Grantham-- Letters to the Investment Committee XI*
Let’s All Look Like Yale
Part II: Yale Meets Goldilocks
Jeremy Grantham
Summary of Part I
Last quarter I made the point that a continuously large
flow of funds from the traditional assets – U.S. stocks and
U.S. bonds – towards diversifying assets – everything
from emerging markets equity to infrastructure and
private equity – was almost certain. This quarter it is time
to look at the effects of this revolution in asset allocation
on individual asset categories.
First of all, it is important to realize that the “let’s all
look like Yale” effect is not the only important driver of
asset allocation. The other extremely important issue
is the effect of sustained global liquidity combined
with sustained rapid global growth, which has created
an unusual Goldilocks effect where the economic and
financial world are “just right,” which in turn has led to
an unprecedentedly low risk premium across all assets
(see the first section of the quarterly letter) and broadly
overpriced assets.
These two quite separate effects – Yale and Goldilocks
– interact. The Yale centrifugal force unfortunately often
coincides with the drive towards riskier assets stimulated
by Goldilocks. Prime examples of this would be emerging
country debt and equity and private equity, all both risky
and diversifying. There are, in fact, few examples of
intrinsically conservative investments where only the
Yale effect holds. The obvious example would be forestry
holdings, where even alone the diversifying effect has been
enough to dramatically change the pricing. The worst
effects, though, should rationally be at the intersection of
these drivers to high risk and exotic diversification, and
this is where we should expect to see the most extreme
relative overpricing in coming years. Certainly in the last
five years the outperformance of these categories has been
extreme. Here is just a sample.
Cumulative Performance of S&P 500 and
Other Assets from 3/31/02 to 3/31/07
S&P 500 35.5%
Russell 2000 68.1%
U.S. Low Quality Stocks 72.7%
Int'l. Small Cap Stocks1 191.8%
Emerging Equities2 221.4%
Lehman Brothers U.S. Government 28.1%
U.S. Junk Bonds 63.9%
Emerging Country Debt3 87.0%
Other than commenting on the broad outperformance of
these newly desirable areas, a few categories bear special
mention, either for their unexpectedness, such as timber,
or for their potential dangers.
Let us start with timber. This has gone from an obscure
asset favored passionately 10 years ago by a dozen or so
institutions thought to be eccentric, to a fashionable new
frontier 5 years ago favored by an incremental handful
of avant-garde institutions, to a hot asset class today
that is at least considered by most larger endowments
and foundations. The impact on this small asset class
– in 2000 Microsoft’s market cap was larger than all the
world’s forests (what a nice arbitrage that would have
been!) – was of course spectacular. The discount rate used
in evaluating forest properties was as recently as 3 years
ago about 8.5% in the U.S. and over 10% in New Zealand
This was a ridiculously high real return for an asset whose
virtues included that it was exceptionally diversifying – it
has had a history of rising in all great equity bear markets– and in the context of a diversified forest portfolio, very safe: if the sun shines and it rains, the trees grow about on schedule. The discount rate today with forestry’s new popularity and the general desperation to fi nd high returns
has fallen to barely over 5% and 6.5%, respectively, in the
two countries. This represents both a wonderful windfall
for existing owners (Harvard was rumored to have sold
most of its U.S. forestry holdings in one big transaction)
and a heart-breaking loss of a great opportunity for asset
allocators like us.
Other commodities have changed perhaps even more
profoundly. Their attractiveness hinged on great
diversification characteristics. Both bonds and stocks
are hurt by unexpected inflation – nominal bonds suffer
directly and stocks suffer behaviorally – investors
are unsettled and P/E ratios fall. In glorious contrast,
commodities are positively correlated with inflation, and
in a real inflationary crisis their prices are likely to rise
far more than the rate of infl ation as a scarcity of infl ation
protecting investments rapidly develops. This attractive
case for commodities was formerly held back not only by
unfamiliarity (and hence more career risk) but also by the
well known dreary track record for price increases. As
The Economist magazine has periodically reminded us,
the 100 year history in just about all commodities has been
of falling real prices, in the range of 1% to 1.5% a year
as productivity gains have exceeded the naturally rising
marginal costs of deeper wells and second-class land, etc.
