Grantham, Mayo and Otterloo & Co. (GMO) has released a white paper, “Investing for Retirement: The Defined Contribution Challenge.” The authors, Ben Inker and Martin Tarlie, divide their discussion into two sections:
• Asking the Right Question
• Dynamic Allocation: Move Your Assets
Let’s take a closer look at what the authors have to say.
Asking the Right Question
According to Inker and Tarlie, the right question to ask is not what the return should be. Instead, they suggest, the focus ought to be on “expected shortfall of wealth relative to what’s needed.” At first blush, this seems to be a play on words — isn’t it return that ultimately drives wealth? The authors contend that a portfolio based on Modern Portfolio Theory is not focused on the expected shortfall of wealth but on “maximizing return for a given level of risk, where risk is return volatility.” This creates a situation in which portfolio design is more a function of an investor’s “personality” rather than being “driven primarily by his needs and circumstances.” Therefore the right question is what is required to “minimize the expected shortfall relative to what is needed,” they assert.
The paper goes into great detail on the impact of focusing on returns verses wealth, all of which sheds an interesting light on the interplay between the two concepts. However, at the end of the day, there seem to be only two things that the investor can do to respond to the an expected shortfall of wealth:
• alter the savings rate based on one’s risk assessment (i.e., risk-adversity requires more savings); and
• change the allocation based on asset class valuation changes.
Given the already extensive treatment of the subject of liability-driven investing (LDI), it is the latter concept — “valuation-aware portfolios” — that is the more interesting (or less talked about) subject of the two.
Dynamic Allocation: Move Your Assets
At one point in the paper, the authors state that it is “essential to go beyond a brute-force approach in designing a glide path.” Given the way that participants either choose or are defaulted into TDFs, the term “brute force” does not seem to be too far off. Regardless of whether or not the S&P 500 is trading at 45 times (as in 2000) or 7 times (as in 1982) normalized earnings, the participant’s retirement date is matched up with a time appropriate TDF; and that is, more often than not, the end of the process.
In referencing the valuation extremes referred to above (45 vs. 7 times normalized earnings), the authors state that it “is the height of folly” to assume that both scenarios “can achieve similar return … let alone the expected returns of any reasonable glide path.” They bolster their argument by demonstrating that while valuations cannot tell us much about returns in a the short term, over a longer period of time, “the correlation between valuation and subsequent stock market returns [increases] as the time horizon lengthens from 1 to 20 years.” The authors back this statement with an analysis illustrating that the correlation of valuation and future return is 20% over a 1-year period and then steadily rises to over 70% as the investment period lengthens to 20 years. Even 10-year returns have a 60% correlation between current valuation and future returns.
Much of this is simply common sense. What goes up must come down, and vice versa. Take a look at recent history: Should the allocation to equities be the same in 2009 when the Dow bottomed out at 6,547 as it is today, when it is over 16,500? The statement that this would be the “height of folly” would seem to fit the current situation. However, what may appear to be a rationale from an investment perspective is much more difficult to implement from a practical standpoint.
There are a couple of major challenges to implementing a “valuation-aware” portfolio:
• The correlation between valuation and return increases over the long term (e.g., 10-20 years) while, comparatively speaking, plan sponsors and their advisors are more focused on how funds perform on a short-term basis (e.g., 3-5 years). This is a systemic problem with the structure of investment policy statements as well as the tendency to chase returns in the highly commoditized world of open architecture.
• There is always the danger of “catching a falling knife.” Many investors, such as Warren Buffett, suggested that late 2008 was the time to expand into equities. Few investors, including the Sage of Omaha, knew that it would continue to fall until the spring of 2009. To call a market bottom is notoriously difficult. It is one thing to catch a falling knife as an individual investor. To do so when managing a client’s assets is an entirely different story. Envision this reaction from a client: “The market has dropped like a rock and you’re telling me to invest more?”
Conclusion
The GMO paper does a good job of pressing the point that it is not so much about how an investor feels about risk as it is about the need to create the wealth they require to avoid the risk of “lifetime ruin.” Again, there is a great deal of emphasis being placed on helping participants understand the double-edged sword of investing for retirement. If you are not willing to take the risk, then you must save more. That is the short answer.
The other topic — dynamic allocation based on asset class valuations — seems to be spot on. As the authors state, “given that workers have very few other effective ways to save for their own retirement, the stakes seem too high to leave such a valuable tool on the bench.”
However, for the reasons discussed above, we should not expect a mad rush to “valuation-aware” portfolios anytime soon. For many plan sponsors and their advisors, the safest path is to stick with the traditional glide path given this simple fact: No good deed goes unpunished. A plan sponsor can be as right as rain but still be a lone trailblazer. If it is correct, it could be a hero. However, if the backward-looking valuation metric fails — as it did in Japan — then it would have a lot of explaining to do. As Keynes famously said, “The market can remain irrational longer than you can remain solvent.” Or, better still, a much less famous Keynes quote: “There is nothing so disastrous as a rational investment policy in an irrational world.”
