What are good returns?
Expectations on return and risk must be founded on today's economic realities, not on simple rules of thumb, independent of asset class. As uncertainty about the future of the stock market increases, more people search for uncorrelated returns.
A question that I have been asked numerous times since announcing the SEF Entropics Cat Bond Fund is, what are “good returns”? Mostly, these questions have come from ordinary people, and relate to the expectation that the stock market will rise some 8-10 percent annually.
Given the global economic situation where we have an extended period of low interest rates and low growth as well as geopolitical risks, I am skeptical about this assumption. I believe that this is a typical case of the need to carefully manage investor expectations.
If we look back at the returns from the stock market, the development of the Nasdaq OMX exchange in Stockholm has been excellent for a number of years. Post-Lehman, the SIX RX index has delivered 13.6 percent annually, driven by the low interest rate stimulus by the Central Bank. Annual inflation has over the same period amounted to 0.81 percent, and the stock market’s largest drop in one year was 13.5 percent. Over a ten-year period, the returns have been lower; 11.6 percent, while inflation was 1.2 percent. The largest value decline in these ten years was 39.8 percent.
Historically, the response to the volatility of the stock markets has been hedge fund investments. However, many of these managers have had problems in delivering returns in recent years. HFRX Global Hedge Fund Index shows an annualized growth of 1.1 percent over the past five years. Investors will also see that hedge fund indices have followed the stock indices for six consecutive years. The ongoing discussion on alpha generating ability is likely to continue.
Nor are bonds an obvious alternative. Yields are low and demand is higher than the supply, pushing yields down.
Low interest rates will perhaps continue to drive stock valuations for a while, but this will sooner or later go back to normal, and investors should be prepared for lower returns than over recent years.
As more analysts start expressing doubts about the stock market, such as Citigroup’s Global Head of Credit Products Matt King – “It’s not the underlying economics that’s driving things, it’s central bank liquidity” (Financial Times, Oct 27, 2014) – interest in alternative and uncorrelated assets will increase.
The search for uncorrelated assets partly explains the decreased returns on corporate bonds and cat bonds alike. Simply put – risk has become cheaper in recent years. Thus, the historic returns of cat bonds, just as is the case with the stock market and corporate bonds, is currently not a good indicator of future returns. Rather, expectations have to be adjusted to what’s feasible given market conditions.
My bet is that the SEF Entropics Cat Bond Fund target return range of 4-6 percent annually, (after fees and excluding returns on the money market instruments where the collateral is invested – which currently is very low, but will increase if inflation increases), seems not only feasible, but also a fair return. This is especially the case when considering the very low correlation to traditional asset classes and that including cat bonds will dampen the volatility of traditional portfolios.
Of course, every investor still has to make his or her own analysis of the market conditions and predictions for the future, and based on that decide what are “good returns”. I simply want to argue that expectations, no matter what asset class you invest in, must be reasonable and be founded in financial realities today, not in simple rules of thumb.