With over 50 years of combined wealth management experience, we have unearthed a fundamental wealth management principle that, amazingly, most wealth/money managers don’t understand: the timing of when money flows in and out of a portfolio, combined with the sequence of returns, has a dramatic impact on how much wealth is created or lost.
Before we illustrate the full principle, allow us to demonstrate how most advisors and money managers sell their services.
When selling their wares, most money managers talk about a time-weighted return. For example, assume you invest $20 million. Your investment achieves a 15 percent return in year one, during which the equities market return was 5 percent. At the beginning of year two, you add another $20 million since you were so happy with the first year. And in the second year, your money manager achieves a 1.6 percent return.
Meanwhile, the equity market achieves a 10 percent return in year two. Your manager informs you that she beat the stock market by achieving an 8.3 percent time-weighted rate of return, for the two years while the equity market achieved a time-weighted rate of return of 7.47 percent for the same two years. Clearly, she is right: the time-weighted average return of your money manager is better than that of the stock market. Yet, does it really translate to more wealth for you?
You probably knew we wouldn’t have asked if the answer was yes! In this case, your wealth would have grown by $3.688 million with the money manager, while it would have grown by $5.1 million if you had just invested in the equities market. Pretty eye opening isn’t it? The moral to this story is that time-weighted rates of return can be misleading. What truly matters is your wealth-weighted return, preferably calculated after fees and taxes.
Here is a scenario that we illustrate in our newly published book “The Art Of Protecting Ultra-High Net Worth Portfolios And Estates, Strategies For Families Worth $25 Million to $500 Million” (available from Amazon.com at http://www.amazon.com/Protecting-Ultra-High-Worth-Portfolios-Estates/dp/1599326558).
An ultra-high net worth family:
- currently has $7.5 million to invest
- wishes to grow it to $20 million in 10 years
- will invest $250,000 at the end of each year
- will invest an additional $750,000 at the end of year 3
- will invest an additional $1,250,000 at the end of year 5
- will withdraw $2,500,000 at the end of year 7
Given all of the above variables, let us say that the investment grows at a fixed annual return of 8.12 percent, and thus reaches the $20 million goal on target at the 10 year mark.
However, as we all know, reality is not nearly this predictable! There are ebbs and flows, highs and lows, bulls and bears. As such, let us keep the variables above in mind, but instead of unrealistically assuming a clockwork-like growth of 8.121 percent per year, the investment:
- grows 25 percent in each of the first 3 years
- grows 8.3 percent in year 4
- grows 15.1 percent in year 5
- grows 14.1 percent in year 6
- grows 18.1 percent in year 7
- loses 10 percent in year 8
- loses 15 percent in year 9
- loses 13 percent in year 10
These fluctuating returns equate into the same average annual rate of return: 8.12. However, the end total is $19,234,851, which is $765,148 less than the example above. In other words, the annual average return is the same, but the end results are dramatically different!
It bears repeating because this concept is so poorly understood by brokers and advisors, which is why so many of them quote time-weighted returns: what ultra-high net worth families must focus on – and what we explore further in our book – is not the average annual rate of return, but the wealth-weighted return. This is the return that shows the ultimate impact on a family’s wealth at the end of each year, preferably after taxes and fees (which were not applied in the above examples).
Avoiding the Traps
The reason we drive this point home in our book is because ultra-high net worth families are, after all, human beings. And that means they can fall into the same traps as other investors, including thinking that their wealth is somehow more secure if they follow the crowd, and hand the reigns over to money managers and hedge fund managers with high time-weighted returns.
Unfortunately, this is a scenario where “safety in numbers” does not apply! According to Morningstar, at the end of the last decade 72 percent of all mutual funds deposits – about $2 trillion – was flowing into 4 and 5-star funds. And yet about 98 percent of money managers and hedge funds under-perform the market over ten years.
So not only do ultra-high net worth investors have a high chance of underperforming, they stand to potentially lose something much more valuable: their wealth and their legacy; both of which have typically taken decades, if not generations to grow.
Going forward, we hope that you will insist on seeing an evaluation of wealth-weighted returns, after taxes and fees. It is the true measure of your family’s investing and financial success!
About Pillar Wealth Management, LLC
Haitham “Hutch” Ashoo and Christopher Snyder are privileged to have worked with ultra-high net worth families, some of whom attained wealth reaching $400 million, helping them achieve a positive change in their lives and finances. They co-founded Pillar Wealth Management, LLC, an independent, fee based, private wealth management firm. As their clients’ go-to advisors, they are brought in to help with investment management, strategic planning, asset allocation, risk control, and tracking of their clients’ progress towards life-goals. Their services are provided to a limited number of clients. They only accept a new client when they have determined that there is mutual admiration and respect and only if they can add substantial value to the client’s financial life. Learn more at https://pillarwm.com. You can reach us at [email protected]