The Business Times, Wednesday 21 March, 2007
A closer look at net investment
returns
Realised capital gains are a poor gauge of performance and don't
make for good criteria for the drawing of returns from our foreign
reserves
, says JOSEPH CHONG
AS part of the process of drawing a larger
percentage of returns from our foreign reserves, there is a need to
provide a constitutional re-definition of net investment income
contribution (NIIC).
The initial cut has been to define it as a function
of 'realised capital gains'. However, as mentioned in Parliament
recently, realised capital gains are inherently volatile year to
year. I could not agree more. I believe that it is good to draw a
bigger percentage of returns from our foreign reserves in a stable
manner annually but making it a function of 'realised capital gains'
may not be the way to do it.
The level of realised capital gains is often a poor
gauge of the true economic performance of any investment portfolio.
The following example is illustrative of the problem.
The table shows a portfolio with two securities
(Dell and Google), which illustrates the problem with 'realised
capital gains'.
US$1 million was invested on Jan 3, 2006 in two
stocks. Of the money, 80 per cent went to Google and 20 per cent to
Dell. After one year, the portfolio had appreciated by more than 100
per cent - a very good performance indeed.
This notwithstanding the loss of about US$78,000 on
Dell that was realised and the proceeds left as cash to await better
opportunities. If realised capital gains were used as the yardstick,
we would have nothing to draw from this portfolio although it has
appreciated by over 100 per cent!
Portfolio 2 is the
reverse of Portfolio 1. Again, this portfolio has two securities -
Dell and Google again - but with different weightings.
US$1 million was invested on Jan 3, 2006. This time, 20 per cent went
to Google and 80 per cent to Dell. After one year, the portfolio had
depreciated by 3.2 per cent. This notwithstanding the gain of about
US$277,000 on Google that was realised and the proceeds left as cash.
If realised capital gains were used as the yardstick, we would have
US$277,000 to draw from this portfolio although the portfolio has lost
more than 3 per cent in value! Again, realised capital gains have been
a poor indicator of the performance of the portfolio.
The danger is, because of national budgetary requirements, fund
managers might be pressured to take profits when they should be
letting their winners run. Indeed, the reverse of this, taking capital
losses to offset other taxes, is an annual event in the fourth quarter
in the US - an occurrence which we have been profiting from on behalf
of our clients.
Similarity: The drawing of returns
from our foreign reserves is similar to retirement portfolio mandates.
Indeed, most of these retirement mandates which we manage have the
requirement to at least preserve the nominal value of the initial
portfolio. The drawdown is either based on a percentage of the total
annual returns or a percentage of the value of the portfolio, which is
the more stable approach. However, in no case are realised capital
gains used as the yardstick for drawing down funds.
Ironically, we are quite happy to realise losses as we use the
drawdown process as a regular opportunity to spring clean and
streamline portfolios, making a good thing even better.
Solution: The solution clearly is to avoid realised capital gains
altogether. I would suggest that we keep it simple and effective. I
believe we should either stipulate the drawdown as a percentage of
total annual returns (income and capital gains) or, better still, as a
percentage of the total value of the portfolio.
Indeed, this would not be dissimilar to what Harvard University aims
for its endowment (which is a collection of 11,000 mandates).
According to the September issue of the Harvard Gazette, the
university aims to spend 5 per cent of its endowment on the various
programmes.
The writer is CEO of financial adviser New
Independent. He welcomes feedback at : josephchong@ni.com.sg
