When you think of a fund manager, you probably think of an individual proud of doing his own research, patiently picking individual equities or bonds, delivering a unique portfolio that gives superior performance.
Instead, imagine something quite different. Consider a manager who has billions of dollars in assets under management, but rather than buying individual equities, he’s buying other mutual funds. And of those mutual funds, all of them are managed by the very firm he works for. Imagine a fund of funds whose quantitative investment process is so refined it is only rebalanced three or four times a year.
Meet Ben Inker, chief investment officer of quantitative developed equities and director of asset allocation at Boston-based GMO Trust Funds, a division of Grantham, Mayo, Van Otterloo & Co. LLC. Managing the GMO Trust Global Balanced Asset Allocation Fund/III (GMWAX) along with several other funds, Inker relies mostly on the underlying investments and research of the GMO funds he invests in to maintain his above-average returns. “I know what is going on in the underlying mutual funds because we manage them,” he says. “And because I know that my underlying implementation alpha is going to buy me some time for things to work out on the asset-class level, it gives me the flexibility to be somewhat more aggressive in moving money from asset class to asset class to find the places that are priced to give good returns.”
For the five-year period ended August 29, 2003, GMWAX had an average annualized total return of 10.7%, versus a total return of 1.4% for the FTSE World Index (excluding U.S.), and a 5.7% return for all international balanced funds, according to Standard & Poor’s. The fund also earned five stars from Morningstar and S&P and is ranked fifth within the entire universe of 34 funds in the international balanced funds peer group.
And though this is an institutional fund with a minimum initial investment of $5 million, there is a retail fund, Evergreen Asset Allocation Fund (EAAFX), that GMO subadvises for individual investors. “That fund is a clone of [GMWAX],” he says. “They are managed exactly the same way.” The Evergreen Asset Allocation Fund also carries the five-star mark from S&P, has a $10,000 minimum initial investment, and reports an annualized total return of 9.2% for the five-year period ended August 29, 2003. There is, however, a 5.75% front-end sales load on the fund.
We recently spoke to Inker about his fund and the GMO approach to quantitative investing.
Tell me about this fund-of-funds investment approach and why this fund only invests in other GMO funds. What are you trying to accomplish? Are you more comfortable with the style purity of the GMO funds? We use only GMO mutual funds for a couple of reasons. First, we know what we’re getting in the GMO mutual funds. If we’re investing in a GMO small-cap value fund, we know that we’re going to get small-cap value exposure. We don’t have to worry about whether the fund has leapt into technology stocks because the manager has a hunch that they are going to be hot this quarter. Since we are choosing to invest in small value because we think that small-value stocks are attractive, it is essential that the investments we buy be true to that style.
Second, we have a lot of confidence that GMO mutual funds will outperform over time. Our strategies have outperformed their benchmarks by 3% per year on average over the 25 years we have been in business. Much of the value added in this fund comes from the fact that our U.S. large-cap equities should outperform the S&P 500 over time, our emerging market equities should outperform the MSCI Emerging Index, and so on.
Tell us about your management style. What is your role in managing this particular fund? Each of the funds within the firm is run by a team of portfolio managers. The funds are quantitatively managed, so the teams and researchers are [constantly] working on improving our tools for picking stocks in various sectors around the world. My job–as director of asset allocation and portfolio manager for this fund–is to determine what the weights should be across different funds. All of the funds that we are managing here exist as stand-alone products.
This particular fund started as our way of helping [institutional] clients who wanted advice on allocation across asset classes. It was a way for us to do that for them rather than having them keep going back to their investment committees and saying things like “Okay, now we want to move 2% out of U.S. stocks and into international stocks.” The underlying pieces are funds that we have been managing for up to 20 years where the bulk of our outperformance should come in the long term. But in addition to that, we want to look around the world to see which asset classes are priced to deliver good risk-adjusted returns. For instance, while I’m quite confident today that our U.S. core fund should do a very good job relative to U.S. large-cap stocks, we don’t think that U.S. large-cap stocks are priced to give a decent return. We want to have as little of that as we can, given that this is a fund that should look like other global balanced funds. So while we can’t have zero in U.S. large caps, we want to err on the side of having less, and put more of the money into asset classes that are priced to give a decent return.
