GMO is urging investors to stop obsessing over their portfolios and pay more attention to factors beyond their holdings that are more difficult to measure — or risk failure in meeting their goals.
Investors tend to ignore assets and liabilities that lie outside their portfolios because they lack the “quantitatively well-estimated characteristics” they can easily rely on to measure performance, according to the fund manager’s first-quarter letter to clients. Their preference for simpler analysis of historical returns has led them to build portfolios that solve the “wrong problem,” wrote Ben Inker, GMO’s head of asset allocation, in the letter.
“No investment portfolio exists in a vacuum,” Inker said. “It is almost certain that investors would achieve better overall outcomes if they recognized the risks outside of their portfolios that really matter and invested accordingly.”
Conventional wisdom in portfolio construction is flawed because it misses the larger objective that a portfolio is meant to serve, leading to bad investment decisions, according to the letter. Investors should shift their mindset to consider factors like the potential for the sponsor of a pension plan to make additional contributions when needed, or the type of mission that a charitable foundation supports.
When investors such as pensions, foundations and sovereign wealth funds take the harder path of determining “the nature of the true problem” they’re trying to solve, Inker said, they are likely to benefit from insights that would not have occurred to them otherwise. For example, private foundations aren’t all equally impacted by an economic downturn.
A foundation focused on feeding the poor in its local community would find “the need to feed the hungry grows materially in a depression,” said Inker. But the costs at a private foundation supporting cancer research would not see a similar rise in costs because the need for a cure is unaffected by economic circumstances, he said.
“The nature of those liabilities strongly suggests the two portfolios should have different allocations to stocks and bonds,” Inker wrote. The “same risk aversion” that would give the cancer-curing foundation a portfolio consisting of 75 percent stocks and 25 percent bonds would suggest a portfolio mix of 49 percent in stocks and 51 percent in bonds for the hunger-oriented foundation.
“Once we move beyond the investment portfolio, estimates of risk and correlation are necessarily judgment calls,” Inker said. “Investors or risk managers cannot simply rely on a historical returns-based covariance matrix to estimate overall risk.”
While pension fund managers partly consider the larger framework for investing due to accounting standards that force them to recognize how their liabilities vary with interest rates, they could do better, according to GMO.
“In worrying about the funding ratio of the pension rather than simply the volatility of the portfolio, they are moving in the right direction,” he said. “But most pension fund managers tend to stop there, failing to fully take into account the assets outside of the portfolio that are relevant to the overall problem.”
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They often fail to consider the additional contributions the pension fund’s sponsor may make to the portfolio, according to Inker. “Because the sponsor’s ability to make these contributions varies depending on economic circumstances, all deteriorations in the funding ratio of the pension fund are not equal,” he said. “A deterioration that occurs when the cash flow position of the sponsor is worse than average is significantly worse than one that occurs when sponsor cash flow is strong.”
In another example cited in his letter, Inker said that a sovereign wealth fund backed by commodities revenue has different risks to cash flow than one whose funding stems from a surplus in manufactured goods trade. “If these two sovereign wealth funds had otherwise similar risk aversions, they should wind up with materially different portfolios,” he said.
According to GMO, the investment portfolios of workers should consider their job type — not just how close they are to retirement when making allocation decisions. While a teacher, a manufacturing worker, and a financial services employee may have the same tolerance for risk based on their age, their ideal portfolios can vary based on the volatility of their labor income and how it correlates to the stock market.
“If we assume a strong covariance between labor income and stock returns, such as might be the case for a worker in the financial services industry, we get the interesting result that workers in their 40s or older should have less in stocks than they should at retirement,” Inker said.
“While this runs counter to the standard advice and most traditional retirement glide paths, it does make plenty of sense when you think about how a depression impacts someone who is relatively close to retirement versus someone who has already retired,” he said. A depression could be far worse for someone who is five years from retirement, as the likelihood of that person becoming unemployed is “material,” according to Inker.
Of course, shifting investor mindsets is easier said than done.
Investment professionals are up against practical hurdles when making decisions based on “theoretical superiority,” according to GMO. Should the right portfolio for a particular institutional investor’s mix of assets and liabilities underperform peers, “it is not clear whether an investment committee will care much about the theoretical superiority,” Inker said.
