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GMO: Two Questions We Can't Answer
By Robert Huebscher
March 27, 2012


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Ben Inker

Its reputation was built on stellar returns achieved with long-term bets on undervalued asset classes.  Current market conditions, however, pose two unanswerable questions for Grantham, Mayo, van Otterloo (GMO) – leaving the firm with an uncertain strategy for its equities and fixed-income allocations.

Those questions have arisen because GMO foresees unattractive performance from both stocks and bonds in the next seven years, the time horizon over which the firm has traditionally forecast asset class performance.  Ben Inker, the head of asset allocation at the Boston-based GMO, spoke at a Boston Security Analyst Society seminar on trends in asset allocation last Tuesday.

Given negative real interest rates, Inker said the first of those two questions is that it is not clear what role bonds should play in a portfolio.  Second, is not clear that investors should overweight stocks, just because bonds are unattractive.

As a result, he said, GMO has upped its allocation to cash.

Let’s look at GMO’s outlook for bonds and stocks and at the reasons Inker cited for increasing its cash position.  I’ll also review why there is only one commodity resource in which GMO is willing to invest.

GMO’s capital market outlook

GMO employs a straightforward methodology to project asset class performance, which I’ve described previously.  Its forecasts are based on certain key metrics – P/E ratio, profit margin, sales growth and dividend yield – that GMO believes will revert to their mean over a seven-year time horizon.   Given that those variables are known today, anticipating future returns is a simple matter of assuming that these measures will revert to their historical means and calculating the implications.

GMO’s forecasts have been remarkably accurate.  Inker said that, over the last 10 years, it had ranked asset classes correctly by their relative performance with 94.5% accuracy.  “The stuff that was cheap proceeded to do well,” he said, “and the stuff that was expensive proceeded to do badly.”

Moreover, correlations between asset classes proved largely irrelevant, he said.   Over long periods of time, the performance of asset classes can diverge widely, even in the face of high correlations.

Inker said he is confident that GMO’s methodology will continue to work, because “it is what capitalism is supposed to do.”  Capital should flow into markets where the return on cash is high and the cost of capital is low; conversely, there will be few investments when the return on cash is low and the cost of capital is high. 

“Things revert,” he said, “and if you bet on them reverting you will be able to make some money.”

Moreover, he presented data showing that the most undervalued asset classes not only achieve the best returns, but do so with less risk than one would normally expect.

Inker reviewed the firm’s most recent forecast, as of February 29:

Forecast annual real (after-inflation) returns for a seven-year horizon

Equities

Fixed-income

US large cap

0.4%

US bonds

-1.1%

US small cap

-1.8

International bonds

-2.5

US high-quality

4.4

Emerging debt

0.8

International large cap

4.0

Index-linked bonds

-1.8

International small cap

3.3

Cash

0.6

Emerging

5.0

Timber

6.5

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