Amid calls from global leaders for pension funds to invest more in the green economy, institutional green investments still languish at less than 1 per cent of portfolios.

A recent OECD report looks at some of the barriers facing investors wanting to invest more in the sector, with regulatory uncertainty and a lack of suitable financial products key hurdles.

Sharan Burrow, the head of International Trade Union Confederation (ITUC), is one of those calling for more investment from pension funds.

Burrow says that green investment will lead to green jobs and the ongoing viability of pension funds themselves.

The ITUC recently released research claiming that 48 million jobs could be directly created if green investment was lifted to 2 per cent of GDP in 12 countries over the next five years.

It is “sound business management” to consider how investments would impact jobs and, therefore, future inflows into the pension industry, Burrow says.

“If you see diminishing jobs in your own industry and backyard, which means less money is flowing into your industry, then that has got to be a consideration of risk that would feed into any notion of fiduciary responsibility,” she says.

“It would, therefore, stand up that funds must be conscious of where their own investments may drive a more secure environment for the industry itself.”

The ITUC has identified a tipping point of a 5-per-cent allocation of portfolios to green investments, which it believes would provide enough critical mass to ensure confidence in green investments.

Burrow says the ITUC is pushing to reach this 5 per cent allocation target by 2020.

 

OECD lowdown

The OECD report handed down in late 2011 reveals that the industry is a long way from this goal.

The Role of Pension Funds in Financing Green Growth Initiatives by Raffaele Della Croce, Christopher Kaminker and Fiona Stewart, reports that pension funds represent $28 trillion in combined capital. But despite the recent growth in socially responsible investing, green investments represent less than 1 per cent of portfolios globally.

The authors find a lack of regulatory certainty, with unsupportive government policies and ongoing subsidies of fossil fuel-intensive industries make most green investments uncompetitive.

“Pension funds and other institutional investors will not make an investment just because it is green – it also has to deliver financially,” the paper finds.

Estimates of how much money would be required to mitigate the effects of climate change vary wildly. The World Economic Forum has estimated that the clean-energy investment necessary to restrict global warming to less than 2°C would be $500 billion per year by 2020.

Another barrier to investment is the lack of financial instruments that would enable long-term-focused institutional investors to make these types of investments.

The market for green investments remains small and illiquid, with investment opportunities concentrated around small start-ups and higher risk venture capital-type opportunities, the report finds.

Researchers find governments could play a role in this regard by ensuring an adequate flow of investment-grade deals at appropriate scale are available.

Public finance could also be invested alongside private capital and there are a range of partial guarantees or subordinated equity and debt arrangements that could make green investing more attractive.

The report identifies green bonds as a particularly effective way of tapping institutional capital, while meeting funds’ investment requirements.

The market size of green bonds is approximately $15.6 billion with these fixed-income securities typically issued as AAA-rated securities by the World Bank, development banks and other entities focused on raising capital for green investing.

The current market in green bonds represents 0.017 per cent of the capital held in bond markets.

“There is clearly scope for scaled-up issuances of green bonds (at least in the tens of billions per year) but if this capital is to be raised through a thriving and liquid green-bond market, transparent politics based on long-term comprehensive and ambitious political commitment is needed,” the report states.

 

How to go green

However, some of the problems around investing in green infrastructure are not particular to this sector of the economy and are shared by the broader asset class.

Researchers make the point that problems around high fees, a lack of transparency and additional social, political and regulatory risks associated with infrastructure investments also hold back further investment in green infrastructure.

Governments can play a role in this by encouraging infrastructure investment through a range of regulatory and investment incentives.

The report notes that there is potential for countries to leapfrog the development of others through attracting capital to allow them to nimbly make the transition to a green future without the constraint of being tied to old fossil fuel-hungry infrastructure.

The focus on ESG and socially responsible investment and the growing push from asset managers to meet this demand is also muddying the waters of what is a green investment.

The OECD has started working on defining and measuring foreign direct investment as a way of offering support to governments in evaluating the effectiveness of policy.

