In the complex world of wealth management, achieving long-term financial goals seems straightforward in theory. For families, endowments, or pension funds, the core task appears to be threefold: clearly define client objectives, identify diverse avenues for risk-adjusted returns, and strategically calibrate risk exposure to align with those objectives. Navigating this delicate balance is crucial; excessive risk can lead to devastating losses, while insufficient risk may result in returns that fail to meet long-term needs.
The widely accepted “passive” 60/40 portfolio, consisting of 60% equities and 40% bonds, has historically been a reliable strategy for wealth accumulation. Its success lies in capturing two primary risk premiums: the equity risk premium, earned by investing in the potential for economic growth, and the inflation risk premium, gained by mitigating the impact of unexpected inflation. Since the inception of the Bloomberg U.S. Aggregate Index in 1979, a 60/40 portfolio of U.S. stocks and bonds has yielded an impressive 10.2% annualized return, outpacing inflation by 7.0% and satisfying the return expectations of many investors.
This track record might lead one to believe that a simple 60/40 allocation is the optimal, set-and-forget solution. Indeed, this approach has been remarkably successful since 1979, and even across longer historical periods. While investment disclaimers rightly caution against relying solely on past performance, analyzing 120 years of 60/40 portfolio performance reveals valuable insights. As illustrated in Exhibit 1, a 60/40 portfolio (using U.S. stocks and bonds in this example) has delivered a real return of approximately 4.8% annually since 1900. While slightly lower than the 1979-present period, this return still meets the objectives of many investors seeking long-term growth.
However, this impressive long-term average masks a critical reality: there have been six distinct periods, averaging 11 years each, where a 60/40 portfolio either barely kept pace with inflation or, worse, lost real value. These “lost decades” share a common thread – they invariably followed periods of exceptional performance for traditional portfolios, commencing when either or both stocks and bonds were trading at historically high valuations. Just as a doctor might order a second opinion when health indicators are concerning, investors should consider a fresh perspective when portfolio valuations are stretched.
Exhibit 1: 60/40 Portfolio “Lost Decades”: More Frequent Than You Think
Typically Initiated by Elevated Stock and/or Bond Valuations
*Data as of 6/30/2024, reflecting a 60% U.S. Equities (S&P 500), 40% U.S. Bonds (U.S. Treasuries) portfolio, rebalanced monthly. Sources: Bloomberg, Global Financial Data (historical data), Factset (S&P500 returns and CPI), J.P. Morgan (J.P. Morgan GBI United States Traded), Shiller data, Federal Reserve Bank of Philadelphia (U.S. Treasury Yields and Long-term Inflation Expectations). Real yield is calculated as the yield on the 10-Year U.S. Treasury minus Philly Fed Long-Term Inflation Expectations (1992-present) or the 12-month trailing CPI (historical). Current CAPE = 31 and Real Yield = 1.0%. This chart illustrates historical periods where 60/40 portfolios faced headwinds due to valuation levels.
The most recent bull market, spanning from early 2009 to the end of 2021, saw the passive 60/40 portfolio deliver an extraordinary 9.4% real return, roughly double the long-term average. This remarkable performance was fueled by surging equity markets and declining interest rates, pushing valuations for the S&P 500 and real bond yields to historically unattractive levels. Currently, after the most aggressive interest rate hiking cycle in three decades, nominal and real yields on government bonds appear more reasonable, although the inverted yield curve may limit bond returns relative to cash. However, the additional yield for taking on credit risk remains unappealing, and equity valuations, particularly in the U.S., are still elevated. In this environment, a reversion to longer-term average valuations could result in disappointing medium-term returns for a standard 60/40 portfolio. Just as a doctor’s diagnosis might change based on new symptoms, investment strategies must adapt to evolving market conditions.
Enhancing Traditional Allocations: Seeking a Second Opinion for Portfolio Health
Relying solely on a static 60/40 allocation is essentially accepting the market’s prevailing valuation views, or, more accurately, the fluctuating sentiments of investors. A passive 60% equity allocation inherently invests more in companies with larger market capitalizations, while the 40% bond allocation increases exposure to borrowers with greater debt issuance. In an industry where deviating from the consensus can be challenging, obtaining a “Doctor-ordered” second opinion—a perspective that genuinely assesses valuations relative to underlying fundamentals—becomes increasingly vital.
