Risk, costs, and returns in CPF Investment Scheme Funds
Our previous post, What does Risk do to your Investment Returns? – Is there a Free Lunch? looks at how taking higher risk to achieve higher investment returns can backfire. This is because the higher volatility of riskier investments create a drag on investment returns. This drag on returns may not show up in favourable economic conditions, as the yearly average returns have minimal fluctuations. However, volatility is always lurking around the corner, and can bite the investor at the worst possible time. Not convinced? Just ask two storied investors, Victor Niederhoffer and Julian Robertson of the Tiger Fund.
Victor Niederhoffer is a former American squash champion and the father of Statistical Arbitrage. Moving from academia to hedge fund management, he did so well that George Soros had his son learn from him! In 1998, due to the market volatility of the collapse of Long Term Capital Management, he had to close his fund. In the process, he even had to mortgage his house and sell his antique silver collection. He started another fund later, but was again forced by the market volatility in 2008 to close as well.
Julian Robertson is another contemporary of George Soros. He founded Tiger Management, turning US$8 million of capital in 1980 into US$22 billion in the 1990s. But it was forced into closure in 2000 due to the volatility of the yen. It is said that the fund lost more in that episode than it ever made for investors over the 18 year before that!
So the drag on returns due to volatility is not theoretical, and risk can be right around the corner. Which is why risk management is always more important than picking multi-bagger investments in the long run.
Risk an return in real life
Previously, we show how we can compute the drag on returns due to volatility. We also show how this affects the returns compared to the rock-steady and risk-free CPF returns. But does it work in real life? To answer this, let’s look at the risk, costs and returns of CPF Investment Scheme funds, which we can invest in using our Ordinary Account savings. These also have a long term record, which we show in the table below:
5-year Annual Returns of CPFIS Approved OA Funds
From this information, we compute the average annual returns over the past 5 years (just averaging the returns of each year), and the compound annual returns over the whole period. The “Difference” column shows the Average Annual Returns minus the Compounded Returns. It shows that the compound returns are always lower than the average returns, as predicted.
Average and Compounded Returns of CPFIS Approved OA Funds
In the last 2 columns of the table above, we also compute the volatility of the fund over the last 5 years, and the predicted drag on the returns due to this volatility. Recall that with an annual return of x% and a volatility of y%, we get an annual compounded return of:
Compare the columns “Difference” and “Predicted Difference”. We see that the actual drag on returns in reality are roughly 75% of the prediction using our formula above. Not too bad! Perhaps the value-add of the fund manager is to mitigate the drag on returns, although they not able to offset it completely.
Risks and Costs and Returns
But the fund manager is well paid for mitigating the effects of risk! Looking at the CPFIS approved OA funds, the average expense ratio of the funds is 1.75% pre year. That means we pay the managers 1.75% out of the returns for managing the fund. Of course, part of the expenses are for brokerage, which we cannot avoid even when we DIY our investments. So, to be fair, let’s assume that the true management cost is 1.50% instead.
How does risk and costs affect our returns on our investments? As before, we show this in the chart below for a lump sum investment of $100,000 over 30 years.
Effect of risk and costs on returns over 30 years
Previously, we show that risk reduces the value of our investments by half over a long period of 30 years. Here, we see that even if the fund managers try to mitigate the risk, we will still have a returns drag of about one third of the final value due to the risks taken. But what is even more interesting is that the 1.50% annual cost of fund management over 30 years reduces our investment value by around the same value as the risk!
Often, we find that the higher the expected returns on the investment fund, the higher the risks taken and volatility, and the higher the fees for the active management. This means that the highest risk funds have the highest drag on returns due to costs and volatility.
Many of our pre-conceived notions of how much return to aim for still persist despite low interest rates. This means many investors still try to get the 7% – 10% returns on equity investments. While this may have been the norm when interest rates were higher, to achieve this level of returns now on investments means that much more risk needs to be taken.
A decent level of risks is necessary to get investment returns which can outpace inflation over time. But it is important not to go overboard in search of higher returns.
The drag on performance from higher costs and higher volatility can add up in the long term. This is especially true when we look at the risk, costs and returns of CPF Investment Scheme funds.
One of the sources of investment performance drag, which affects a lot of investors, is of course the participating funds in Whole Life insurance policies. This is the subject of a future post, so please do keep reading!