Does GMO Add Value for Investors?

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1 Does GMO Add Value for Investors? March 1, 2016 by Larry Swedroe My series evaluating the performance of the market s most prominent actively managed mutual fund families continues today with an in-depth analysis of the offerings from Boston-based Grantham Mayo van Otterloo (GMO). Why GMO? The firm was founded in 1977, and Morningstar reports that as of July 31, 2015, the fund family had $115 billion in assets under management, making it one of the largest fund families. In addition, Jeremy Grantham, the firm s chief investment strategist, is a highly respected money manager. Grantham was the co-developer of the first index fund, making him particularly interesting from the perspective of this series. To quote Vanguard founder John Bogle: In 1971, Batterymarch Financial Management of Boston independently decided to pursue the idea of index investing. The developers were Jeremy Grantham and Dean LeBaron, two of the founders of the firm. Grantham described the idea at a Harvard Business School seminar in 1971, but found no takers until For its efforts, Batterymarch won the prize for the Dubious Achievement Award from Pensions & Investments magazine in It was two years later, in December 1974, when the firm finally attracted its first client. GMO s website states that the company is a global investment management firm committed to providing sophisticated clients with superior asset management solutions. Our sole business is investment management and, as a private partnership, we are accountable only to our clients and to ourselves. We forge strong partnerships with our clients, managing their money as if it were our own and offering them honest counsel. Our deep and talented investment teams are highly experienced and forward-thinking, investing with focused expertise in a wide range of asset classes. It adds: GMO proudly serves some of the most prestigious and sophisticated investors globally, focused on providing them with great investment results. It also observes that it has a sophisticated client base of mostly institutional investors, including corporate and public defined-benefit and definedcontribution retirement plans, endowments, foundations and financial intermediaries. Here s what it says about its investment strategy and how it serves clients: Our approach seeks to identify asset classes and securities for which we believe we can get paid to take risk and utilizes a long-term investment horizon, a belief in the power of mean reversion, discipline, conviction, and a commitment to research. We are willing to take bold, differentiated positions when opportunities warrant and have the patience and fortitude to invest with a long-term perspective. We have managed Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 portfolios through multiple market cycles and we constantly re-examine market opportunities across asset classes, testing our assumptions and embracing changing market dynamics. We utilize this deep experience to construct portfolios that we believe will offer our clients superior investment results. There is one question: Do the firm s deep and talented investment teams deliver the superior results they re focused on producing? To answer that, I ll compare the performance of GMO s actively managed equity funds to similar offerings from two prominent providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) DFA funds can be purchased through some 529 and 401(k) plans, but generally they are available only through an advisor. An investor would incur fees from that advisor; those fees vary greatly (in some cases they are very low) and cover the full range of financial planning services provided by the advisor. Also, John Hancock recently introduced a series of ETFs that are managed by DFA (with expense ratios that differ from the DFA funds cited in this article). Those ETFs can be purchased directly by investors. All Vanguard funds can be purchased directly by investors. As is my practice, to keep the list to a manageable number of funds, and to ensure that I examine longterm results through full economic cycles, I will analyze the 15-year period ending December 31, I ll use the lowest-cost shares available for the full period when more than one class of fund is available. And in cases where a fund family has more than one fund in an asset class, I ll use the average return of those funds in my comparison. The table below shows the performance of nine funds offered by GMO in one domestic equity asset class and four international equity asset classes (the international large-value asset class is split into regular and tax-managed categories). 15-year fund performance ( ) Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Symbol Expense Ratio Annualized Return U.S. Large-Cap Blend GMO U.S. Equity Allocation GMRTX DFA U.S. Large Company Portfolio DFUSX Vanguard 500 Index Fund VFINX International Large Value GMO Foreign Fund GMFFX GMO International Equity Allocation Fund GIEAX GMO International Equity Fund GMCFX GMO Average DFA International Value III Portfolio DFVIX International Large Value (Tax Managed) GMO Tax-Managed International Equities FundGTMIX DFA Tax-Managed International Value DTMIX DTMIX Emerging Markets Value GMO Emerging Countries Fund GMCEX GMO Emerging Markets Fund GMEFX GMO Average DFA Emerging Markets Value Fund DFEVX International Small Blend Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 International Small Blend GMO Foreign Small Companies Fund GMFSX DFA International Small Company Portfolio DFISX International Small Value GMO International Small Companies Fund GMISX DFA International Small Cap Value Portfolio DISVX The following is a summary of the most important takeaways from this data: In the single category for which there was a comparable fund from Vanguard, the GMO fund underperformed by 0.5 percentage points. Additionally, the GMO fund has an expense ratio 0.24 percentage points higher than the Vanguard fund. In the six categories for which there are comparable DFA funds, the GMO funds outperformed in three and underperformed in three. In the six categories for which comparable DFA funds are available, an equal-weighted portfolio of GMO funds returned 7.7% a year. The average expense ratio was 0.64%. An equal-weighted portfolio of