The researchers say this has the potential to assist pension funds to arrive at a common understanding of what a green investment is.

A potential solution to this problem could involve a recognised ratings agency that could provide analysis of green bonds or funds to ensure that monies are used for green investments.

A backdrop to push for more green investments is the question of the role of pension funds and what their fiduciary duty is when it comes to ESG investments.

Burrow is unequivocal when it comes to what trustees’ fiduciary responsibilities are.

“The world has no choice to change. There are simply no jobs on a dead planet and that means no industry and investment is irrelevant,” she says.

“We need to look at the risk element of fiduciary responsibility, which is a traditional notion, and one that hasn’t played out if you look at the financial crisis and the lack of fiduciary responsibility around the question of analysis of risk that drove us to the brink based on simply accepting somebody else’s word on what products were secure. So, from our point of view fiduciary responsibility, particularly for workers’ capital, has to include risk. If it doesn’t, then fiduciaries are not doing their jobs. The second thing fiduciary responsibility is set up to do is to deliver a return on capital.

 

Fiduciary duty and green jobs

Expanding fiduciary duty to take in consideration of ESG issues and the broader impact of investments is a hotly debated topic in investment circles.

At a UN-backed investor summit in January, CalPERS chief executive Ann Stausboll called for funds to look beyond just returns to members and push for broader environmental and social action on such issues as climate change.

Other investors, such as Swedish buffer fund AP7, go as far as saying that returns are a secondary consideration to ensuring that investments meet the ethical values of members.

Opponents of this broadening of fiduciary duty beyond the aim of maximising financial returns for members within acceptable risk parameters point to the difficulty in making assumptions around what the values and ethical standards of members are.

Funds may also be taking on an unseen opportunity cost through allocating capital to green investments when other types of investments may generate better returns to members.

Like the OECD, Burrow sees a much bigger role for government in providing a catalyst for investment, saying they must drive a new “new global stewardship” of the world economy.

“We believe that the combination of patient capital and regulatory certainty, where government has to play a role, will mean that these investments will indeed be secure, but also profitable, and contribute to a future where our world is much more sustainable,” Burrow says.

“The issue is what the role for government is, and governments must find a new stewardship of the global economy. We are not suggesting that all of this money should come from government. Obviously, it must come from investors and a mix of private and public capital, depending on the context.”

The ITUC-commissioned research Growing Green and Decent Jobs , which identifies the potential impact of green investing on job creation, was conducted by the Millennium Institute.

The researchers attempted to construct a “green job creation benchmark” for particular industries that could act as a guide for the effectiveness of green investment.

The analysis looked at low, middle and high-income economies, with the institute analysing green-investment scenarios in seven industries.

These included energy, construction, transport, manufacturing, agriculture, forestry and water. The number of jobs created was measured through what researchers describe as quantitative simulations that looked at direct job creation.

A simulation of green investments for a particular country involved a 2 per cent of GDP investment in four key industries over a one-to-five-year time frame.

Industries selected vary via country and the research did not take into account potential job losses resulting from a reallocation of capital on this scale.

 

The €109-billion PGGM has been one of the global leaders in allocating assets according to ESG criteria. Now it is taking the philosophy one step further and aims to measure how all of its investments have a positive influence on the state of the world by measuring “sustainable returns”.

The Dutch pension-fund service provider claims it is developing a methodology to measure what it calls “sustainable returns” – the non-financial, societal and environmental benefits derived from its investments.

PGGM will then report to institutional clients how its investment portfolios positively affect the broader society and the environment generally.

Marcel Jeucken, managing director of responsible investment at PGGM, says the fund has been working with Erasmus University in Rotterdam to develop a method to measure the sustainable returns generated through targeted-ESG investments totalling €4.73 billion in 2011.

The measurement of these returns looks to capture both the return on current investments and the expected return on an annual basis of long-term investments.

“This can be done for our focused ESG investments, and this year we are also trying to think through whether we can use this idea to capture societal returns for all the assets we manage,” Jeucken says.