What is your process for determining the weights of each holding? We start off attempting to come up with a fair value for each of the asset classes that we invest in. That is derived from our views of what an equilibrium return would be to that asset class, and then what pricing would be consistent with earning that return in the long term. We come up with a fair value, and then we use that to generate an expected return for the asset class, using the assumption that the asset class will lend its way toward fair value and achieve it within seven years.
The good news is that asset classes are predictable in the long term. It is possible to come up with an estimate of fair value and asset classes will revert to it–they always have. The problem is that it is difficult to figure out the timing of that [reversion]. So in coming up with our asset class forecast, we look to see where the big deviations from fair value are, and assume that they are going to take a while to come back to fair value. We use that to generate a forecast, which we then use to put together a portfolio that is biased toward the asset classes that are cheap and against those that are expensive.
We manage with one eye toward delivering absolute returns in the long term, and another eye toward the relative risk of being too different from what people would expect a balanced portfolio to do. That is an important issue. One of the real problems in managing money is [within the management style itself. In other words,] the appropriate way of managing money for a client is not necessarily the exact same way you would manage it for yourself. That’s partly because you know yourself very well and, among other things, you know you are not going to lose faith in yourself. But you don’t know as much about [someone else] who is managing your funds.
The perfect level for every client would be just aggressive enough that, say, once every 20 years the client comes really close to firing you but cannot quite do it. Why do you want to do that? The more aggressive you are–assuming you have some skill–the more value you are going to add. But if you are too aggressive, then even though in the long term you would add more value, the account won’t survive. And that won’t do the client any good. So in this portfolio we are trying to make the best tradeoff between making good absolute returns and adding a lot of value, and also making sure that we don’t cause a sufficiently large relative underperformance that the client gets spooked and fires us.
So then your diversified exposure in bonds, equities, and domestic and international investments are important for that reason? Exactly. This is a balanced fund, so people expect it to be between 25% and 50% fixed income. Even if we think equities are substantially overvalued, it wouldn’t be a good idea for us to go to 80% or 100% fixed income.
You tend to invest in larger-cap stocks. Is this by intent, or is it an outgrowth of your quantitative approach? This fund has a pretty substantial overweight of smaller-cap stocks relative to its benchmark or a traditionally balanced portfolio. The indexes out there and the average portfolio have an awful lot of large caps, and right now we see significant opportunities in non-U.S. smaller-cap stocks in Europe and in the emerging markets, so we have significant overweight there. In the U.S. market, we don’t think that small caps are priced particularly attractively anymore and so we have [only] a small bet there. Today we have a modest [exposure] to small U.S. caps, and a very substantial overweight to non-U.S. small caps. The real important issue in the portfolio right now is taking whatever money we can get away with out of the U.S. equity market and putting it into the international equity markets.
Your single largest sector is financial services. Do you specifically like financials now? It’s not that we have a particularly large overweight in financials; it’s more that as the tech stocks sell off, financials are making up a larger portion of the indexes. And since we do have something of a value bias to our equity portfolio, the financial sector generally speaking is looking reasonably cheap, so that tends to make us have a bias towards financials.
What index do you benchmark against? How closely do you manage to the index? This fund’s benchmark is 35% the Lehman Aggregate, 48.75% the S&P 500, and 16.25% the MSCI all-country index excluding the U.S. We put this fund together to make a nice one-stop shop for smaller endowments, foundations, etc., and in general, if you look at those funds, they have about 65% of their money in equities, and of the equities, three quarters are U.S. And that was the benchmark that we put together: 65% equities, 35% fixed income, with the equities being 75% U.S., 25% international. It was intended to be about where our clients were starting out.
