Is There a Better Way to Measure Fund Performance?

Morningstar's John Rekenthaler makes a compelling case for switching the industry standard to measuring projected income rather than total return

John Rekenthaler 5 November, 2014 | 2:48PM
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BlackRock dropped by our Chicago headquarters earlier this week to discuss its new solutions-based funds. "Solutions-based funds," meaning funds such as target-date or managed-payout that describe themselves in terms of goals rather than what asset classes they hold, are the new black of investment marketing. In using that language, BlackRock is far from alone.

Its effort, though, is unusually ambitious. BlackRock aims not merely to offer funds that carry a different label but also to overturn the foundation of performance measurement: scoring funds by their total returns. The company argues that for investors approaching (or in) retirement, the better way to think about progress is the growth (or shrinkage) of projected income.

This might strike you as a tautology. After all, if projected income is calculated by multiplying an investor's current assets by a fixed withdrawal rate (say, 4%), then any change in portfolio value will lead to a corresponding change in projected income. That is, if the portfolio gains 5%, then the income that can be generated from that pool will also grow by 5%. So, how is projected income anything more than total return restated?

Two differences.

One, BlackRock uses a floating rather than fixed withdrawal rate. It gears the rate to current annuity quotes, so as market rates fluctuate, BlackRock adjusts its calculations accordingly. Thus, a portfolio with a perpetually flat total return would nevertheless see its projected income shift each year as annuity quotes change.

Second, the calculation also moves with investor age. In going through BlackRock's materials, I was initially taken aback by its example of a 58-year-old investor with a $650,000 portfolio who was projected to have $42,071 annual income from her investments at retirement. Mental maths said, "5% of $650,000 is $32,500, BlackRock is showing a lot more than $32,500 available, what's up with that?" The answer: With an expected retirement age of 65, this investor has seven more years with which to grow the portfolio's value, to the point where it can sustain the forecast $42,071 annual withdrawal.

That makes three moving parts for projected retirement income--a) the portfolio value (that is, conventional total return), b) annuity rates, and c) the time remaining to retirement.

With three levers in operation, it's quite possible for a fund to succeed according to total return but fail as measured by projected income. If annuity prices rise significantly and/or the fund's gain is less than what BlackRock baked into its annual calculation, then projected income may decline even as the fund's net asset value increases. The fund might have enjoyed a good year for total return--as well as in Morningstar's star-rating system--but its shareholders lost their income ground. 

The reverse could also occur. An apparently unsuccessful year could end up boosting retirement income. If annuities become cheaper, so that the investor can purchase more annual payout for the same portfolio amount, then projected income might improve even as the fund's NAV declines.

Projected income is a concept whose time has come. Most investors struggle to relate the numbers on their fund statements to their goals--particularly when the task is the large and long one of retirement. I am 31 years old (hypothetically only!) and have $43,000 accumulated in my workplace pension and ISA accounts. What does that amount mean for me when I am 65? Or 70? The answer is neither intuitive nor easily obtained on the back of an envelope. Show me what annual retirement income those savings might be able to generate, and now I have something I can work with.

Communicating through projected retirement income, I believe, also makes it easier for investors to abide by their plan. Under the current system, delaying saving in a workplace pension in order to buy a new car causes little mental pain--which is why so many young investors do just that. Doing the same thing with a projected $3,200 of annual retirement income would seem to be harder. Reframing pension plan balances as projected income could assist in improving aggregate investor behaviour. 

Actually, I am pushing this concept further than BlackRock does. BlackRock advocates switching from an accumulation-oriented, dollar-balance presentation to showing projected income as the investor nears retirement, during the mid-50s. For me, though, there's no reason to wait. Start showing projected retirement income--and training investors to think that way--from the first investment date. Do it on fund company websites, in pension plan statements, in ISA tools.

Such presentations would supplement rather than replace total return. Projected retirement income is superior to total return for conveying to investors how they are progressing towards their goals, but it's not much use for measuring a fund's quality. After all, in a happy market, almost every fund will grow its projected income. Conventional measures such as total return, alpha and peer rankings will still be used to judge which funds are deserving, and which are not.

Obviously, BlackRock alone cannot possibly effect this change. If projected income is to become a standard, it must be adopted widely across the industry. This cannot be properly done company by company, as the calculation is not standardised; thus, each company will give slightly different results for the same investor situation. For projected income to take hold, it needs to be supplied by an independent research firm.

All right, I will see what I can do about that.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.

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