This argument was countered by what we can call the
Goldman Sachs case: that there has been, notwithstanding
falling commodity prices, a positive return to buying
commodity futures. This theory is based on original
observations by my usual hero, Keynes, that speculators
who bought futures were rewarded by producers who
were laying off their risks.
The intellectual case seems a little unconvincing since
speculators by no means only go long – I am still personally
short copper as we speak – but the historical numbers were
not bad. Rolling long positions in the futures seemed
historically to have good returns comparable to equities if
you weighted your positions heavily to oil contracts, say
equal to their relative market value, or if you only invested
in contracts that typically paid you to roll (contracts said
to be in “backwardation”). Many contracts however were
not typically priced this way and cost the speculators to
roll (said to be in “contango”). The data was moderately
convincing, but not very convincing. But combined with
undoubted diversification benefis and the institutional
drive to have their portfolios be new and improved, the
total package was deemed by some to be attractive. The
final straw for breaking down resistance was the surge in
growth rates of developing countries led, of course, by
the all-time monster growth story – China. Incremental
demand for commodities from these new sources of
major growth has changed the relationship between
technology improvements and demand so profoundly that
most commodities now probably have price trends that
are moderately up – say, 1 to 1.5% real a year. In the long
term, this shift from a downward drift to an upward drift
is very important. In the short term, recent great strength
in most commodities may have already discounted this
change for the next 20 years.
The rush of new investors drawn to commodities in the last
3 or 4 years has, in addition, pushed up the prices of the
commodity futures in relationship to the commodity itself,
perhaps by a lot: it may have permanently changed the
shape of the futures curve so that few if any contracts may
now routinely pay long investors to roll. In a neat irony the
flood of new money attracted by the ability to roll contracts
profitably may have ended that condition forever!
Venture capital is a tough market these days that always
has plenty of competition, and I’m not going to kick
someone when they’re down other than to say that the
returns have been poor now for quite a few years. In any
case the flood of new money is for the time being more or
less passing them by, which is a relatively good sign, for
it is worth remembering that the size of the yearly cohort
of investors is the largest determinant of future returns:
small inputs predicting good future returns and vice versa.
There is nothing that suppresses the success of a brilliant
new idea more completely than having 12 nearly identical
start-ups.
Infrastructure is the most recent area to attract rapid
increases in capital partly, no doubt, in response to other opportunities becoming overpriced. In some of these pools the fees, both declared and submerged in the complex
financial structures, go on and on so that infrastructure has
become an extremely appealing proposition to the managers.
And the supply of funds is such that infrastructure can
appear in odd places, bidding up, for example, the pricing
of very large forestry deals (although it’s not clear from the
early deals if they would know a tree if it bit them on the
leg). As always, the effect of the much increased supply
of funds has been to take formerly handsome risk-adjusted
returns down quickly to the lean and mean.