“This is very complicated and will start with some pilot projects, but we think it is increasingly necessary to be able to communicate to our wider stakeholders and especially the beneficiaries of the pension funds we work for.”

 

Measure for measure

The methodology for targeted-ESG investments aims to measure the impact across eight key areas: employment, local development, capacity building, empowerment, health and safety, material use, ecosystems, and waste and emissions.

The expected impact of each environmentally focused fund is reflected in a score on a scale of -3 for highly negative to +3 for highly positive. Reporting also discloses the social impact of every investment over €1 million in a specific fund.

Its first pilot project to try and measure the sustainability returns in its broader portfolio of investments will be in real estate. This year it has one other pilots planned but PGGM has not decided which asset class this measurement program will be expanded to.

PGGM is a founding partner of the Global Real Estate Sustainability Benchmark (GRESB) database, which records the sustainability of a number of real-estate funds around the world.

The benchmarking system will form a valuable basis from which to measure its sustainable returns generated through real-estate investments.

Jeucken says that government bonds and derivative-type investments will be areas where measurement of sustainable returns will prove challenging.

“This will be a project over multiple years and will be very complicated, but we are also hoping to develop this with others, going forward,” he says.

“We could collaborate or we could go to the market with our thoughts and ask for feedback and wider consultation within the principles for responsible investment, for example. This is a journey and it will take some time to do this.”

The fund will also extend ESG considerations to its broader asset-allocation decision-making processes, Jeucken says.

Previously, asset allocation had been limited to issues around climate change. Work on this included participation in Mercer’s Climate Change Report.

This year PGGM plans to expand the ESG factors it considers when setting its strategic asset allocation.

“Which assets are more prone to ESG risks or opportunities than others and what does it mean for your asset allocation? This isn’t about implementing within your portfolio from a portfolio-management perspective, but more talking about the role of asset owners in terms of how they allocate assets within their strategic benchmark,” he says.

PGGM started a project last year and is applying what it has developed with a view report its progress more fully by the end of this year.

“We will look at expected risk and return and also expected risk and opportunities in ESG factors in the context of achieving our objectives in asset allocation, which is not just high returns but higher and stable returns,” he says.

“Now, we are adding responsible returns to these key asset-allocation objectives and that is quite interesting for us and why we are looking at ESG in terms of asset allocation.”

The environment-focused investment funds include three infrastructure funds. and one offshore wind-power park. In private equity, PGGM works through a fund-of-fund mandate with AlpInvest, which invests in companies developing innovative and proven clean technologies.

PGGM also supports alternative energy through structured credit that finances a range of initiatives including solar and wind projects.

In real assets PGGM invests in carbon credits and sustainable-forestry funds.

 

 

 

Monday 21 May
9:00 – 11:30 am
The Codrington Room, Corinthia Hotel London
Whitehall Place, London SW1A 2BD
United Kingdom 

 

Over the next several years, it is estimated that European banks need to dispose of approximately €2.5 trillion of non-core assets. The €800 billion “firewall” against sovereign debt default in Europe and long-term refinancing operations (LTRO) have eased liquidity stress among the region’s banks, but has not dealt with their solvency issues.

Like US banks, European lenders bought plenty of lower quality, higher yielding debt between 2003 and 2008 to support leveraged buy-outs, real estate deals and structured financial products. They are now under significant pressure to sell these, and other, assets as a result of upcoming Basel III regulation, the need to reduce reliance on wholesale funding and requirements from the EU and local governments. For the first time, Europe is experiencing a distressed debt cycle of vast proportions.

This presents a compelling opportunity for investors. However some widely believed myths are preventing private capital from investing in European corporate distressed debt.

Banks are unwilling to sell assets at distressed prices due to weak balance sheets

The truth is that a number of European banks are selling distressed assets, but this is not necessarily visible because divestitures are generally less public for a number of reasons. The roundtable will discuss the reality behind this myth, what skills and experience are required to access these sales processes and the size of the actionable distressed debt opportunity.

