return on the various holdings within a portfolio and (2) the relative weight of each of these holdings. All portfolio managers structure their clients' portfolios according to one model or another. The Dalpé-Milette Group uses the following simplified format:
The overall performance of a client's portfolio depends on the individual performance of each security within categories 1 through 5 and on the relative weight that each category has within the portfolio. For instance, if fixed income securities grow by 8% in a year and equities grow by 13% and if the proportion between the two is 60% / 40%, the annual return on the overall portfolio will be 10%. The structure of a client's portfolio is primarily determined according to his or her investment goals and the level of volatility/risk desired. For example, a client receiving an annuity and looking to secure regular investment income may prefer a portfolio consisting mainly of bonds. The annual return on this portfolio would be influenced to a large degree by the overall performance of fixed income securities over the period, this performance being influenced by variations in interest rate. Comparing the performance of this client's portfolio to the TSX/SPX, the Canadian stock index, would therefore not be pertinent. In this case, the DEX Universe bond index would be a much better point of comparison. In order to compare the performance of one's portfolio with other investment options, it is absolutely essential to ensure that the alternatives are compatible with one's investment goals and that they respect the desired level of volatility/risk. For example, our clients have on several occasions approached us comparing the performance of their portfolios, which they consciously chose to be conservative, with the return on an investment fund specializing in biotechnology stocks that has recently done very well. Although a conservative portfolio may indeed direct a certain percentage (perhaps 5%) to funds of this type, it would not be appropriate to compare a portfolio containing only 5% of aggressive securities with one that is composed solely of this type of investment. The same rule applies here as anywhere else: we must compare apples with apples, and oranges with oranges. The portfolio manager's performanceTo properly assess the performance of the Dalpé-Milette Group in managing your portfolio, one must compare our performance over a sufficiently long period of time (at least three years) with that of other competent fund managers who are managing portfolios with the same investment goals and with the same volatility/risk constraints as yours. This is not a simple exercise, as there are innumerable subtleties, which make the determination of investment goals and of volatility difficult to measure. Notwithstanding these difficulties, there are general guidelines that can be used to assess the overall quality of a portfolio manager such as us. We have, in fact, carried out monthly comparisons of this kind since 1990. We have even created a database to accumulate financial statistics on the performance of a wide variety of investment alternatives available to all investors. We also use information published monthly on the top performing investment funds and pension fund managers. The aim of these efforts is to evaluate both (1) our performance in managing (or in having managed) each of the five asset classes presented in our model portfolio well and (2) our success in properly weighting these asset classes yearly, according to the investment goals and the desired volatility/risk profile. A table included in each of our year-end Quarterly Letters gives an indication of the type of data we use and that is available for comparing the performance of the portfolios we manage with those of other investment alternatives. The aim of this analysis is to verify the following three points: (1) the true wealth created by the increase in portfolio value, (2) the advantages of dynamic and enlightened portfolio management, and (3) the comparative expertise of our management vis-à-vis that of other seasoned managers. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||