The attention to the fiduciary responsibility of pension plan sponsors has escalated over the past few years as the bear market uncovered weaknesses in the selection of active money managers. Performance still counts, but plan sponsors must now be more vigilant in measuring the value a manager adds given the risk the manager assumes, and merely looking at historical returns or an average of those returns is not sufficient. There can be too much variability between the data points just to look at the averages and variability affects returns over time. What every plan sponsor, and investor, should require from an active manager is a return above a selected benchmark index, but with low volatility or risk. Reduced volatility boosts the power of compounding on rates of return, and compounding causes money to grow exponentially over time. A simple example showing a $100 investment with a 10% average return per year for three years from, from a Market Index and an Active Manager is instructive.
| Market Index | Active Manager | |
|---|---|---|
| Return Year 1 | +30% | +15% |
| Return Year 2 | -10% | +5% |
| Return Year 3 | +10% | +10% |
| Average Annual Return | +10% | +10% |
| Total Compounded Value after 3 Years | $128.70 | $132.83 |
Suppose this same 3-year "average" performance scenario was repeated for a total of 15 years. Although the Market Index and the Active Manager each provided an "average return" of 10% annually, the Market Index would generate a total value of $353.10, while the Active manager would create a total value of $413.42. This represents a 23.8% increase in value added by the Active Manager.
| Market Index | Active Manager | |
|---|---|---|
| Total Compounded Value after 15 Years | $353.10 | $413.43 |
Compounding Returns with Low Volatility: Furthermore, when low volatility is combined with addition of excess return (alpha) an even more powerful effect on compounding occurs. Suppose the Active Manager added a net 2% of excess return per year with no increase in volatility. The average return would be 12% and over a 15 year period the Active Manager would create a total value of $541.92, a 74.6% greater value compared to the Market Index as shown in the chart below.