There are some who say that as the world shrinks, there’s little negative correlation investment-wise between a foreign-domiciled corporation and a U.S. corporation, especially in the large-cap area. Do you agree? Do you see opportunity and negative correlation in emerging markets only? Is that part of how you seek to balance your portfolio? The issue of correlation is a tough one. If you were going to ask the question, if the U.S. markets were going to fall 20% in a day, what would I expect European markets, or emerging markets, or Japan to do? You would expect them all to fall by 20%. If I expected the S&P 500 to fall by 20% in a month, I still expect them to all move pretty similarly. But over the longer period, you can get very large differences between the returns. So if you look over the 12 years from 1990 to 2002 and you look at how the U.S. market did vs. Europe, the U.S. outperformed by 80 percentage points. The S&P 500 outperformed MSCI Europe by 77% over the period 12/31/1989 to 1/31/2002, rising 309% versus 131%, which means that an investor investing $1 in each at year-end 1989 would have had 77% more if the money was in the S&P 500 ($4.09) than if it was in MSCI Europe ($2.31). The day-to-day correlations were pretty high, but 80 points is a lot of money. We are really focused on circumstances under which you could expect long-term large performance differentials. There is not much we can do to protect against the market falling 20% in a day. But if you can put yourself in assets that are priced to outperform in the long term, then even if the correlation is high you are still going to outperform. So the real reason we are investing in European and emerging markets is not because we think the correlation with the U.S. is going to be particularly low, but because the actual mean return is going to be a good deal higher. The reason we think that is because those markets are a lot cheaper than the U.S., and in the end, if you can buy assets for a 30% to 50% discount, you should do it.
What sort of inflows have you experienced in the fund? Has increased investor confidence or investor worry about U.S. equities over the past two years affected your fund’s total assets? We have gotten a fair bit of inflows into this strategy over the last two years largely because our warnings to clients in 1999 and 2000 came to pass. We showed we could make money for clients in an environment where they were otherwise losing money.
Is there a ceiling to your fund? How large do you want it to become? Some of the underlying pieces of what we are doing are getting close to capacity. Our emerging equity and our emerging debt funds are no longer allowing direct investments from new clients. From our perspective, global balanced money is good money to get because when you do have capacity-strength products, a dollar directly into the emerging market fund is a dollar into the fund, but a dollar into the emerging market fund through the global balanced fund is more like $10 or $20 to the firm. [So it's better use of your investment.] I don’t think it should be a problem for us to take in another $4 or $5 billion dollars into the product as it stands.
The stock market is in a recovery so far this year. Do you expect it to continue? I wouldn’t be surprised to see the stock market continue to run for a little while, but it does have a fundamental problem: it is overvalued. Right now we have the benefit of the election cycle. The third year of a presidential term is the best year for the stock market for the simple reason that the administration will do whatever it can to try to push up the stock market and get reelected. We have seen that in spades this year. There has been a huge fiscal stimulus, and there has been a lot of monetary stimulus. That can help in the short term and it may last long enough to get us through the 2004 election, though it is unlikely to last much longer than that. Sooner or later the stock market is either going to come down, or it is going to have to flatten out for a long period of time to let the underlying value catch up to prices. Enjoy this rally, but we do not expect it to be the start of the next great bull market.
How often are current holdings reviewed? Anytime we get a flow into or out of the fund, we can use that to tweak our weightings. But generally, three or four times a year there is a big enough change in the overall pricing of the markets to cause us to make a meaningful change to our allocations. This past winter when equity markets were having a tough time, we took some money out of fixed income and put some into equities, particularly international equities. But, as the rally has gathered some significant steam, we have taken some money out of equities and put it back into fixed income. It is not a high-turnover strategy. That would be unfair to the managers of the [other GMO] funds to be moving money in and out on a daily basis.
What other funds do you manage? I oversee our asset allocation funds: we have an international equity allocation fund, a global equity allocation fund, a U.S. sector allocation fund, the Evergreen asset allocation fund, and I also manage a couple of our hedge fund strategies. What I do is pretty easy. I don’t have to spend my time trying to figure out which stocks to buy. All I have to worry about is the asset classes. If I like international stocks better than U.S. in this portfolio, then I am going to like them there, too, and it’s really not a different problem. I use the same basic tools for all of the funds I manage; I am just managing them against a different benchmark and a different risk/return tradeoff.
Staff Editor Megan L. Fowler can be reached at [email protected].