“We live in a reliably mean-reverting world.” – Jeremy Grantham, co-founder of GMO
Jeremy Grantham is one of the better known value investors in finance today. His long successful track record, bold forecasts, and firm belief that all things revert to the mean has set him apart from the rest of the pack. Back in 1977 he co-founded GMO along with two other partners as a private partnership (e.g. hedge fund) focused on investment management. Today, GMO manages over $100 billion in assets with offices spread across the globe. Until recently, GMO was only accessible to institutions and ultra-high net worth individuals, but last year that changed when they decided to partner with Wells Fargo to roll out a suite of mutual funds which would be sub-advised by GMO and made available to all types of investors. One of the funds which was introduced last year was the Wells Fargo Advantage Absolute Return Fund, which we will profile in this week’s Insight.
As the opening quote aptly states, the core investment philosophy of Jeremy Grantham and by extension GMO, is that things revert to their mean over time. We like to call this the bungee effect since it is a good way to think about mean reversion. Basically, asset prices can diverge for short or even long periods of time from their long-term average rate but the further they diverge, the tighter the bungee cord becomes which will eventually snap them back in the direction of the mean. The bungee works in both directions so assets that are producing above average returns will revert downward and assets that are generating below average returns will eventually revert upward.
The core belief in mean reversion is why GMO has long been considered a value-oriented investment shop. They are attracted to things that are unloved and out of favor, believing that over time these assets will recover and revert to their mean. By the same token, they also try to avoid overvalued and highly loved assets. This philosophy has served them well and helped them avoid major losses from the Japanese stock and real estate bubble in the late 1980’s, the tech bubble at the turn of this century, and the most recent financial crisis back in 2008. GMO prides themselves in their ability to recognize asset price bubbles based on their extensive research on this subject. In GMO’s April 2010 quarterly letter, Mr. Grantham rehashed three very salient predictions he had made on the eve of the Financial Crisis based on his study of asset price bubbles and his firm belief in reversion to the mean.
For the record, I wrote an article for Fortune published in September 2007 that referred to three “near certainties”: profit margins would come down, the housing market would break, and the risk-premium all over the world would widen, each with severe consequences. You can perhaps only have that degree of confidence if you have been to the history books as much as we have and looked at every bubble and every bust. We have found that there are no exceptions. We are up to 34 completed bubbles. Every single one of them has broken all the way back to the trend that existed prior to the bubble forming, which is a very tough standard.
The dogmatic belief that asset prices revert to their long-term growth trend gave birth to the now infamous GMO 7-year forecast for various assets. GMO first started publicizing their fundamentally based, long-term forecasts back in 1994. As an example, their equity forecast is based on current vs. historical levels of the price-to-earnings ratio, profit margins, sales growth, and dividend yield. Looking at GMO’s most recent (December 2012) 7-year forecast for US large cap stocks, they predict the P/E ratio to compress acting as a -2.4% headwind to returns, profit margins to fall acting as a -2.7% headwind, real sales per share to grow acting as a 2.9% tailwind, and dividend yields to increase acting as a 2.5% tailwind for a net result of 0.1% real annualized growth.
One of GMO’s core tenants, in addition to mean reversion, is to wait for the “fat pitch.” Often times, the fat pitch can take years to develop which lends itself to extreme patience on the part of the asset manager. Needless to say, based on their recent 7-year forecast, GMO isn’t very bullish on the US stock or bond markets as a whole, but they still see opportunity within stocks and bonds for positive, although below average, returns over the next 7 years. One of the unique characteristics of the fund mentioned in the opening paragraph is that it follows GMO’s Benchmark-Free Allocation strategy which is truly unconstrained. This gives GMO the ability to invest where they see the most opportunity and be patient in waiting for the fat pitches. As of the end of the first quarter of 2013, the fund was positioned with 16% in US stocks, 29% in international developed stocks, 9% in emerging market stocks, 8% in global bonds, and 38% in alternatives and cash providing them “dry powder” to deploy as fat pitches arrive.
The track record of the GMO Benchmark-Free Allocation strategy is rather impressive. The chart and table below show the returns for this strategy going back to the launch of their institutional mutual fund in the summer of 2003. The returns have been adjusted downward to account for the higher expense ratio on the Wells Fargo Advantage Absolute Return Fund.
There are several interesting nuggets to point out from these statistics. First and foremost, it is impressive that GMO has been able to compound stock market beating returns without being fully invested in stocks and while only realizing about half the volatility of the S&P 500. This is why their Sharpe Ratio, a measure of return per unit of risk, is so much higher than that of the S&P 500. The key metric to drill into is the upside versus downside capture of the GMO Benchmark-Free Allocation strategy to the S&P 500. Although GMO was only able to capture roughly 60% of the upside of the S&P 500, which led to them lagging this arbitrary benchmark almost half of the time, they were able to limit the downside capture to a little under 30% making the upside-to-downside capture ratio better than 2-to-1. As we’ve explained numerous times before and unpacked in our Economics of Loss video, often times protecting against large losses in the portfolio is more important to generating long-term, sustainable returns than keeping up with the market during the good times. This is further exemplified by the shallower maximum drawdown (loss) and quicker recovery from said drawdown in the GMO portfolio versus the S&P 500.
Although GMO’s Benchmark-Free Allocation strategy shows higher levels of correlation to the stock market then we typically like to see out of what we consider to be a “global macro” manager, we are comfortable making this strategy a core holding in our Absolute Return bucket based on GMO’s long and successful history, their disciplined and patient investment process, and their ability to be unconstrained in their allocation. As we pointed out in a previous Insight entitled Staying Flexible where we profiled another absolute return manager, “A true alternative fund doesn’t always have to maintain low-correlation to the equity market. It just needs to be flexible enough to not be correlated at the right times.”
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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