Hedge funds are getting to be an old topic, but make for
a remarkable story. An esoteric $35 billion enterprise
15 years ago with 800 funds serving rich individuals has
turned into a $1.2 trillion enterprise with over 8,000 funds
and numerous funds of funds increasingly owned by
institutions as well as individuals. The trillion is leveraged
several times and turns over far more frequently than
‘old-fashioned’ money, so that the percentage of trading
represented by hedge funds has been said to be closing in
on 50% of U.S. equities. The effects of this flood of money
are numerous and significant. Hedge fund investing does
not change the iron rule of investing: it is a zero sum game
minus the fees and the trading friction. The total cost of
regular long-only investing has averaged about 1% for
institutions (½ fees and ½ transaction costs) and about 2%
to individuals (? fees, ? transaction costs, and ? selling
costs). Hedge fund fees are of course a tad higher: typically
about 1.5% fi xed fee plus 1% transaction costs (typically
ignored and often much higher) plus at least 20% of all
the profits (including the risk-free rate that can usually
be had free of charge). Today let’s assume a 5% risk-free
rate and 4% outperformance for a total performance fee
of 1.8%. The total fees thus reach 3.3%, and the total
costs including transactions total 4.3% for institutions,
or almost twice the ‘slippage’ for long-only. Thus, the
first consequence of increased alternatives, especially
hedge funds and private equity, in a world that remains
mercilessly a zero sum game is an incremental drain
on total assets. The second effect is on the availability
of alpha (or outperformance) to the winners in the poker
game. Increased hedge fund money absolutely does not
increase the available inefficiencies. They at best stay
the same, so the same inefficiency is now exploited by
more aggressive alpha-seeking dollars and is therefore
spread thinner. This effect of increased competition is
also not by any means confined to hedge funds only, but
is also affecting long-only investors. There is a nice irony
here too: that the institutional drive into these new, more
expensive vehicles may also lower the return available
to those of their existing long-only managers fortunate
enough to have a positive alpha.
But it is not only the case that the dollars chasing alpha
increase. The other, closely related but clearly separate
effect is, as mentioned last quarter, the enhanced flow of
bright and even brilliant people drawn into our industry
by the sometimes vast fees, and hence salaries, that until
recently was a quiet backwater in terms of talent flow.
With an increased inflow of more talented people, the
standard of competition rises and rises until … well, to
be honest, I’m not quite sure how the story does end.
What for sure does not end soon is the flow of money, for
a survey released last quarter based on interviews with
large institutions said that these institutions expect to
triple their hedge fund holdings in 4 years, which would
make institutional hedge fund holdings larger even than
those of individuals.
Private equity has been growing in the last 3 years even
faster than hedge funds with the leading firms leap-frogging
each other in the size of new funds raised, with several
already well over $10 billion. The dirty secret here is
that their ‘2 and 20’ fees are not justified by any positive
alpha (or outperformance of the asset class) at all. But,
unlike traditional equity investing where outperformance
is mainly dependent on style, and therefore mean reverting
with good performance typically followed by bad, in
private equity, returns are in complete contrast very sticky:
there is a huge and remarkably consistent difference
between the best and the worst of them, so this is an area
where endowments and others with the resources, talent,
and pull have exercised those advantages. Accordingly,
the early moving and skillful institutions have picked
the better managers that are now largely closed. These
better managers have produced wonderful performance in
the range of 20% to 30% compounded per year. In stark
contrast, the larger, later arrivals have barely averaged a
return that is even positive. More to the point perhaps, the
cap-weighted average is at best, depending on the analysis
you read, equal to the S&P 500. It does this, however, by
sometimes leveraging over 4 to 1 in today’s market. 2 to 1
leverage on the S&P 500, let alone 5 or more would have
produced a much higher return, order of magnitude 21%
compared to 14% max for private equity (source: Private
Equity Performance: Returns, Persistence and Capital Flow
by Steven N. Kaplan and Antoinette Schoar, November
2003). However, fees of ‘2 and 20’ charged on 21% could
account for this gap, so there may not actually be a negative
alpha pre-cost – lucky investors! (Although there probably
is.) LBOs are thought by several academics, in fact, to
be a modest destroyer of real value. But let’s be friendly:
the case for private equity creating societal or long-term
economic value at a company-by-company level is modest,
and the case for the average invested dollar returning more
than an equivalent leveraged S&P return is non-existent.
