Real Expectations for Returns Going Forward

The reality of plausible long-term returns, consistent with likely investor behavior in the face of down periods, is not as great as many would think. Most investors can't take the pain of staying in during thick and thin. Consequently, they get out too late in down legs, and stay timid too long and miss important parts of up legs. The result is performance below their benchmark.

There are the shooting stars each year that double or more, and if we could pick those correctly and never make bad choices, we could become rich beyond imagination. The problem is that it doesn't happen.

Look at the most celebrated current mutual fund manager Bill Miller. He exceeded his 15-year (1991-2005) S&P 500 benchmark average 12.7 % with his 15-year Legg Mason Value Trust [LMVTX] portfolio average of 16.4%. Very impressive, but almost nobody has done that with such consistency. Others have done better in terms of total return, but not necessarily by exceeding the benchmark in each discreet year.

Looking more broadly, let's see how the "World's Best Money Managers" did for large-cap US equity (roughly the same category as the S&P 500), as published by Nelson's (part of Thomson Financial). These results include institutional portfolios, such as pension funds and separate accounts, as well as mutual funds.

First, we notice that the average 10-year (1996-2005) performance of the top 40 managers was 14.95% versus Bill Miller's 10-year 17.57% average. There were 3 of the top 40 managers who did better than Miller with returns of 18.05%, 22.67% and 26.97% (Capital Management Associates, Warwick Capital Management and Hillman Capital Management, in that order).

The chart below shows Miller's LMVTX 1996-2005 performance relative to his S&P 500 benchmark. You can see that he was consistently ahead of the market, even with the hefty 1.68% expense ratio for his fund (compared to roughly 0.10% to 0.20% for S&P 500 ETFs). You can also see that a large component of his excess return was earned in the internet bubble years.

As Miller's 10 points of underperformance in 2006 roll onto his record and 18 points of 1996 outperformance roll off his record, his excess 10-year return dwindles to 5 points (14.3% for LMVTX to 9.5% for S&P 500). In 2007, Miller will roll off a 20 point advantage for 1997 and roll on his 2007 return. Then in 2008, he will roll off his 30 point 1998 excess return and roll on his 2008 returns.

The chance of his maintaining a wide excess return over the next two years is slim. And so it is eventually with most, if not all, money managers, as they revert toward their benchmark mean over the long-term. However, let's give a superior past performance its proper recognition. Miller did great!

Shifting to a current 10-year period, including 2006, when Miller did not beat the S&P 500 benchmark (Miller 5.9%, S&P 500 15.95%), we can see [using (SPY) as a proxy for S&P 500], how a cumulative annual advantage adds up to big money in the end. As of year-end 2006, $1.00 invested and held for 10 years in LMVTX would be worth about $1.90 versus $1.00 in SPY that would be worth about $1.30 (nearly 50% more gain with LMVTX).

At the same time, we can see that setting goals to consistently "punch the lights out" is not realistic. Yes, the China ETF (FXI) went up 83% in 2006, but would you have been wise to put all your chips there? Perhaps that would be wiser than going to the casino and placing all your chips on Red Eight, then spinning the wheel, but it would not have been "prudent."

There were several indices and related ETFs that substantially exceeded the US market. It would not have been prudent to put all your chips on one, but it probably would have been wise to divide the chips and place significant bets on diverse non-US and sector bets… if only you knew in advance which would rise and which would fall, and if only you had the ability to make the correct call consistently, period after period.

Examples of great 2006 performances:

China (FXI) 83%

Spain (EWP) 49%

Latin America (ILF) 41%

REITs (ICF) 39%

Telecom (VOX) 37%

Europe Top 350 (IEV) 33%

Emerging Markets (EEM) 31%

Certainly, managers mandated to work in a particular region, style or sector could have long excess return streaks, but their mandate won't let them get out of the way when the cycle turns against them. And, apparently managers with broad mandates have not been able to do too much more than about 15% on average over the last 10 or so years according to Thomson Financial.

In summary, the US market produced a recent 10-year return in the vicinity of 10%, and the best money managers with broad mandates have produced returns in the range of 13% to 18% over the same recent 10-year period.

We would conclude that unless you are a major risk taker, a minor genius, and incredibly consistent, you should plan on a range of 9% to 15% with a tendency toward 10% for your own investments.

Disclosure: author owns SPY, FXI, EWP, ICF, EEM