RETURN

Asset Management

Investment success starts by setting an adequate target return

This article is offered under “public access”.

The corporate world introduced the term “stretch goal” long ago. The idea is simple enough: fix an ambitious target, for example double revenue in 5 years, become world leader in one particular product segment, reach an “ROE” of 25%. Even if the “stretch goal” is not ultimately reached, but business grows, investors are satisfied. In this case the “stretch goal” indicates a direction in which to go, a trend to set, and acts as a motivator of business development.

The world of investments is very different. If an investor sets too high of a target for his return on investment relative to what the market can offer, he may end up taking ill-considered risks.

In this article and a follow-up article we explain why, in our opinion, an investor should start by setting a realistic and rather conservative target rate of return

Since the financial crisis of 2009 investors have been quite slow to revise their target investment return lower. They have continued to consider 5% per annum a “reasonable” rate of return, long after central banks had reduced their target rates to or below zero. This phenomenon helps explain why issuers such as Valeant Pharmaceuticals and Tesla Motors had no trouble in finding investors for their bonds by offering what then seemed like a “normal” coupon:

In January 2015 Valeant Pharmaceuticals issued a bond in Euro paying a coupon of 4.5% and maturing in 2023. Two years later the price of the bond had fallen by over 25%.

In August 2017 it was Tesla Motors that was able to place a USD bond issue paying a coupon of 5.3% and maturing in 2023. Less than two years later the price of this bond had also dropped by almost 20%.

At the time of issue, the respective companies had substantial debts, and we assume that most investors must have been aware of this fact. These investors were looking for a return of 4.5% on their Euro cash and 5.0% on the USD. They must have judged that these two issues presented no more risk than many other similar investment oppotunities of similar quality and similar duration. It seems clear that these investors had underestimated the risk associated with these two issuers.

What is a reasonable target return for a diversified, balanced portfolio with an investment horizon of 5 years?

The target return depends in first place on the investment currency. In general we feel comfortable aiming for “3 month LIBOR + 2.5%” per annum. Today, for a portfolio denominated in USD, this translates to a target return of roughly 4.5% per annum. However for a EUR-denominated portfolio, this target is only about 2.5%.

Sticking with the USD reference currency for now, and absent any market upheaval, the portfolio should now be allocated so as to yield a “expected return” below this target rate of 4.5%, either by keeping a significant portion in cash, or by selecting relatively conservative market instruments. This is what we call being “underexposed” in absence of strong volatility, so most of the times.

While it is impossible to accurately predict when market turmoil will ocur, it is easy to recognize the onset of it. It is during prolonged periods of turmoil that it is advantageous to increase exposure to the markets, even if a typical investor is often reticent to take on market exposure during those times.  

An “active” professional asset manager – like Vierny Partners SA – can naturally outperform during these periods by increasing his “exposure” and thereby achieve the target return. If markets were always “efficient”, without any upheaval or dislocations, without unexpected bankruptcies, and immune to geopolitical events, then this approach would not pay off.

Rather than buying insurance from such events, Vierny Partners SA uses them as opportunities to generate extra investment return.

In our follow-up article title “You cannot avoid volatility but you can embrace it” we explain this approach of market timing in more detail, and we explain how our clients have profited from it.

We conclude by pointing out that our approach can be adapted for any risk profile, from conservative to dynamic. Vierny Partners SA recommends remaining underexposed for most of the times relative to a defined risk profile. It is when the market enters a period of high volatility that we increase our exposure to the market, always respecting the individual risk profile established together with each of our clients.


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