The messenger shoots back
As the bull market raged in the late 1990s, more than a few value managers threw caution to the wind and chased Nasdaq highfliers. Not Jeremy Grantham. Just a few weeks after the market peaked in March 2000, Grantham, a co-founder and chairman of Boston-based money manager Grantham, Mayo, Van Otterloo & Co., publicly predicted that the Nasdaq composite index would fall from 5,000 to 1,250 and that the Standard & Poor’s 500 index would drop from 1,500 to 750.
Little good it did him. Like most value-biased managers, GMO had already lost a painfully large number of clients to growth-firm rivals. “I pleaded at the top of my lungs. I told clients the market was wildly overvalued, but clients wouldn’t listen,” Grantham recalls. “Why would people believe us when all the pundits were proclaiming a magical new era? There was this enormous wall of propaganda, starting at the top with Alan Greenspan and permeating the entire investment industry.”
GMO nearly unraveled. From a peak of $31 billion in mid-1998, assets shrank to $20 billion in mid-2001, a roughly 35 percent decline, as long-time clients dismissed GMO as hopelessly out-of-date. “It was a grim time to be knocking on the doors of potential clients,” says Anthony Ryan, the partner in charge of marketing.
GMO suffered more than most value-biased managers, and the firm -- a 26-year-old private partnership -- has also rebounded more dramatically, winning back old clients and attracting new ones. At the end of May, GMO reported assets of $35 billion, and if Grantham can’t resist a touch of schadenfreude, who can blame him? His firm is growing even as larger rivals like Janus Capital Group and Putnam Investments are struggling. “I guess I wasn’t half as mad as many people thought,” he says.
GMO has benefited from the resurgence in value investing, of course. But that’s just part of the story. In the late ‘90s and early part of the new century, when the institutional money manager had fallen on hard times, Grantham seized the reins to strengthen his firm and salvage his life’s work, even as he refused to pay up for pricey growth stocks the way many value managers were doing. Spending scarce resources in the face of an asset drain, he expanded GMO’s product offerings, invested in marketing and launched a client service department, now staffed by eight investment professionals.
The firm, once known as a value equities shop, boasts $3 billion in eight hedge funds and one fund of funds, $4 billion in tactical asset allocation strategies, $2 billion in emerging-markets debt, $3 billion in emerging-markets equity and $300 million in timber assets. Overall, 80 percent of assets are invested in stocks, 13 percent in fixed-income securities and 7 percent in cash. Around 60 percent of assets are invested outside the U.S.
“As a firm, we were very early into international markets and very early into quantitative investing,” says Grantham. “We have always believed in diversification, for the benefit of the clients and the business. Today, with U.S. assets so unattractive, that is more important than ever.”
Might the 64-year-old Grantham and his partners be looking to sell GMO, now that the cash is coming in and the stock market is showing signs of life? “Independence is a strategy that has served us well so far. And as more money managers become arms of giant financial services conglomerates who don’t understand this business, it will definitely be a competitive edge in the future,” says Grantham. Indeed, last year GMO’s 40 partners -- out of a staff of 200 -- rebuffed an offer from BNP Paribas to buy a 20 percent stake, with an option to increase the share, for an undisclosed price. (Of the other two founding partners, Dick Mayo left in December 2001 to run a hedge fund with his son, and Eyk Van Otterloo, though an active board member, has not had a day-to-day money management role since 1996.)
Says Grantham: “As a money manager, you live for moments like the huge dislocation created by the bubble. It is a tremendously exciting, tremendously entertaining time to be in this job. Why would I want to do anything else?”
Certainly, he has cause for celebration. GMO reported record net new account gains of $5 billion in 2002. For the first five months of 2003, it gathered assets at an even faster pace, adding some $4 billion. Among its more high-profile mandates: $200 million in international equities from the Nebraska Public Employees’ Retirement System, an $80 million emerging-markets equity account from International Paper Co. and a E50 million ($53 million) emerging-markets equity account from the ABB Foundation.
In the long term GMO’s core portfolios have handily beaten their benchmarks. Over the past ten years, the firm’s U.S. Core equity product has beaten the S&P 500 by 1.23 percentage points on an annualized basis. GMO’s international active product -- benchmarked against the MSCI Europe, Australasia and Far East index -- has outperformed by an annualized 5.34 percentage points.
“Apart from market conditions, which have obviously brought its style back into favor, GMO’s attitude to servicing institutional clients has evolved. It has brought people in from outside who understand the needs of institutional investors,” says Jeffrey Nipp, director of investment manager research at Watson Wyatt Worldwide in Atlanta. “There has always been much to like about GMO, but in the past they haven’t gotten to grips with what sophisticated institutions want.”
GMO remains an American operation. Though it has had a London office since 1987 (it opened a Sydney outpost in 1995 and a Zurich branch in 2002), some 85 percent of GMO assets come from U.S. institutions.
THE SON OF A CIVIL ENGINEER, GRANTHAM GREW up in the Yorkshire town of Doncaster, England. He earned an undergraduate degree in economics from the University of Sheffield and an MBA from Harvard Business School. Grantham worked as an economist at Royal Dutch Shell and as a portfolio manager at Keystone Custodian Funds, a Boston-based mutual fund group that’s now part of Evergreen Funds.