European insolvency laws make it next to impossible to achieve debt-for-equity swaps

European insolvency laws are varied and complex. Knowledgeable investors carefully select the jurisdictions they work in and know what can and cannot be achieved. The roundtable will compare and contrast legislation in different countries to highlight the most attractive areas and how laws in more difficult countries are evolving.

Unions, laws and culture prevent effective operational restructurings of European companies

Restructurings in Europe are fundamentally different than in the US. European labour laws, unions and culture are important and powerful considerations. We will discuss how it is possible to work constructively with local officials and unions to develop realistic plans which can ensure a company’s long-term viability and maximize employees’ welfare over time while agreeing to appropriate short-term sacrifices.

CLICK HERE TO REGISTER YOUR INTEREST

Water and how a company manages its exposure to this increasingly scarce resource is a key focus for Norway’s sovereign wealth fund in assessing the environmental and social performance of the more than 8000 companies in its portfolio.

Anne Kvam, the head of Norges Bank Investment Management’s (NBIM) corporate governance team, says the sheer size and scale of understanding the plethora of environmental, social and corporate governance (ESG) risks in its investments demands a focus on a selection of companies and a few key risks. Norges Bank is Norway’s central bank and NBIM manages the Norwegian Government Pension Fund Global on behalf of the ministry of finance.

“If we are to work actively on all 8000 holdings on all environmental, social and corporate governance topics, this would, of course, be impossible,” Kvam says.

“This is why the executive board decided we will have six focus areas and three of those are tied into environmental and social areas, and they are children’s rights, water and climate change. This doesn’t mean that we don’t see that there are many other risks out there that we hope and expect companies to manage.”

NBIM, the asset management arm of Norway’s central bank, is responsible for managing the investments of the $576-billion sovereign wealth fund.

Kvam explains that its investment staff can access an easy-to-handle, one-page report on a company that includes a scorecard of its performance across these three key areas.

The report draws on internally generated information and external research that the asset manager purchases.

Data on these three focus areas is gathered on more than 2000 companies. Broader ESG reporting for the fund covers 4000 companies, representing 80 per cent of the fund’s holdings.

 

Distilling best practice

NBIM has had water as one of these key focus areas since 2009. This includes issuing guidelines for companies it invests in on how they should report and manage water risk.

Under these guidelines, companies are expected to have a water-management strategy that evaluates the extent of water use in the production process and, more broadly, in a company’s supply chain.

Companies are also required to report on how its water use affects surrounding communities and how water risk management is built into corporate-governance processes.

NBIM reports that it is invested in several sectors with high water consumption. It has determined seven sectors particularly exposed to water-related risk: agriculture, food, manufacturing and power, mining, pharmaceuticals, pulp and paper, and water supply.

The fund has identified 1100 companies where water is an important input and output factor and these companies have a combined market value of $46.1 billion.

Kvam says that NBIM has narrowed its analysis of water risk at the companies it invests in to 447 companies selected from these high-risk industries.

These companies represent the largest holdings for the fund across these chosen sectors.

It reports annually on these companies in its Sector Compliance Report, which aims to encourage better reporting practices across industries, as well as identify top performing companies for disclosure and management of water risk.

The report notes that: “despite a notable increase, companies’ reporting on relevant metrics that track their exposure to water-related risks and the performance of their water management systems was still too low.”

The forestry and paper sector had the highest level of disclosure whereas companies in the mining and industrial sector had the lowest.

“We are dependent on companies disclosing good relevant information so we can make good investment decisions and good calls,” Kvam says.

Nestlé, Anglo American, Anheuser-Busch InBev and Danone were among 14 companies with the highest marks for reporting on water-related risks in 2011.

GlaxoSmithKline, Kellogg, Kirin Holdings, Merck & Co, Molson Coors Brewing, PepsiCo, Pfizer, PG&E, SABMiller and Sanofi were also top performers.

