Survival of the Fittest

his article continues the investigation of the characteristics of fund performance during the "draw-down" phase when money is being systematically withdrawn, or hereafter referred to as withdraw mode. The analysis reported here expands the length of the withdraw mode analysis to 40 years. In addition, a 12 year period with relatively poor equity returns was also examined.

Each pair of funds in the analysis had a comparable lump sum annualized return over a 40 year period from January 1, 1964 to December 31, 2003. The differential within each pair of funds is the standard deviation of return, with one being higher than the other. In each case, the fund with the higher volatility of return is listed second.

The 40 year withdraw mode analysis was constructed as follows: an initial investment of $100,000 was made on January 1, 1964 after which withdrawals were initiated on February 1, 1964 through December 1, 2003. Two withdrawal amounts were studied, (1) 0.50% of account value per month with no annual increase over time, and (2) $250 per month with a 3% annual increase over the 40 year period. A 0.50% monthly withdrawal represents a 6% annual drawdown rate. The 0.50% withdraw rate will be referred to as the "% withdraw" and the $250 per month will be referred to as the "$ withdraw."

The two different withdraw modes (% and $) were analyzed in a pre-tax and post-tax environment. Interest, dividends, and capital gains were reinvested. Shares were sold to pay taxes. In the post-tax analysis, tax rates were set at 35% for interest and dividends and 15% for capital gains. All sales loads were set to 0%. The analysis was performed using Morningstar data in the "Scheduled Portfolio Mode" of Morningstar's Principia software.

The results of the pre-tax analysis are reported in Figure 1. In a tax-free environment, low volatility funds tended to have higher ending account values in the $ withdraw mode.

In the % withdraw mode the results are mixed. Judging solely on ending account value, seven low volatility funds had the advantage out of the 12 fund pairs. When the differential in total withdrawal over 40 year period was combined with the differential in ending account value the results were evenly divided between high and low volatility funds (as shown in the column titled "Net Advantage to High Volatility Fund"). A negative number in that column indicates an advantage to the low volatility fund, whereas a positive number indicates an advantage to the high volatility fund. The actual calculation is noted in a footnote to Figure 1.

It appears that low-volatility funds with higher levels of return (in this analysis funds with 40 year annualized return of about 9% or higher) perform better in % withdraw mode than high-return, high-volatility funds. This can be seen by the fact that in 5 out of the top 6 fund pairs (fund pairs are listed in descending order of lump sum return) the lower volatility fund had the higher ending account value in % withdraw mode. Of those same six higher-return fund pairs, four low-volatility funds had a higher "Net Advantage."

In $ withdraw mode, the advantage to lower volatility funds is demonstrated through the entire range of returns. Generally speaking, funds with lower return volatility tend to generate more income. Funds in this category include income funds, balanced funds, and possibly growth and income funds. In a pre-tax setting, such funds are naturally advantaged because a larger percentage of their total return (i.e. dividends and interest) is subject to a higher tax rate. Funds with higher return volatility tend to be growth-oriented funds whose total return is more often generated by capital gains, which have a lower tax rate.

In a taxable environment (Figure 2), funds with higher return volatility (e.g. growth-type equity funds) made a slightly better showing, particularly when withdrawing a fixed amount of money each month. In 7 out of the 12 fund pairs the higher ending account balance was in the higher volatility fund. In the pre-tax analysis, only 3 higher volatility funds had a higher ending account balance in $ withdraw mode.

Another differential in the after-tax results is that high-return, high-volatility funds (the top six fund pairs listed in Figure 2) survived better in % withdraw mode. Only 2 out of 6 high-return, low-volatility funds (i.e. income funds and balanced funds) had the higher ending account balance whereas in the pre-tax analysis 5 out of 6 high-return, low-volatility funds had the higher balance. Conversely, low-volatility, low-return funds (the bottom six fund pairs in the table) demonstrated some advantage over high-volatility, low-return funds when withdrawing a percentage-based taxable amount of money.

In % withdraw mode (after-tax), "Net Advantage" (account value differential combined with total withdrawal differential) slightly favored high volatility funds. This is reasonable inasmuch as low-volatility funds generally produce more income which is taxed at a higher rate than capital gains. Among the top six high-return fund pairs in Figure 2 (Fidelity Congress Street/AmCentury Growth through Dodge & Cox Balance/Value Line), the "Net Advantage" favored four high-volatility funds.

When comparing funds with similar lump-sum based returns, high volatility growth funds are just as likely as low volatility income or balanced funds to preserve capital in a withdraw mode, particularly on an after-tax basis. In a tax-free environment, there appears to be an advantage among funds with lower return volatility, which generally tend to be income-generating funds.

These findings are derived from a period of time in which equity investments experienced robust returns. The returns of the S&P 500 Index over this particular 40 year period are shown in Figure 3. It was clearly a favorable period for equity investments, where 30 of the 40 years had positive returns. The average annualized lump sum return over the 40 year period was 10.61%. How might funds perform in withdraw mode during a period of time with less favorable returns? To examine this issue, a 12 year period from January 1, 1966 to December 31, 1977 was analyzed (see Figure 4). The average annual return for the S&P 500 during this particular 12 year period was a dismal 3.92%.