Then in 1969, Grantham and Dean LeBaron co-founded Batterymarch Financial Management, a Boston-based quantitative money manager that made its name by avoiding the Nifty Fifty before they nose-dived in 1973'74. Several years later Grantham had a falling-out with LeBaron, and in 1977 he joined forces with Boston portfolio managers Mayo, Van Otterloo and King Durant. They launched their firm as a conservative, value-oriented money management shop.
Through the 1980s and 1990s, GMO’s U.S. and international funds outperformed their peers. One of Grantham’s shrewdest moves: cutting the Japanese exposure of GMO’s international funds in 1986, well before the Nikkei cracked in 1989.
By 1998 Grantham had become very leery of stock valuations. Applying a quantitative measure known as Tobin’s Q ratio, which calculates the replacement value of corporate assets, Grantham and Ben Inker, then head of GMO’s asset allocation, determined that the S&P 500 at the start of 1998 would be fairly valued at a price-earnings ratio of around 16.
In 1999, as the S&P 500 soared to 30 times earnings and beyond, GMO began positioning portfolios more defensively. Grantham had no doubt that he was witnessing a stock market bubble of historic proportions. One sure sign, in his view: the curious behavior of small-cap stocks. Between March 1998 and March 1999, he noted, U.S. small caps were down 18 percent and large caps were up 25 percent.
What explained the divergence? Grantham analyzed historical data and found that such a discrepancy in the performance of small and large caps had occurred only twice before, immediately before the 1929 and 1972 crashes. But clients were growing restive with Grantham’s bearish stance, however well reasoned: GMO’s funds were badly underperforming. In 1998 and 1999, for example, GMO’s core EAFE portfolios returned an average annual 14.9 percent even as the index rose 25.9 percent. In 2000, Exxon Mobil Corp. and Bechtel Group, among other longtime clients, dismissed GMO.
“Clients were completely caught up in this chase for relative performance,” recalls marketer Ryan. “We tried to explain that absolute risk to their portfolios was of a much higher magnitude than the relative risk of modest underperformance.”
As the bubble expanded and more GMO clients pulled their equity mandates, the firm’s marketers emphasized GMO’s recently expanded product lineup. In 1997 GMO had set up GMO Renewable Resources, a specialist timber management business. Between 1997 and the end of 1999, assets grew to $200 million.
Says Grantham: “Timber is one of the best investments out there. It has outperformed the S&P 500 handily over time and has a higher yield.” GMO predicts that managed timber assets will generate an annualized real return of 9.5 percent for the next seven years, comfortably beating the predicted 2.1 percent annualized real return of U.S. large-cap equities.
GMO’s first hedge fund, a long-short strategy in emerging-market debt, debuted in 1996. Since then it has returned an impressive 17 percent annualized net of fees. Then in July 2000 GMO rolled out a U.S. equity market-neutral hedge fund, followed that September by an aggressive U.S. long-short equity fund. In the next two years, GMO launched five more hedge funds as well as a fund of funds whose assets are invested only in GMO hedge funds. Its aggressive U.S. long-short equity fund returned an impressive 28.2 percent net of fees last year; the market-neutral hedge fund returned 1.93 net of fees over the same period.
“Since the average manager must underperform net of fees, arguably all hedge funds do is increase the amount of fees paid,” Grantham says. But he was persuaded that GMO could make good use of the latitude given to hedge fund managers. “Investment constraints and tightly defined mandates are the bane of long-only managers. Those constraints are more costly, relatively speaking, in a low-return investment environment” (see box, page 20).
With some $3 billion in hedge funds, GMO’s alternative business is roughly comparable in size to that of far bigger institutional rivals such as Barclays Global Investors, which has $5.2 billion in hedge funds, and Alliance Capital Management, with $2.6 billion.
Naturally, GMO has been doing more than pitching alternative products. After the bubble burst the money manager began to make a more forceful case for its skepticism, to solidify its existing client relationships. In early 2001 GMO set up a client service department dedicated to getting its message out. Though most money managers GMO’s size already had such a function, it was a first for GMO, which now has eight full-timers handling clients and an additional four staffers working with consultants.
“During the bull market we had not been effective at dealing with clients and explaining why we were taking the stance we were,” explains Ryan. “I’m confident that in another bubble we would again remain true to our investment philosophy. My hope is that we would do a much better job explaining our position to investors.”
To bolster its presence outside the U.S., GMO’s three foreign outposts, in London, Sydney and Zurich, have been working more closely with the Boston headquarters, selling GMO’s full range of products rather than just local equity strategies. To lead the European marketing push, the firm last year hired Alex Orus, who was running the Swiss office of State Street Global Advisors.
GMO will need to continue to expand internationally and in the U.S. if it is to retain and attract talent. The firm already boasts a strong bench: quantitative chief Chris Darnell, who joined GMO in 1979; head of emerging markets Arjun Divecha, who joined in 1993; and chief investment officer Inker, who joined straight from Yale University in 1992.
