Adjusted long term return

What Is Adjusted Long-Term Return?

Adjusted long-term return is a financial metric that measures an investment's performance over an extended period after accounting for various factors that can erode purchasing power or alter the true gain. This concept falls under the broader category of Investment Performance Measurement within portfolio theory. Unlike simple nominal return, which only reflects the percentage increase in value, an adjusted long-term return provides a more realistic picture of an investor's gains by considering elements such as inflation, fees, and taxes. This adjusted view is crucial for evaluating the real growth of wealth over significant time horizons, especially for long-term financial planning.

History and Origin

The evolution of investment performance metrics has progressively moved towards more comprehensive measures beyond simple gains. Historically, investors often focused solely on the raw percentage increase of an asset's value, which can be misleading over longer periods. The recognition of factors like inflation, which erodes the purchasing power of money, became increasingly important, particularly after periods of high inflation. Academic and professional finance began emphasizing "real" returns in the mid to late 20th century to provide a more accurate depiction of an investment's success. The development of sophisticated performance reporting standards by regulatory bodies, such as those from the U.S. Securities and Exchange Commission (SEC), has also driven the need for more transparent and "adjusted" performance figures. For instance, the SEC has introduced rules requiring detailed disclosure of fund expenses and their impact on returns in shareholder reports, a measure to provide better information to investors about costs, investments, and performance¹⁶. These regulatory pushes, alongside a deeper academic understanding of true wealth accumulation, cemented the importance of looking beyond just the headline numbers to the adjusted long-term return.

Key Takeaways

• Adjusted long-term return accounts for factors like inflation, fees, and taxes to reflect an investment's true purchasing power gain over time.
• It offers a more realistic assessment of wealth growth, especially crucial for long-term financial planning.
• This metric helps investors understand if their investments are genuinely increasing their buying power after accounting for various costs.
• Calculating adjusted long-term return is essential for comparing diverse investment strategyies and asset classes on an apples-to-apples basis.
• Ignoring adjustments can lead to an overestimation of actual investment performance and future wealth.

Formula and Calculation

The calculation of an adjusted long-term return typically begins with the total return and then subtracts the impact of relevant factors. While the specific adjustments can vary, the core idea is to move from a nominal return to a real, net return.

A common approach to calculate the inflation-adjusted return (or real return) is as follows:

To further adjust for fees, these are typically subtracted from the nominal return before or after the inflation adjustment, depending on how the fees are structured and applied. If fees are expressed as a percentage of assets, they are directly subtracted from the nominal return rate.

For example, if an investment has a nominal annual return of 8% and the annual inflation rate is 3%, the real return would be:

If there was also an annual management fee of 1%, this would be subtracted from the nominal return before calculating the real return, resulting in a nominal return of 7% (8% - 1%) for the calculation.

Interpreting the Adjusted Long-Term Return

Interpreting the adjusted long-term return involves understanding what the final percentage signifies in terms of actual wealth accumulation. A positive adjusted long-term return indicates that an investment has increased an investor's purchasing power over time. Conversely, a negative adjusted long-term return means that, despite potential nominal gains, the investment's value has decreased in real terms, often due to high inflation or significant fees.

For instance, if a portfolio generates a 7% nominal return annually over 20 years, but the average inflation rate during that period was 4%, the actual purchasing power gained is closer to 2.88% per year. This demonstrates the critical importance of looking at the adjusted figure. Without this adjustment, investors might mistakenly believe their wealth is growing substantially, when in reality, its ability to purchase goods and services is barely keeping pace or even declining. Understanding this metric helps in evaluating the true effectiveness of a portfolio performance and making informed decisions about future allocations.

Hypothetical Example

Consider an investor, Sarah, who invests $10,000 in a diversified mutual fund for 15 years.
Over this period, the fund achieved an average annual nominal return of 9%.
However, the average annual inflation rate during these 15 years was 3.5%, and Sarah paid an average annual management fee of 0.75% on her assets.

First, calculate the nominal return after fees:
Nominal Return (after fees) = 9% - 0.75% = 8.25%

Next, calculate the adjusted long-term return (real return after fees) using the formula:

If Sarah had only considered the 9% nominal return, she might believe her money grew significantly more than it did in real terms. The adjusted long-term return of 4.59% annually provides a much more accurate picture of how much her purchasing power actually increased over the 15-year period. This highlights why focusing on the adjusted long-term return is critical for evaluating genuine capital appreciation.

Practical Applications

The adjusted long-term return is a fundamental metric across various financial contexts, offering a robust measure of true investment efficacy.