DFA funds in the same six categories returned 7.8% a year, outperforming the comparable GMO portfolio by 0.1 percentage points a year. The DFA portfolio s average expense ratio was 0.44%. In this case, the slight underperformance of the GMO portfolio (0.1 percentage points) was more than fully explained by the 0.2 percentage point difference in the average expense ratios of the portfolios. Factor analysis I will now take a different look at the performance of the domestic fund from GMO (GMRTX) that has a Vanguard counterpart using the analytical tools and data available at Portfolio Visualizer. Factor analysis provides important additional insights because Morningstar asset class categories are very broad and actively managed funds often style drift. The table below shows the results of the three-factor (beta, size and value), four-factor (adding momentum) and six-factor (adding quality and low beta) analyses for the firm s U.S. fund. The data covers the period from October 2000 through September Each t-statistic is in parentheses. October 2000-September 2015 Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 Fund Three-Factor Annual Symbol Alpha Four-Factor Annual Alpha Six-Factor Annual Alpha GMO U.S. Equity Allocation 0.1 GMRTX (0.08) -0.1 (-0.09) -1.8 (-1.93) When we examine the results from the three-factor analysis, we find there was virtually no alpha. The fund was able to add just enough value to offset its expense ratio and trading costs. The results from the four-factor analysis, again, show basically a zero alpha. However, when all six factors are included in our analysis, the fund generated an alpha of -1.8%, which was very close to statistically significant at the 5% level. Summary GMO is one of the most highly regarded fund families in the world, and investors have entrusted them with over $100 billion in assets. However, despite their efforts, there isn t any statistical evidence that the firm has been able to add significant value versus a passive index fund. Alternatively, investors who put their faith in GMO s ability to exploit market inefficiencies (mispricings) and add value (generate risk-adjusted alpha) were not penalized either, because the results of the comparison between GMO and passively managed funds in the same asset classes were a virtual draw. In the world of active management -- where the vast majority of actively managed funds underperform even before considering taxes -- that s a victory. Reviewing results This is the 14th installment in my ongoing series reviewing the performance of leading mutual fund families. The following table shows the performance of the portfolios constructed for each of the fund families relative to the performance of comparable portfolios from Vanguard and DFA, as well as the results of the factor analyses. With TIAA-CREF, I did not originally perform the factor analysis. Thus, it wasn t in the original article. However, I ve now added that data so that we have the same analysis for each of the active fund families. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 Fund Family Portfolio Return Versus Vanguard Portfolio Return Versus DFA Three-Factor Average Alpha Four-Factor Average Alpha Six-Factor Average Alpha TIAA- CREF Goldman Sachs JPMorgan Chase American Funds Gabelli Funds Waddell & Reed John Hancock Morgan Stanley Wells Fargo Russell SEI Hartford Vanguard GMO Average Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

7 The following are some of the highlights from the table. Of the 14 actively managed fund family portfolios, just four outperformed their comparable Vanguard portfolios, and in one case the outperformance was just one-tenth of a percentage point. The average for all 14 was an underperformance of 0.3 percentage points. Compared to the DFA portfolios, just one of the active fund families (American Funds) I analyzed managed to outperform, and that was by the very slimmest of margins, just 0.1 percentage points. The average underperformance for all 14 was 0.8 percentage points. The three-factor regressions produced an average alpha for the 14 active fund families of -0.1%. The four-factor regressions produced an alpha of -0.2%. And the six-factor regressions produced an alpha of -1.0%. The only actively managed fund family in the group that added value when compared to both Vanguard and DFA (though in the second case by only a small margin) was American Funds. American Funds also showed positive alphas relative to each of the factor regressions. Active funds from Vanguard were able to outperform their own passive funds, but they underperformed the DFA portfolio by an amount four times greater than the Vanguard underperformance. Vanguard s active funds posted positive alphas relative to each of the factor regressions as well. Waddell & Reed funds also showed positive alphas relative to each of the factor regressions, but they underperformed comparable portfolios from both Vanguard (by a small amount) and DFA. Overall, the evidence is compelling. The leading mutual fund families have had an extremely difficult time outperforming low-cost, passively managed alternatives. In addition, active fund families have had a difficult time generating risk-adjusted alphas. This is strong evidence that, while the market may not be perfectly efficient, investors in actively managed funds are highly unlikely to benefit from efforts to exploit any inefficiencies that do exist. Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. Disclosure: The included data and analysis is a summary of 13 other pieces related to an ongoing series evaluating actively managed mutual fund families. For a complete list of those pieces, click to search Larry Swedroe at: The exception is the Hartford fund family analysis, which can be found at The corresponding portfolios are provided for informational purposes only, were constructed specifically for this review and are not portfolios that Buckingham recommends. The returns data included is from Morningstar, and the factor analysis tool was provided by Portfolio Visualizer: Performance is historical and does not guarantee future results. Information comes from sources deemed reliable but its accuracy cannot be guaranteed. It should not be assumed that any of the securities listed were or will prove to be profitable. Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.