Grantham remains the spiritual and intellectual leader of the firm. Though he carefully weighed selling a minority stake in the business, he believes that GMO’s independence is a real strength. He cites a recent decision to close two high-performing strategies -- emerging-markets debt and equities -- to new investors, a decision that might have been challenged if the firm were part of a bigger financial conglomerate.
“Size is the biggest barrier to performance. We are the first broad-based firm that I am aware of that is in close-down mode,” says Grantham. “We would close all of our strategies if we thought it was in the best interests of the firm and our clients. That is the sort of freedom to decide your own destiny that independence gives you.”
For all his foresight in 1999 and 2000, Grantham is by no means complacent. His single -- or single greatest -- insight, he says, is that markets revert to the mean. The painful fact for Grantham -- indeed, for every investor -- is that no one can know when that reversion will occur. “There is no joy in being right and being out of business,” Grantham says. “Fortunately, we have avoided that fate.” i
FREEDOM FIGHTER: Grantham’s take on the markets and money managers
One of the industry’s elder statesmen, 64-year-old Jeremy Grantham remains a shrewd -- often provocative -- observer of investment practices. He is also highly critical of many conventions in today’s money management business.
When a pension fund narrowly defines a portfolio by style and market capitalization and restricts its tracking error, a fund manager’s ability to outperform the market is compromised, Grantham argues. In the past, he says, talented managers could shift assets from one sector or style to another, following value where they found it. Now managers are far too beholden to benchmarks set by pension fund clients.
“No one has the job of moving the money around anymore,” says Grantham. “And with a handful of honorable exceptions, most policy benchmarks are inherited by investment committees. If they do change them, they look at what the peer group is doing. As the manager’s ability to arbitrage is dissipated by these tightly defined mandates, deviations of asset prices will get worse. If you have any doubt, look at the bubble. This is no accident or quirk of history. It is a reflection of how weak the arbitrage mechanism has become.”
Grantham’s plea to pension funds: Give your money managers broader mandates. For the moment, he says, the tightly defined mandates of most institutional fund managers mean that unconstrained hedge funds will outperform, almost by definition. (GMO’s own core portfolios have outperformed their benchmarks over the past ten- and 20-year periods.)
“Hedge funds have the freedom to act on their best ideas, and that will attract talent,” notes Grantham, whose firm runs $3 billion in hedge fund strategies. “A disturbingly large number of the best people are being drawn into hedge funds. Let’s face it: There is nothing on earth more supremely useless than a mediocre fund manager.”
Grantham predicts tougher times ahead for the money management industry, especially for those firms dependent on retail customers. Investors may have been willing to pay handsome management fees when portfolio returns were in the double digits, but those days are gone. “Even as market capitalization grew and grew, fees paid to money managers rose, a contradiction of how we normally understand economies of scale. That cannot persist in a low-return environment.”
In Europe, he believes, a whole generation of retail investors may never buy equities again. “It’s Murphy’s Law, but the first time German investors got excited about equities, they got wiped out,” he says. “The Neuer Markt went up 12 times in four years. Compared with that, the Nasdaq was a real piker. The Neuer Markt gave back all its gains. I’d say 90 percent of the people who go through that sort of experience will not queue up to repeat it. There will be a big drop-off in investors willing to own equities and a complete unwillingness to speculate. Basically, that won’t change for a generation.”
Looking ahead, Grantham sees markets heading south again. “My best guess is that the S&P will indeed pass through 680 from its recent 1,000. That’s where the fun really starts. There is a tendency for the overshoot on the downside to be as deep as the overrun on the upside. It’s an ugly thought we don’t dwell on too much.”
Grantham expects the Standard & Poor’s 500 index to hit 680 by next spring and then generate average real annual returns of about 1 percent for the next seven years as the market shakes off the lingering effects of the bubble. Then U.S. stocks should revert to their long-run mean return of 6 percent.
“The great thing about the bubble is that it created enormous anomalies,” Grantham says. “In the first two years of the bear market, small-cap value was actually up, which is unprecedented. Now finding pockets of protection is harder.” Grantham believes that value stocks and small caps are overpriced. He’s shifting global portfolios toward international markets and recommending that U.S. clients beef up their overseas stock allocations. “The disparity between U.S. and international equity markets is a two standard deviation event,” says Grantham. “In my view, international has to rally 36 percent to get back to the long-term trend versus the U.S.”
Grantham believes that the continuing slide of the dollar will give a further boost to unhedged dollar-denominated portfolios.
“Emerging markets are capable of outperforming the S&P 500 by 20 percentage points a year. There is a decent chance that when the S&P hits its low, emerging markets will be up in absolute terms.”
And what does this natural contrarian make of Japan? Grantham believes that the Nikkei’s 13-year bear market may be over. As a result, GMO has a small overweight position in Japan. “To be underweight is a big, scary bet. Being underweight the U.S. is far easier. Japan is the most dangerous market in the world, because there will be a period in the not-too-distant future when Japan is up 40 percent and the rest of the world is flat or down.” -- A.C.