Risk premiums are not static; they fluctuate with valuation levels. Therefore, an effective asset allocation strategy should prioritize assets that are priced to deliver satisfactory returns at any given point in time. Valuation-sensitive multi-asset class strategies, such as GMO’s Benchmark Free Allocation Strategy (BFAS), offer a dynamic approach. BFAS actively adjusts allocations in response to extreme valuation environments, aiming to mitigate bubble risks and capitalize on market dislocations. By dynamically shifting allocations and expanding beyond traditional risk premiums, BFAS exemplifies how a “second opinion” can diversify risks and potentially enhance returns.
Identifying and capitalizing on diversifying exposures presents a significant challenge. Investors must not only recognize valuation disparities across numerous asset classes and sub-asset classes but also possess the ability to access investment vehicles that effectively exploit these opportunities. Another hurdle lies in persuading clients to embrace dislocations, which often involves investing in underperforming assets or betting against recent market winners – actions that require a strong conviction grounded in thorough analysis, akin to the confidence a patient places in a doctor’s expertise after seeking a second opinion.
Over Two Decades of Experience: A Doctor’s Proven Track Record in Asset Allocation
GMO’s BFAS is a valuation-sensitive strategy with a proven track record of dynamically allocating capital across and within various asset classes. Its primary objective is to generate positive real returns above inflation and superior risk-adjusted returns compared to a traditional 60/40 portfolio over the long term. By strategically avoiding overvalued assets and capitalizing on undervalued opportunities, BFAS has consistently helped investors enhance risk-adjusted returns and navigate diverse market cycles with greater resilience since its inception in 2001, as demonstrated in Exhibit 2. This long-term performance is akin to a doctor building trust through years of successful patient outcomes.
Exhibit 2: The Value of a Doctor-Ordered Approach: Valuation-Sensitive Investing’s Long-Term Performance
Benchmark-Free Allocation Strategy: Solid Risk-Adjusted Returns Over Time
Data as of 8/31/2024 | Source: GMO. Strategy Inception Date: 7/31/2001. The chart illustrates the historical performance of the Benchmark-Free Allocation Composite (the “Composite”). Prior to January 1, 2012, the accounts in the Composite were a core component of a broader real return strategy. From January 1, 2012, onwards, the accounts in the composite have been managed as a standalone investment strategy. Past performance is not indicative of future results. This chart highlights the historical success of a valuation-sensitive approach, akin to the reliability investors seek in doctor-ordered financial advice.
Given its valuation-driven philosophy, BFAS may underperform during extended periods of inflated valuations as it reduces risk exposure proactively. Because market valuations often overshoot during strong bull markets, BFAS typically lags in the later stages of these cycles. However, this approach proves particularly beneficial during market corrections, especially during significant drawdowns of 10% or more in a 60/40 portfolio, as illustrated in Exhibit 3. This protective characteristic is similar to a doctor’s preventative care, mitigating potential harm before it fully materializes.
Exhibit 3: Doctor-Ordered Diversification: Valuation Sensitivity in Market Drawdowns
BFAS: A Helpful Diversifier in Major 60/40 Declines
Source: GMO | Market Drawdown Periods: Internet Bubble (8/31/01 – 2/28/03); Global Financial Crisis (GFC) (5/31/07 – 2/27/09); U.S. Debt Downgrade (4/29/11 – 9/30/11); Europe Crisis (12/31/19 – 3/31/20); Covid-19 Pandemic (5/31/21 – 9/30/22); 2022 Rate Liftoff (12/31/21 – 12/31/22). This exhibit demonstrates BFAS’s ability to act as a diversifier during significant market downturns, offering portfolio protection akin to doctor-ordered preventative measures.
In today’s market, a traditional 60/40 portfolio is heavily weighted towards expensive U.S. growth equities and credit exposures with minimal spreads over Treasuries. GMO believes such a portfolio is likely to deliver disappointing low single-digit real returns. However, the encouraging news is that seeking a “doctor-ordered” second opinion can uncover compelling investment opportunities.
