Over the next decade or two, which is likely to be dominated by low or even negative real returns, only truly brave asset managers will be able to deliver the alpha, according to Jeremy Grantham, co-founder of GMO, a Boston-based fund manager.
Valuation metrics such as the cyclically-adjusted price-to-earnings, or CAPE, ratio, while poor at predicting market tops or troughs, have a pretty good record of predicting long-term returns, and at current high levels imply low long-term returns for U.S. and European equities.
Perhaps, too low for pension funds, which require 7%-8% annualized returns to keep up with their obligations.
According to the Shiller PE model, the CAPE measure popularized by Nobel laureate Robert Shiller, future long-term returns from U.S. equities are set to come in the low single digits. The rest of the developed as well as emerging market equities are also expensive, though on a relative basis they are cheaper compared with the U.S. markets.
Read: Why U.S. stocks don’t belong in a global portfolio—now, say strategists
Fixed income returns continue to be depressed thanks to loose monetary policy by global central banks, with safe assets, such as long-dated U.S. Treasurys yielding at about 2.5%.
In a sea of low-yielding assets, the only way to meet required returns that does not involve market timing is by making big and bold bets through asset-class allocations for the long term, Grantham wrote in a quarterly investor letter last week.
And career risk usually prevents asset allocators from making big and bold bets.
“I firmly believe that asset allocation advice should not be offered unless you are willing, on rare occasions, to make major bets and accept a big dose of career and business risk. Otherwise asset allocation should be indexed,” Grantham wrote.
Finding ‘alpha’ or extra return via asset allocation is still possible because the process is inefficient, according to Grantham.
“You go to cash too soon and your business or career melts away, you stay too long and you are seen as useless. In short, investing at the asset class level remains dangerous to career and profits and is, hence, inefficient, thereby allowing for occasional great opportunities with the old attendant caveats,” he wrote.
The caveat is the risk: for asset allocation to work the diversification should be meaningful, according to Grantham.
“If you mean to offer a useful asset allocation service to institutions, one that is designed to beat benchmarks and add value as well as lower risk, then you must make bets. And when there are great opportunities, which is all too often not the case, you must make big bets,” Grantham says.
And at this stage, the asset that is most likely to deliver decent returns over the long term is emerging market equities, especially value equities, according to this GMO chart.
The caveat Grantham was referring to is the fact that emerging-market, or EM EEM, +0.13% , equities tend to have a higher beta, a measure of volatility, than the S&P 500 SPX, -0.08% So, in a major downturn, an EM decline would be far deeper, making it look like an imprudent decision over the short term.
For managers whose careers literally depend on delivering a 4.5% annual return at the very minimum, the only option is to put all the equity allocation in emerging markets.
“If only the standard asset classes on our list were available to me, I would invest 100% in EM equities, with two-thirds tilted to value,” Grantham said.
The strategy of allocating heavily to emerging market equities would be hard to beat, even if investors were able to successfully time the markets, Grantham contends.
He concludes that a conventional diversified approach is nearly certain to fail, but standing out from the pack and investing in less popular and a less familiar asset class such as emerging markets can earn decent returns over the long term.