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Departures at GMO Spur Fund Downgrade

A manager change and organizational stress at GMO have led us to downgrade GMO Benchmark-Free Allocation from Silver to Bronze.

Securities In This Article
GMO Benchmark-Free Allocation III
Allspring Absolute Return A

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We have downgraded GMO Benchmark-Free Allocation's Morningstar Analyst Rating to Bronze from Silver because of a manager change and organizational stress at the firm. On June 2, 2016, GMO announced that Sam Wilderman will leave the firm on Dec. 31, 2016. Wilderman joined GMO 20 years ago and became co-head of asset allocation in 2012. As comanager of this fund, he helped implement investment ideas and put structure behind the 24-person asset-allocation team. His departure represents a loss for investors. Ben Inker, this fund's longtime lead manager, will become the sole head of asset allocation upon Wilderman's exit.

Changes have also occurred more broadly at GMO, which led us to downgrade the firm's Parent rating to Neutral from Positive. GMO has recently suffered from generally subpar performance and outflows; assets under management currently stand at about $99 billion, down from $124 billion in June 2014 and $155 billion in September 2007. That spurred the firm to lay off roughly 10% of its 650-person staff, including three portfolio managers and nine analysts, during the past month. Notably, GMO has discontinued its fundamental selection efforts within its global-equity team--which manages this fund's stock stake--because of uninspiring results. Fundamental stock picks have played a role in the portfolio since 2012, but the fund will now go back to relying exclusively on quantitative models. Similarly, GMO's relative value interest-rate and foreign-exchange strategy, which represents about 5% of this fund's assets, will revert back to a purely quantitative approach after morphing into a more fundamental strategy in 2014.

GMO has demonstrated greater expertise in quantitative research as compared with fundamental analysis, so the changes may prove to be a step in the right direction. Importantly, GMO's quantitatively derived asset-class forecasts, which drive the bulk of results here, remain intact, and Inker's continued presence inspires confidence. Still, personnel turnover and outflows require close monitoring and detract somewhat from the appeal.

Process Pillar: Positive | Leo Acheson, CFA 06/23/2016 Unlike a typical 60/40 allocation fund that tries to beat a blended stock/bond benchmark, this fund takes an absolute return approach. GMO believes that such static allocations can suffer greatly when the market gets overvalued, providing poor returns going forward. Instead, this fund aims to beat inflation by 5% annually over the long haul, with 5% to 10% annualized volatility, as measured by standard deviation. That goal can seem lofty at times, especially given recent low interest rates. Thus far, the team has shown its ability to capably maneuver across asset classes to deliver on its goal.

The team running this fund is also responsible for GMO's seven-year asset-class forecasts, which are derived from its views on current profit margins and price/earnings ratios. These forecasts are predicated on the belief that valuations eventually revert to their long-run averages. This fund holds several underlying GMO strategies to gain exposure to asset classes with the most-attractive risk-adjusted valuations. The underlying GMO managers have delivered respectable, but not standout, results. Nonetheless, GMO's asset-class calls will primarily drive results here. With an absolute rather than benchmark-focused target, this fund is the purest play on the team's views. The team's asset-class calls have overall been additive during the past 20 years, a key to the fund's Process Pillar rating of Positive.

This fund's team invests based on where it sees the best risk-adjusted values. For example, it boosted the fund's stake in high-quality stocks during 2009, while their share prices lagged during the liquidity-driven rally. While that hurt relative results through 2010, that position paid off as market jitters caused cyclical stocks to stumble in 2011.

More recently, the team has been hard-pressed to find compelling investment opportunities, citing generally unattractive valuations and high profit margins. As of May 2016, it forecast slightly negative real returns over the coming seven years for broad U.S. equity, U.S. bond, and international developed bond markets. However, it finds a few areas relatively attractive. For instance, GMO expects modestly positive real returns from high-quality U.S. stocks, which represent about 5% of the portfolio. It also believes emerging-markets equities--the fund holds a 15% position--look especially appealing.

The managers maintain a relatively high 20% stake in alternatives, largely because other asset classes look overpriced. The group added Treasury Inflation-Protected Securities to the portfolio in late 2015, which it prefers over cash, based on the belief that inflation expectations are unrealistically low. The group also initiated a 5% position in high-yield bonds. Both of those positions rallied in the first four months of 2016, spurring the team to trim the allocations.