Of the 447 companies assessed in this area, 32 per cent scored zero.

“It is common to name the worst performers as a kind of naming-and-shaming part of ESG, but we are trying the other route by naming what we think are the best performers and who are the best at disclosure,” she says.

The global scarcity of water continues to make headlines, but a water-themed investment approach is only just starting to make waves with large institutional investors.

Estimates of the assets in equity funds in this niche corner of the investment world vary from about $3 billion to $6 billion in funds under management – a veritable drop in the ocean in terms of the asset management world. However, proponents of a water-investment strategy are seeing a surge in interest from large institutional investors.

Mechanical and biomedical engineer Bill Brennan is also a portfolio manager at Summit Global Management, the oldest and biggest water-focused investor in the United States.

Summit’s founder John Dickerson has been investing in the water sector for 40 years and launched a hedge fund more than 12 years ago.

The hedge fund tracks an investable universe of 405 companies involved in what it describes as “hydro commerce”.

Industry estimates put the total global investable opportunity set, across all asset classes, as somewhere between $360 billion and $700 billion.

Companies Summit invests in typically have a 30-per-cent or greater direct exposure to water and ideally generate more than half of their revenues from the water industry, according to Brennan.

He says that some long-term focused investors who previously classed water investments as part of their natural resources, commodities or infrastructure asset classes are now beginning to think of it as a discrete asset class.

“This industry has gone from being a sideline to becoming a recognisable, investable theme and really a line item with the consultants,” Brennan says.

“Before you could chuck it in resources, natural resources, commodities and for some reason it wasn’t a perfect fit. Now people are taking a look at single-line item water investing as part of the overall asset allocation.”

Brennan notes that Summit’s team is made up of water-industry veterans, not just financial analysts, because understanding the interconnectedness of the industry, as well as its unique risks, is vital to investment success.

“It is one of those things where people looked to see how the water-investing industry would evolve and they needed time to better understand the underlying nuances. It is not just financial analysis that you need, it is a grasp of the engineering, the political and regulatory landscapes.”

Summit has around $425 million in assets under management, split evenly between its water-focused equities and a water-rights fund invested in the US and Australia.

 

How the water funds flow

Typically, corporate pension-fund investors have been those already in the water industry, says Brennan, but this is expanding with sovereign wealth funds in particular, showing growing interest in water.

Recent headline-grabbing forays into water investing by sovereign wealth funds include the Chinese Investment Corporation snapping up more than 8.68 per cent of British water utility Thames Water, the utility that supplies water to households in London and the Thames Valley, an area of 5000 square miles. This follows a 9.9-per-cent stake bought by the Abu Dhabi Investment Authority in December.

Norges Bank Investment Management, the asset manager for Norway’s sovereign wealth fund, also invests heavily in water as part of its 21.1-billion-Kroner ($3.65 billion) environmental-investments program.

Three of its 10 environmental-investment mandates cover water, mainly focusing on companies that develop technology and infrastructure for its treatment and distribution, often in emerging markets.

Water also forms part of Norges’ overall investment strategy and is recognised as one of its six key risks.

For water investors, the crisis in Europe has resulted in a short-term hit to portfolios but may result in long-term opportunities.

Water stocks were hit hard as the Euro crisis caused markets to tumble in late 2011. However, investors are seeing the potential for attractive opportunities as countries running austere budgets look to privatise their water utilities in the coming years.

In Europe one of the longest water-focused managers is Kleinwort Benson Investors (KBI) whose 11-year-old Water Strategy equity fund has attracted more than $600 million in assets under management.

Matt Sheldon, portfolio manager for KBI environmental strategies sees investors using the fund in a number of ways to compliment other exposures in their portfolio.

“There is no obvious bucket, there is no global asset allocation that has a slice called water,” Sheldon says. “So, it fits into a lot of different places like global equities. Think about it as mid-cap, core, global equities with an emerging-market component to that. But it also fits anywhere from infrastructure to alternatives to inflation protected to sustainability. These are the other niche slices that our clients are slotting it into.”