Despite robust equity market gains over the past 18 months and many indices approaching or reaching record highs, GMO remains optimistic about the investment landscape. This positive outlook is underpinned by a wealth of assets ranging from fairly valued to undervalued from an absolute return perspective, coupled with attractive valuation spreads within asset classes, presenting the most compelling relative asset allocation opportunity seen in 35 years. By focusing on three key market dynamics, GMO is constructing portfolios with some of the highest forecasted relative and absolute returns they have ever observed:
- Non-U.S. Equities: Undervalued and Poised for Growth. U.S. equities have demonstrated solid fundamental performance, aligning with long-term expectations, but their valuations have also expanded significantly in recent years. Across numerous valuation metrics, including CAPE ratios, the U.S. market trades at or near its largest premium ever compared to the rest of the world. Even considering price-to-forward earnings ratios, which incorporate forward-looking growth, U.S. valuations remain stretched, trading at over a 50% premium to their long-run average. Conversely, markets outside the U.S. are trading at or below their long-run averages, creating a substantial valuation gap. Furthermore, non-U.S. stocks stand to benefit from undervalued currencies. Equity investors can capitalize on cheap currencies through currency appreciation or by companies leveraging lower relative costs to boost earnings growth. Japanese small-cap value equities are particularly attractive today due to their absolute and relative undervaluation, ongoing improvements in corporate governance and profitability, and a historically weak currency. This presents a “doctor-ordered” prescription for diversification into overlooked global markets.
- Deep Value: A Significantly Dislocated Asset Class. The cheapest 20% of markets, categorized as deep value, is severely dislocated, trading at historically low percentile discounts compared to historical averages in both U.S. and developed ex-U.S. markets. Value investing, particularly in its deepest value segment, offers outperformance potential through two mechanisms: the normalization of valuation discounts and the benefits of portfolio rebalancing. Rebalancing is inherent to value strategies. While cheap companies as a group may not grow as rapidly as the average company, some inevitably outperform expectations. As positive surprises and improved outlooks attract investor attention, these companies’ valuations rise, even if the broader value segment remains discounted. These outperforming companies eventually exit the value universe, delivering strong returns in the process. Simultaneously, other companies, initially expensive growth stocks, may disappoint investors, leading to valuation declines. These underperforming growth stocks then enter the value universe, providing a continuous source of newly cheap companies to replace those that have re-rated. This constant rotation within the value universe creates a powerful tailwind for relative returns, even if the overall valuation spread between growth and value remains constant. Importantly, the wider the value spread, as seen today, the more impactful rebalancing becomes. GMO is heavily invested in this compelling deep value opportunity across portfolios through their long-only U.S. Opportunistic Value and International Opportunistic Value strategies. Due to the robust opportunity set in deep value and thoughtful portfolio construction, both U.S. and International Opportunistic Value strategies trade at significantly cheaper valuations than broad value benchmarks while exhibiting higher quality characteristics in terms of debt-to-equity and ROE metrics. This deep value opportunity is akin to a “doctor-ordered” focus on fundamentally sound, yet undervalued, assets.
- Value vs. Growth: A Historically Wide Spread Creating Long/Short Opportunities. Deep value is not the only area exhibiting dislocation. Growth stocks, broadly, are trading at expensive valuations relative to their historical norms. In fact, the most richly valued 20% of markets (extreme growth) trades at historically high percentile premiums compared to historical averages in both U.S. and developed ex-U.S. markets. The spread between extreme growth and deep value cohorts is exceptionally wide today, creating an ideal environment for long/short strategies to profit from the potential narrowing of relative valuations. GMO’s Equity Dislocation strategy, which is 100% long deep value and 100% short extreme growth stocks (and the largest single exposure within BFAS), aims to capitalize on this anomaly. As Exhibit 4 illustrates, a significant valuation gap exists between the long and short positions in this strategy. The long portfolio trades at a valuation that is between one-third and one-fifth of the short portfolio’s valuation. This long/short strategy offers a “doctor-ordered” approach to capitalizing on market inefficiencies.
