For institutions with access to professional advice and with long investment horizons, a fixed mix approach to asset allocation is “aiming too low”, according to Jeremy Grantham, outspoken chief of GMO, who argues instead for a more dynamic approach to asset allocation in times of severe mispricing.
“If the last 15 years has taught us anything, hasn’t it taught us that asset classes can be incredibly mispriced, along the lines of the 35 times inflated earnings for the S&P in 2000? Why would you ignore these opportunities to sidestep trouble?” Grantham ponders in his latest quarterly letter.
Grantham says it is sensible to be fairly static when pricing is normal, or even half way normal, but when very large mispricings occur, he asks whether it is more reasonable to move away from extremely overpriced assets towards more attractive ones.
“Markets are very mean reverting over longer horizons, and sophisticated clients always proclaim their patience,” he says, arguing that asset allocation based on serious action at the extremes and inactivity the rest of the time has a good record and can be done quite simply.
GMO puts its money where Grantham’s mouth is. Over the past 16 years, more than 60 per cent of the total outperformance and more than 60 per cent of the reduction in volatility in its global balanced asset allocation strategy has come from moving the mix of assets, rather than implementation.
“Asset allocation is simply much easier than adding alpha to a fund, since there is more to sink your teeth into,” he sys. “Counter-intuitively, asset classes are more inefficiently priced than stocks.”
Grantham says there is a large and relatively efficient arbitrage between stocks, and the career risk of picking one stock versus another is quite modest, but in contrast when picking one asset class against another it is very clear when mistakes have been made.
“This immense career risk makes it likely that there will always be great inefficiencies, for investors are reluctant to move money across asset boundaries. Consequently, there is great advantage to be had in getting out of the way of the freight train, rather than attempting to prove your discipline by facing it down. The advantage is in both higher return and lower risk.”