• Retirement Planning: Individuals use adjusted long-term return to project the future purchasing power of their retirement savings. It helps ensure that projected retirement funds will be sufficient to cover future living expenses, which are subject to inflation.
• Institutional Investment: Pension funds, endowments, and other large institutions rely on adjusted long-term return to assess whether their portfolios are meeting long-term liabilities and preserving real capital for beneficiaries.
• Portfolio Management: Fund managers and financial advisors use this metric to demonstrate the real value added to client portfolios, differentiating their performance from market benchmarks that might only show nominal gains. Regulatory bodies, like the SEC, require investment advisors to maintain records demonstrating how they calculate performance referred to in communications, sending a clear message that all performance-related communications must be truthful¹⁵. Recent SEC guidance also emphasizes the importance of presenting both gross and net performance when displaying investment returns¹³, ¹⁴.
• Asset Allocation: When constructing a diversification strategy, understanding the historical adjusted long-term return of various asset classes, such as equities versus fixed income or real estate, is crucial. This helps in allocating capital to assets that have historically provided strong real returns, especially in varying inflationary environments⁹, ¹⁰, ¹¹, ¹².

Limitations and Criticisms

While providing a more accurate view of true wealth growth, the adjusted long-term return also has limitations and faces certain criticisms. One primary challenge is the uncertainty of future adjustments, particularly the inflation rate. Since inflation can be volatile, projecting a future adjusted long-term return often relies on inflation forecasts, which may not materialize, leading to discrepancies between estimated and actual figures. The impact of inflation on investments varies, and while equities theoretically see revenues and earnings increase with inflation, fixed income investments can see their real returns significantly reduced⁷, ⁸.

Another limitation lies in the selection of the adjustment factors themselves. Different methodologies for calculating fees or tax impacts can yield varying adjusted returns, making direct comparisons difficult across different reporting entities. Additionally, the adjusted long-term return primarily focuses on quantitative adjustments like inflation and fees and may not fully capture other qualitative risks or shifts in market conditions. For example, behavioral biases of investors can influence actual returns, which are not directly accounted for in this metric⁶. While widely accepted, it's important to remember that such historical metrics, like all portfolio performance measures, are not predictive of future outcomes⁴, ⁵.

Adjusted Long-Term Return vs. Total Return

The distinction between adjusted long-term return and total return is crucial for investors. Total return measures the overall percentage gain or loss of an investment over a period, incorporating both capital appreciation and any income generated, such as dividends or interest. It represents the raw, unadjusted growth of an investment.

In contrast, adjusted long-term return takes total return and then modifies it to account for specific factors, most commonly inflation, fees, and sometimes taxes. This adjustment aims to show the real increase in purchasing power, or the net gain after all significant costs and external economic factors. While total return might show a positive percentage, the adjusted long-term return could be significantly lower, or even negative, if inflation or fees were high. For instance, dividend-adjusted return considers both capital appreciation and dividends but still might not account for inflation, whereas total return might assume dividend reinvestment but also not explicitly adjust for inflation¹, ², ³. The adjusted long-term return provides a more comprehensive picture of an investment's true value over an extended period.

FAQs

What does "adjusted" mean in adjusted long-term return?

"Adjusted" means that the raw, or nominal, investment return has been modified to account for certain factors that affect the true value or purchasing power of the return. The most common adjustments include inflation and various fees associated with the investment.

Why is it important to look at adjusted long-term return instead of just total return?

Looking at the adjusted long-term return is crucial because it provides a more realistic picture of how much your money has actually grown in terms of purchasing power. Total return doesn't account for the erosion of money's value due to inflation or the reduction in gains due to fees, which can significantly impact your real wealth over long periods.

Does adjusted long-term return always account for inflation?

Not always by default, but in most common financial applications, especially when discussing "real" returns, it implicitly or explicitly accounts for inflation. Other adjustments, like fees and taxes, may also be included depending on the specific calculation.

Is adjusted long-term return the same as risk-adjusted return?

No, they are different but related concepts. Adjusted long-term return typically focuses on accounting for factors like inflation and fees that directly impact purchasing power. Risk-adjusted return, on the other hand, measures the return an investment generates in relation to the amount of risk taken to achieve it. While both provide a more refined view than simple total return, they address different aspects of investment performance.

Can adjusted long-term return be negative?

Yes, an adjusted long-term return can be negative. This occurs if the combined impact of inflation, fees, and any other adjustments outweighs the nominal gains of the investment over the long term. A negative adjusted long-term return indicates that your purchasing power has declined, even if the nominal value of your investment has increased.