All In The Family

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].