It is standard practice to report performance on the assumption that dividends and interest earned are reinvested. The objective is to make it easier for investors to compare performance to help inform their investment decisions. However, not reinvesting dividends and interest and drawing an income can have a significant impact on long-term investment outcomes. This means performance can, in fact, be quite misleading.
The standardised approach to reporting performance aims to help investors compare funds
The reason for reporting investment performance on the assumption that dividends and interest earned are reinvested is two-fold:
- Pre-retirement investors, which form a large part of the market, are reinvesting tax-exempt dividends and income.
2. In the case of investors who have already retired and are drawing an income from their savings, the investment manager cannot be responsible for the timing of cash flows and withdrawals.
The argument is that reporting performance as if dividends and income are reinvested enables investors to compare the performance of a variety of funds on a like-for-like basis.
Comparing performance for pre-retirement investors versus pensioners deliver different results
Even though common practice, this way of performance reporting can be misleading. In addition, pensioners, who rely on their savings for an income and no longer contribute to their investments, are most negatively affected by this way of thinking and investing.
Comparison one – dividends and interest reinvested (pre-retirement investors)
To illustrate this, Figure 1 shows the performance of the following three portfolios over a 20-year period, starting in August 1995 with the introduction of the FTSE/JSE All Share Index, assuming dividends, interest and coupons were reinvested:
- South African equities,
2. South African vanilla bonds, and
3. a typical low-equity balanced fund with 25% exposure to South African equities, 15% to offshore equities, 10% to offshore bonds and 50% to South African vanilla bonds.
Let’s assume an initial investment of R100 for all three portfolios. Figure 1 shows that the all-equity portfolio value with dividends reinvested would have grown from R100 in August 1995 to approximately R2,000 in 2015. The plain vanilla bond portfolio with coupons reinvested would have grown to approximately R1,250. The balanced portfolio would have grown to approximately R1,650, outperforming bonds but underperforming the all-equity portfolio. In other words, if you were saving towards retirement you would have been best off investing in the equity market and reinvesting dividends in the equity market.
Comparison two – drawing an income (pensioners)
Although it would be easy to conclude that the same result would apply to an investor that retired in 1995, this would be wrong. Figure 2 shows the performance of the same three portfolios with an initial investment of R100, but with the following adjustments:
- The investor withdraws R6 as income for every R100 invested.
- The investor’s income requirement grows by 6% every year, which is more or less the inflation rate over this period.
- The investor withdraws this income in equal instalments every month (i.e. 50c per month).
Figure 2 shows that there is now a much smaller difference in the investment value of the all-equity portfolio (approximately R890) and the low-equity balanced portfolio (approximately R860) after 20 years. In addition, if the investor increased the first withdrawal in 1995 to R7 and maintained a 6% annual increase in income, the equity portfolio would actually underperform the balanced fund with an investment value of R700, versus R725 for the balanced portfolio.
The impact of reinvesting dividends and interest and continuous drawdowns is significant
The reason for this significant discrepancy in outcomes can be explained by two factors. Firstly, reinvesting dividends contributes substantially to returns. Between 25% and 30% of returns earned in the South African equity market since 1995 was the result of dividends being reinvested. Secondly, investors who require a predictable income flow from their portfolios are continually selling assets – even when the market is down. The equity portfolio suffered negative year-on-year returns approximately 20% of the time, while the balanced portfolio delivered negative year-on-year returns just 6% of the time, as shown in Figure 3. For investors who constantly draw from their savings this means that their assets are no longer invested in the market when/if the market recovers from a large sell-off.
Pensioners should not use standard performance as a guide for their investment decisions
It is therefore essential that post-retirement investors are invested to minimise volatility and drawdown, while seeking to earn inflation-beating returns. Evaluating reported investment performance, which assumes dividends and interest are reinvested, may not be a helpful guide to inform this decision.