Exhibit 4: Doctor-Ordered Strategy: Equity Dislocation Strategy
Leveraging the Value-Growth Gap for Diversifying Returns
Data as of 8/31/2024 | Source: GMO. Portfolio characteristics are subject to change. The information provided is based on a representative account within the strategy, chosen for its minimal restrictions and accurate representation of strategy implementation. This exhibit highlights the valuation disparity between long and short positions in the Equity Dislocation strategy, reflecting a doctor-ordered precision in targeting market inefficiencies.
Similar to value investing, spread narrowing is not the sole driver of returns for long/short strategies. These strategies also benefit from both sides of the rebalancing process. By being long value stocks that appreciate as they exit the value universe and shorting growth stocks that underperform expectations, the strategy captures gains from both sides of the valuation spectrum. If growth stocks, trading at substantial premiums, fail to meet lofty expectations, their valuations can experience sharp declines. This dynamic further enhances the potential of the Equity Dislocation strategy.
Identifying attractive investment opportunities is only half the equation; effective execution is equally critical. GMO has a long history of developing new strategies to reallocate portfolios toward the most compelling return sources. Currently, over 50% of BFAS’s holdings are in strategies that were not in existence four years ago. GMO’s Asset Allocation team identifies compelling opportunities and leverages GMO’s infrastructure and investment teams to construct portfolios that capitalize on specific themes. This adaptability and innovation are akin to a doctor continuously updating their knowledge and techniques to provide the best patient care.
Exhibit 5: GMO’s Benchmark-Free Allocation Strategy: A Doctor’s Evolving Toolkit
New Strategies Implemented Since 2020
Data as of 8/31/2024 | Source: GMO. *Includes GMO’s Resources and Climate Change strategies. **The headline exposure to U.S. Treasury Notes should be considered within the context of the portfolio’s overall duration profile, including collateral and other exposures. The information is based on a representative account within the strategy, selected for its minimal restrictions and accurate representation of strategy implementation. Weightings are as of the indicated date and are subject to change. Exposure groups are determined using proprietary methodologies and are subject to change. Totals may vary due to rounding. This exhibit showcases the dynamic evolution of BFAS, with new strategies added since 2020, reflecting a doctor’s commitment to utilizing the most effective tools and treatments.
Echoes of the Past: A Doctor’s Perspective on the Future
The current investment landscape bears a striking resemblance to 1999, when GMO first introduced the portfolio concept that evolved into the Benchmark-Free Allocation Strategy. At that time, the 60/40 portfolio had just completed 14 years of delivering 11.4% nominal returns annually (8% above inflation), the S&P 500 was significantly outperforming small caps and international indices, and growth stock valuations were at unprecedented levels.
GMO believed then, as they do now, that a traditional 60/40 portfolio was priced to deliver approximately 2% real returns over the next decade, falling far short of long-term investor objectives. However, they recognized that not all assets were overpriced, and opportunities for decent returns existed. In 1999, a diversified portfolio with attractive expected returns required venturing beyond the conventional 60/40 framework. Taking the risk of deviating from the herd was perceived as offering exceptionally high potential returns.
History seems to be repeating itself. The 60/40 portfolio has once again enjoyed a prolonged period of strong performance. The S&P 500, particularly growth stocks, has been the leading asset class for an extended period. The outperformance of U.S. stocks over non-U.S. stocks, growth over value, and the compression of credit spreads have created a situation where many assets remain attractive, but capitalizing on these opportunities necessitates a willingness to construct portfolios that differ significantly from a standard, capitalization-weighted 60/40 allocation.
Today, GMO believes that shifting away from expensive U.S. growth stocks and tight credit assets towards attractively valued non-U.S. stocks and value investments will generate superior compounded returns compared to a traditional passive portfolio. Through its valuation-sensitive approach, the GMO Benchmark-Free Allocation Strategy has historically served as a valuable diversifier for traditional portfolios heavily concentrated in market-cap-weighted equity exposures. BFAS provides investors with a practical way to incorporate this strategic thinking into their existing asset allocations and is readily accessible across financial advisor platforms without minimum investment requirements. Seeking a “doctor-ordered” second opinion on your portfolio allocation may be the healthiest decision you make for your long-term financial well-being.
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