The pre-tax, withdraw mode results are shown in Figure 5. The initial investment was $30,000 (made on 1/1/1966). A 12 year period is 30% of a 40 year period, thus the initial investment of $30,000 represents 30% of $100,000. Monthly withdrawals of 0.50% of account value (annualized withdraw rate of 6%) began on 2/1/1966 and ended on 12/1/1977. There was also a 1.0% monthly withdraw rate, a $100 per month withdraw rate, and a $150 per month withdraw rate. None of the withdraw scenarios utilized an annual inflation adjustment. The 12 year analysis involved 12 new sets of paired funds, both with very similar 12 year lump sum returns. However, in each pair, one fund had a low standard deviation of return and one fund with a high standard deviation of return.

The results of the 12 year withdraw mode in a tax-free environment (Figure 5) demonstrate a modest advantage for higher volatility funds. In seven cases out of 11 the higher volatility funds had a higher ending account balance when drawing out a fixed dollar amount. If withdrawing a percentage based amount, the results for high and low volatility funds are nearly identical.

In a taxable environment (Figure 6), lower volatility funds tended to perform better in a % withdraw mode - although the differences in several cases were very small. In fact, in half of the cases, the differential in ending account value between low and high volatility funds was less than $250. In a $ withdraw mode the differences in ending account value were larger, but no clear winner emerges.

The withdraw mode results during the 12 year bear market are somewhat surprising in that one might expect income/balanced funds to demonstrate more of an advantage during such a period. However, this was not observed to any substantial degree. In fact, in a tax-free environment, it was the growth-type equity funds that tended to have comparable or slightly better survivor skills - even during a bear market.

In summary, this is a complex type of analysis in which clear findings are difficult to nail down. One "conclusion" of interest is the very fact that there are not clear findings. It is our impression that many financial practitioners may assume that low volatility, income-based funds are clearly a superior asset during bear markets and likely to be an inferior asset during a period of buoyant equity returns. Neither assumption is affirmed by this study.

One observation does seem to stand out. Low volatility funds appear to be a prudent choice in a tax-free, withdraw mode situation. Conversely, high-volatility funds demonstrate some potential for superiority in a taxable, withdraw mode scenario.

Figure 1. 40 Year Withdraw Mode Results (1964-2003) PRE-TAX

	Lump Sum Results		Withdraw Mode Results (highest value shaded yellow)
	$100,000 initial investment on 1/1/1964		.50% monthly withdraw  0% annual increase			$250 monthly withdraw 3% annual increase
Paired Funds with Similar Lump Sum Returns and Different Standard Deviation of Return	Pre-Tax  Average Annualized Return	Standard Deviation of Return	PRE-TAX ENDING ACCOUNT VALUE	Total Withdrawal over 40 Year Period	Net Advantageto High Volatility Fund *	PRE-TAX ENDING ACCOUNT VALUE	Difference in Ending Account Value
Amer Funds Inv Co Am A	12.49	14.65	973,352	966,989	-21,220	6,883,336	767,408
Hartford Growth Opps L	12.22	24.78	902,679	1,016,442		6,115,928
Amer Funds Amer Mut A	11.81	13.05	770,790	813,016	-47,271	4,966,942	1,811,274
AmCent Growth Inv	11.84	30.45	656,512	880,023		3,155,668
Fidelity Puritan	11.73	12.81	757,174	829,846	258,515	5,146,005	615,980
Pioneer A	11.88	16.38	790,385	1,055,150		5,761,985
Franklin Income A	9.86	13.96	380,169	583,577	-327,836	3,098,014	2,873,020
Waddell&Reed Adv Sci A	9.47	26.39	327,121	308,789		224,994
Century Shares Trust	9.86	19.72	384,240	384,288	8,959	1,027,651	192,532
Scudder Technology A	9.52	27.60	324,276	453,211		1,220,183
Vanguard Wellington	9.56	11.84	344,682	386,416	-29,908	1,315,863	412,714
Hartford Growth L	9.40	20.14	313,684	387,506		903,149
Philadelphia	9.03	17.13	283,877	413,004	89,621	1,257,514	539,582
Value Line Spec Situations	9.52	30.12	334,111	452,391		1,797,096
				3
Eaton Vance Balanced A	8.60	11.73	241,288	369,335	-84,326	998,228	583,671
William Blair Growth N	8.33	18.32	212,219	314,078		414,557
Franklin Utilities A	7.54	16.11	148,798	252,110	64,776	254,281	94,181
Dreyfus Founders Mid Cap	7.65	23.19	166,483	299,201		160,100
Putnam Income A	8.12	10.34	169,587	302,374	45,847	686,467	7,642
T. Rowe Price Gr Stk	8.39	17.69	220,582	297,226		678,825
Evergreen Divr Bond B	5.44	9.93	75,459	159,149	11,601	negative	n/a
Evergreen Blue Chip B	5.62	17.17	81,597	164,612		negative
Nicholas Income	6.33	13.22	104,376	244,917	-9,867	336,167	60,371
Stonebridge Growth	6.00	17.76	93,157	246,269		275,796
Low Volatility Fund Advantage			7		6	8
High Volatility Fund Advantage			5		6	3

* Net Advantage to High Volatility Fund = (High Volatility Fund Ending Account Value + Total Withdrawal) minus (Low Volatility Fund Ending Account Value + Total Withdrawal)

Figure 2. 40 Year Withdraw Mode Results (1964-2003) AFTER-TAX

Figure 3. S&P 500 Index Total Return: 40 Years from 1964-2003

Figure 4. S&P 500 Index Total Return: 12 Years from 1966-1977

Figure 5. 12 Year Withdraw Mode Results (1966-1977) PRE-TAX