Performance Pillar: Positive | Leo Acheson, CFA 06/23/2016 This benchmark-agnostic fund targets a return equal to the Consumer Price Index plus 5% annualized over full market cycles. It also aims to deliver a relatively smooth ride, with a targeted 5% to 10% level of standard deviation. The CPI has averaged about 2.2% annualized since the fund's July 2003 inception, and the fund's 8.6% annualized gain from its start through May 2016 topped its return goal during that period. That showing also beat the 5.4% annualized for the world-allocation Morningstar Category. Moreover, the fund has delivered these gains while maintaining one of the category's lowest standard deviations, giving it the category's best risk-adjusted result during that span. This solidifies the fund's Positive Performance rating.

Management's vigilant focus on valuation rather than diversification has helped the fund deliver such strong results. Management isn't shy about making significant shifts, such as nearly eliminating international equities from the mix in mid-2008 and boosting the fund's focus on high-quality stocks--both moves worked well in the ensuing credit crisis.

The asset-allocation shifts will continue to be the major driver of this fund's results, and while the fund's managers have gotten several big calls right during the past decade, the fund isn't infallible. Indeed, performance can drag relative to peers, especially during rising markets, such as the one seen since the beginning of 2012.

People Pillar: Positive | Leo Acheson, CFA 06/23/2016 Lead manager Ben Inker joined the firm in 1992, and in addition to managing this strategy, he also heads the asset-allocation group at GMO and is a listed manager on several of the firm's funds. Sam Wilderman, who had served as co-head of GMO's quantitative equity team since 2005, joined Inker as a comanager of this fund in September 2012. However, Wilderman unexpectedly announced his plans to leave GMO at the end of 2016. He brought considerable experience and tenure to the table, and his contributions will be missed.

Nonetheless, Inker continues to receive plenty of support. Chief strategist and firm co-founder Jeremy Grantham still advises the team, and 21 other investment professionals across the firm are dedicated to global asset allocation. The team has continued to see steady growth since 2008. In fact, during the past year, five members joined the team, including two from other departments at GMO.

GMO also hired Marc Seidner from PIMCO as head of fixed income in March 2014, though Seidner returned to his old firm later that year. Seidner would have bolstered one of the firm's weaker areas. Instead, the fund goes back to relying primarily on the team's asset-allocation prowess, a strength that has long supported its People rating of Positive.

Inker and Wilderman both invest more than $1 million in the fund.

Parent Pillar: Neutral | Leo Acheson, CFA 06/23/2016 During 2016's second quarter, GMO announced several personnel departures. Two were particularly senior: Brad Hilsabeck, CEO since mid-2011, will resign and join the firm's board of directors on June 30, 2016, and longtime investment professional Sam Wilderman, who was added to the firm's flagship asset-allocation funds in 2012, will leave at year-end. Furthermore, GMO announced that it will reduce staff across the firm, including several investment personnel.

These changes come in the wake of weak short-term performance numbers, asset outflows, and a reduced focus on fundamental research in favor of quantitative investing. Several teams at GMO still conduct fundamental analysis, but one group scrapped it altogether, and many of the layoffs were fundamental researchers. Indeed, GMO has mostly distinguished itself through its quantitative efforts; for instance, its famous asset-class forecasts are quantitatively derived.

GMO still boasts some alluring attributes, including its excellent shareholder communications and bold independence, a function of the firm's devotion to investing (instead of asset-gathering). While GMO isn't alone in feeling the impact of redemptions in an environment where passive investing has dominated asset flows, this shift in strategic direction and significant turnover warrant caution and support the firm's Neutral Parent Pillar rating.

Price Pillar:

Positive | Leo Acheson, CFA 06/23/2016

The 0.90% expense ratio charged by GMO Benchmark-Free Allocation III ranks in the cheapest one third among institutionally distributed world-allocation peers, garnering it a Positive Price rating. The fund's required $10 million initial purchase makes it inaccessible to many investors.

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About the Author

Leo Acheson

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Leo Acheson, CFA, is director, multi-asset ratings, global manager research for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

He oversees Morningstar’s multi-asset ratings as well as the firm’s multi-asset and alternatives manager research team. The group covers a range of investment vehicles, including allocation strategies, alternatives, target-date funds, 529 plans, HSAs, model portfolios, and Mexican pension funds.

Before joining Morningstar in 2013, Acheson spent four years working for a Chicago-based investment consultant, conducting mutual fund and asset-class research to help corporations manage their investment programs.

Acheson holds a bachelor’s degree in finance and accounting from Indiana University’s Kelley School of Business. He also holds the Chartered Financial Analyst® designation.

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