The fund holds 45 stocks, with a 13-per-cent direct exposure to emerging-market companies. However, when developed-market companies that generate a large proportion of their revenue from emerging markets are included into the picture, the exposure of the fund to emerging markets rises to about 30 per cent, according to Sheldon.

KBI invests solely in water equities and has other funds focused on agribusiness and renewable energies. Sheldon says that investors also look to its water fund as a potential sustainability diversifier, as it has a low correlation to its renewable energy fund.

Benson and Sheldon point to the capacity of their funds to beat the broader market over the long-term. KBI Water Strategy has beaten its benchmark MSCI World Total Return Index by an average of 4 per cent since inception. Over three and five-year periods, it has returned 22.92 per cent and 1.39 per cent, respectively, compared to its benchmark return of 20.78 per cent and -0.14 per cent over the same time periods.

Summit did not directly provide performance figures, but marketing material shows that it has achieved an average compound annual return of 9.5 per cent since inception, compared to the S&P 500 TR at 2.3 per cent and the Russell 2000 TR at 6.4 per cent.

 

Overflow

Sheldon and Brennan acknowledge that water stocks are not immune to market downturns.

Water-industry research firm Global Water Intelligence notes that its 2011 year-end figures for its global water index showed a 5-per-cent fall in the value of water stocks.

There is a silver lining in the storm clouds of market uncertainty for Brennan and Sheldon.

Long-term valuations are attractive for water stocks, pointing to underlying fundamentals – the growing need to replace ageing infrastructure, increased water needs from industry and the push for water security by India and China – as potential drivers for growth.

“The cycle has turned from the 2008 financial-crisis weakness. We’re just to the right of the trough, but we are still years away from the peak,” Sheldon says.

Summit’s analysis shows that water-utility and industrial-stock multiples are respectively trading about 17 per cent and 18 per cent below their seven-year averages.

KBI’s own analysis points to similar attractive valuations.

“Current valuations of the fund are the cheapest – on an absolute and relative basis – since inception and certainly over the last five years. The fund is about 13.5 times our next 12-month earnings and 12 times calendar year 2013,” Sheldon says.

Usually KBI splits its fund’s exposure evenly between water infrastructure, technology and utility companies but recently has tilted the portfolio to a bigger play at infrastructure companies.

This reflects a bullish outlook for infrastructure spending, with Global Water Intelligence’s research showing that capital expenditure on water infrastructure is expected to grow to $131 billion in 2016, up from $90 billion in 2010.

For KBI it also indicates a growing confidence in what Sheldon describes as infrastructure companies focused on supplying late-cycle water-infrastructure products and services for particularly large projects.

This might involve, for example, water-pump manufacturers supplying a refinery or a water-treatment company providing specialty skills and equipment to a new power plant.

“The visibility of these kinds of projects is very good, as they are multi-billion-dollar projects that have been in planning and, from inception to completion, could take five to 10 years or even longer,” Sheldon says.

“By the time our companies are beneficiaries, there have already been a number of others – from engineering and design companies through to construction companies.”

 

Pipes, pumps and water rights

The infrastructure component of the portfolio was the best performing component of the fund last year. It makes up 41.9 per cent of the portfolio.

Brennan also sees opportunities for infrastructure, not only in the need to replace ageing hardware, but also more broadly as urbanisation trends across the globe continue to gain momentum.

In the US alone, the American Society of Civil Engineers says that that in 2010 alone there was a $54-billion gap in the funding required to maintain and meet the country’s water needs. It predicts this gap will grow to $80 billion in 2020.

In emerging markets, India and China have comprehensive five-year plans around improving water security. In China this would amount to more than $128 billion in new spending.

Brennan says that concerns around corporate governance standards have stopped it investing in Chinese companies. But it accesses China’s growth opportunities through Japanese companies with a China focus and Hong Kong-listed companies that must meet higher reporting and governance standards.

New industries are also seen as potential drivers of growth.

