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Rekenthaler Report

Fortune Doesn't Always Favor the Bold

Discretion can be the better part of valor.

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Case Study
The year is 2013, and you are an investment professional at Grantham Mayo Van Otterloo & Co, generally known as GMO. Your firm has an excellent reputation, highly regarded for its dispassionate asset-allocation process. Other companies may be swayed by the prevailing winds, but not GMO. It invests where the opportunities lie, rather than where the headlines indicate.

The 2013 indicators do not favor stocks. The forward-looking price/earnings ratios for global developed markets aren’t terribly high, about 15, but both gross domestic product and earnings growth are sluggish, and the economic recovery is beginning to feel long in the tooth. It has just finished its fourth year, with the average economic expansion since 1950 lasting just over five years. That doesn’t look promising.

Your seven-year asset-class forecast confirms the suspicions. The expected real returns for stocks are near zero, as opposed the long-term global average of 5% per year. The news doesn’t improve for bonds, with U.S. fixed-income securities also projected to break even and hedged international bonds to fare even worse. Nor does cash figure to turn a profit.

Among the weakest expected investments are U.S. stocks. A notable exception is “high-quality” equities, meaning large companies with high profit margins, good growth rates, and generally low debt. (An example would be the FAANG companies, which received their nickname that very year, although missing an “A,” as Apple (AAPL) was a later addition.) But elsewhere the calculations portend pain. Overall, large-company stocks figure to lose 2% annually (again, in after-inflation terms) and small companies 3.5%.

These findings aren’t quirky. They reflect something of the consensus view among investment organizations that have a quantitative, historical bent. Rival researchers point to the S&P 500’s Shiller CAPE Ratio as evidence that the American stock market is overpriced. That ratio, which attempts to put equity valuations into context, hovers near its highest point ever, save for the late 1920s and late 1990s, neither of which were good times to buy stocks. 

There is a bright side. Although prospects for the developed markets look uniformly glum, the emerging markets are highly attractive. Emerging debt projects to an annualized 2.5%, which beats the developed-market choices save for U.S. high-quality stocks, and emerging-market equities are a splendid 6.8%.

What would you do? How would you invest?

Hedged Bets
I know what the answer would be if this situation appeared in a film, or as the topic of a motivational speaker, or as a politician’s campaign promise: Go all in. Nobody ever got rich by being afraid. Everyday rhetoric praises decisiveness, not waffling. As do our cultural icons: James Bond doesn’t hesitate to put all his chips into play.

James Bond might not equivocate, but GMO did. In April 2013, two months before the company published the cited asset-class forecast, its signature fund, GMO Benchmark-Free Allocation (GBMFX) held 60% in stocks and 40% in fixed-income securities. (On the surface that was the conventional 60/40 mix, although the fund differed from the norm by preferring cash to bonds.) Overall, 44% of its assets were invested in developed markets outside the United States, 36% in the U.S., and 20% in emerging markets. That’s not exactly betting the house on one’s convictions.

Management’s caution would seem to be at odds with the fund’s self-description. The fund “seeks to generate positive return, rather than ‘relative’ return, by allocating dynamically across asset classes, free from the constraints of traditional benchmarks … GMO’s Asset Allocation approach is flexible, not predetermined by static allocations or benchmark-related ranges, constrained only by our unwillingness to overpay for an asset.”

That seems to overstate the matter. If emerging markets had been 90% of the world stock/bond weighting in 2013, as opposed to less than one fifth, then surely GMO Benchmark-Free Allocation would have been almost fully invested in emerging-markets securities. They were, after all, the undisputed leaders of the company’s asset-allocation exercise. That emerging-markets issues were but a modest part of the portfolio would seem to reflect their minority status (along with the fact that GMO management was fairly enthusiastic about high-quality U.S. stocks).

Just as well that it wasn’t. Since summer 2013, emerging-markets stocks have underperformed other equity flavors, especially U.S. securities. Pursuing emerging-markets securities aggressively may have put GMO Benchmark-Free Allocation in real trouble. It would have still turned a profit, but it would have trailed its competitors more steeply, which might have sparked redemptions.

In short, management considered the possibility that it might be wrong when implementing its asset-allocation research. Intrepid souls might call that “lacking in conviction.” I have another word for GMO’s decision: prudence. Or, to use the industry term, risk management. There is a time and place for investment managers to take big relative chances. In 2013, GMO’s management opted against such an approach, and that proved to be the correct decision.

Another Path
Things are different today. As the developed markets have continued to outpace the emerging markets, GMO’s forecasts for the former have shrunk, while the latter have grown. In its mid-2019 report, management predicted negative real seven-year returns for the U.S. across the board, barely positive returns for developed-markets stocks, and a whopping 9.8% annualized gain for emerging-markets value stocks.

GMO's fund has followed suit by deviating further from its peers, becoming a true outlier. Its emerging-markets stocks now comfortably outweigh its U.S. position. Also, the fund is awash with alternatives investments, ranging from distressed securities to structured products, to event-driven and global macro strategies.

It’s a bolder look for the fund’s relative performance, although perhaps more conservative for absolute returns. At any rate, the fund’s 2020 posture differs substantially from that of 2013. Should developed-markets equities falter, with other securities holding their own, it is poised to regain its lost relative ground.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.