What the industry on average offers is freedom from the
traditional margin calls that on a similarly leveraged equity
portfolio would sooner or later ruin you. As long as you
can make your quarterly interest payments in private equity
deals, you are okay. There is, however, a little snag. If our
7-year forecast were to turn out right – it just might happen
one day – then U.S. equities would return minus 1.4% real
per year as P/Es decline modestly over 7 years to their
long-term average and profit margins decline substantially
to theirs (standard GMO assumptions). The T-bill rate
would, in contrast, likely be about +1.5% real, and average
borrowing costs about 2.5% higher than that, or about
+4% real. The incremental cost of debt at 4 to 1 leverage
comes to over 2% a year even after tax deductions. 3.5%
a year loss is not normally a disaster, but with only 20%
equity, it wipes out all value in 6 years, other things being equal!
In real life the losses would be hidden for a while
by selling divisions, reducing research and advertising,
and, above all, by <itreating depreciation charges as profit
rather than necessary rebuilding costs. So the leveraged
deals, even if GMO’s forecasts were correct, would last
longer than expected before defaulting, but only at the
cost of hollowing out the acquired companies. And some
managers would exit so fast by unloading their company
that the clock ticking against them would have had little
time to tick, and any hollowing out would be harder to spot,
although usually still there. But for slow movers, default
will probably be common. The good news for the managers
is that they still get their 2% fixed fees. The good news for
the investors is that at least there would be no carry! The
effect of the current flood of money riding the wave of
diversifi cation and currently cheap and available debt will
also serve to push initially high prices even higher. The
real shocker here is the asymmetry of returns. The first
deal is good: the managers make a fortune and the client
does well. The second deal is good: the manager makes a
second fortune (usually a bigger one on a larger fund) and
the client does well. The third deal is a bust: the manager
makes 2% and the client loses a bundle. Total returns: the
manager makes two fortunes and 2%; the client probably
makes some money but probably not commensurate with
the risk. And this is known as alignment of interest,
apparently so lacking in public companies. I wonder what
this alignment would look like.
Summary
In general, more diversifi cation is better than less. And
it is as near a certainty as things get in investing that 10
years from now institutional funds in aggregate will be
substantially more diversified than they are today. The
flood of institutional money moving into foreign and
emerging equity and alternatives will mean that these
assets will be looking for excuses to be overpriced for
they will, more often than not, be on the right side of
supply/demand imbalances. Conversely, the sources of
funds – U.S. blue chips and U.S. bonds – will be in the
reverse position and will mostly be lower priced relative
to fair value than the trendier ‘newer asset classes.’ An
ominous report from Greenwich Associates, an investment
research firm, in The Wall Street Journal of April 12,
2007 confirms just how powerful this asset movement
is. 24% of institutions expect to lower their allocation to
U.S. active equity portfolios versus only 4% that intend
increases. But for private equity the increase intentions
are 34% and the decreases 2%. It almost can’t compute,
but it will be exciting trying.
Of course in the longer run all assets are worth replacement
cost and supply/demand imbalances do not change that.
Ben Graham famously said that in the short run the market
is a voting machine, but in the long run it is a weighing
machine. In this sense replacement cost is Ben Graham’s
‘weighing machine’ and supply/demand his ‘voting
machine.’ Every time the supply/demand imbalance
is interrupted, even if only for a short time, prices will
trend towards fair value or replacement cost, sometimes
quite slowly and sometimes very fast indeed. So we are
probably in for an extended period of mispricing, usually in favor of the trendy assets, but with reactions that will sometimes likely be dramatic.
It is also worth remembering that some of these trendy assets
are real asset classes like foreign and emerging equities,
small cap equities, and timber. Others, like hedge funds
and private equity, are merely the existing asset classes
repackaged at higher fees, with less regulation and much
greater leverage. They are not new asset classes and should
be reclassified into their component parts, as I’m sure they
will be routinely in a few years. Above all, these fashionable, repackaged assets are still part of a zero sum game and their higher fees are, in the end, your lower returns.
The really difficult task for investment committees is
to steer a careful course between increasing beneficial
diversification while being aware of the landmines caused
by the intersection of the widespread move to risk taking
and the trendiness of exotic investments. All in all we
should fasten our seat belts. It’s likely to be a bumpy ride. |