The shale gas industry in the US is notoriously water hungry, and Brennan says this provides opportunities both for water companies that service these new projects and the holders of vital water rights in shale gas reserves.

Brennan says that the Summit fund focuses its water-rights business in American states where there is an established water-rights trading regime, in some cases going back more than 150 years.

These include Colorado, New Mexico and California.

It is also undertaking a long-term strategy of owning water rights in close proximity to large shale gas deposits in the Rocky Mountains around West Texas, New Mexico and Colorado.

 

Supposedly long-term investors typically have the patience to wait about three years to see if an investment strategy will pay-off with managers needing to manage to their own and their client’s career risk tolerance, investment icon and Grantham, Mayo and van Otterloo (GMO) founder Jeremy Grantham says.

In his quarterly letter to investors, Grantham says GMO believes that what it calls “standard client patience time” is three years in normal market conditions.

“With good luck on starting time, good personal relationships and decent relative performance, a client’s patience can be a year longer than three years, or even two years longer in exceptional cases. I like to say that good client management is about earning your firm an incremental year of patience,” he says.

“The extra year is very important with any investment product, but in asset allocation, where mistakes are obvious, it is absolutely huge and usually enough.”

In his letter Grantham notes that the central truth of investing is that investment behaviour is driven by career risk.

According to Grantham, career risk results in herd mentality and market momentum that creates market volatility and, ironically, the opportunities for investors like GMO to beat the market by betting against irrational bull markets.

He believes that career risk explains the wild movement of stock markets relative to the fundamentals underpinning those markets.

Grantham’s reputation as an investor was built around picking these so-called moments of market irrationality, in particular the 2001 dot-com bust and the global financial crisis in late 2008.

He notes that clients show “little mercy” to managers who underperform as boom markets peak and points to GMO losing 40 per cent of its clients for running a relatively underperforming defensive strategy in the lead-up to the tech bubble bursting.

According to Grantham, GMO were two to three years too early in picking the price bubbles in the 1989 Japanese stock market and the subsequent tech bubble 11 years later.

“Picking cash or “conservatism” against a roaring bull market probably lies beyond the pain threshold of any publicly traded enterprise,” he says.

“It simply cannot take the risk of being seen to be wrong about the big picture for two or years years, along with the associated loss of business. Remember, expensive markets can continue on to become obscenely expensive two or three years later, as Japan and the tech bubble proved. Thus, because asset-class selection packs a more deadly punch in the career- and business-risk game, the great investment opportunities are much more likely to be at the asset-class level than at the stock or industry level.”

 

Do not underperform in bear markets

Grantham advises that investors can survive betting against bull market irrationality if they meet three conditions:

  1. Allow a generous margin of safety and wait for a real outlier before making a big bet
  2. Try to stay reasonably diversified
  3. Never use leverage.

He explains that GMO has to manage to career risk, leaving clients’ pain “just tolerable” and typically tries to leave the portfolio looking “faintly normal” when positioning investments for the end of the an irrational bull-market run.

“Too big a safety margin and we are leaving too much money on the table. We are probably protecting our jobs rather than attempting to maximise our clients’ return,” he says.

“Too narrow a safety margin and clients may fire us, as some have done in the past.”

Grantham’s letter comes as GMO launches its Benchmark Free Allocation Fund on a stand-alone basis. The fund was previously part of GMO’s real return strategy and is an open-ended fund with an objective to provide a positive return regardless of market direction. Year to date, the fund is up 4.71 per cent, and over three and five-year periods, it is up 11.5 and 5.56 per cent, repsectively.

The benchmark-free strategy allows GMO to take bets when markets are overpriced without being constrained by a benchmark, which Grantham says entails its own risk of being swept up in major market downturns.

A conservative investor constrained by a benchmark can relatively outperform in a market downturn but still make a loss in absolute terms.

The benchmark-free strategy looks to protect capital during downturns and provide returns with lower volatility over the long term.

“The cardinal rule is to not underperform in bear markets,” Grantham says.