Incremental Value (Part 3)

Last time I presented some initial calculations to determine the incremental value I might provide to an investment adviser (IA) as a result of trading outperformance.

To isolate the impact of outperformance, I reran the analysis assuming 10% (rather than 6%) annual returns without me and 11% or 12% (rather than 7% or 8%) returns with me. Invested as previously described, $1M now becomes $8.86M, $11.11M, or $13.91M, respectively, over 25 years. The incremental value to the IA is now $110K or $240K for 11% or 12%. In splitting the difference I would earn $55K or $120K over that time.

Interestingly (to me), although outperformance is important, absolute performance plays a more significant role. Outperformance is identical on a gross basis in both simulations (1-2%). On a percentage basis, 7% or 8% vs. 6% is a 16% or 33% increase whereas 11% or 12% vs. 10% is a 10% or 20% increase. The significantly larger percentage increase is accompanied by a roughly equal ratio of incremental value share [($63K / $29K) = 2.18 ~ 2.17 = ($120K / $55K)] whereas the incremental value itself is almost double that for the 10%-12% versus the 6%-8% scenario.*

Note a similarity in calculated numbers for my share. I would earn $63K (over 25 years) by returning 8% instead of 6%; I would earn $55K by returning 11% instead of 10%. I would prefer a conservative estimate and project 2% outperformance over 11% returns. I can comfortably imagine annual returns of 11%, though. I will also do quite well when the overall market is moving moderately higher. While I will [profit but] underperform when the market is screaming higher, history has not presented many such episodes (e.g. second week of March 2009 onward and following the 2016 presidential election). I almost want to say that I can comfortably imagine 2% outperformance and 11% returns per year.

Past performance is no guarantee of future results. Time, as always, will tell.

I think outperformance would provide more value to an IA than higher absolute returns. It’s great if the IA makes 13% one year unless the benchmark returns 14%. One case where I think outperformance might not be good would be when the IA loses money for clients. Being down less than the benchmark is a marketable accomplishment, but clients may still be upset. Hopefully a conversation about the importance of minimizing drawdowns would correct their perception.

Next time I will talk more about my cut.

* If you are someone who spends modest time doing daily computation then you might be laughing at me just now for a failure to recognize basic arithmetic properties. Admittedly, I am a bit rusty with the mathematical proofs but believe you me, I still crunch numbers quite well!