GMO

QUARTERLY LETTER
April 2007

It’s Everywhere, In Everything: The First Truly Global Bubble

(Observations following a 6-week Round-the-World Trip)
Jeremy Grantham

From Indian antiquities to modern Chinese art; from land A critical part of a bubble is the reinforcement you get for
in Panama to Mayfair; from forestry, infrastructure, and the your very optimistic view from those around you. And
junkiest bonds to mundane blue chips; it’s bubble time! of course, as often mentioned, this is helped along by the
finance industry, broadly defined, that makes more money
The necessary conditions for a bubble to form are quite
when optimism and activity are high. Hence they have
simple and number only two. First, the fundamental
every incentive to support rising markets as they do. But
economic conditions must look at least excellent – and
geography and culture can weaken the chain. The South
near perfect is better. Second, liquidity must be generous
Sea bubble was influenced by earlier speculation in France,
in quantity and price: it must be easy and cheap to
but was distant and alien to the rest of the world. The great
leverage. If these two conditions have ever been present
Japanese land and stock bubble was utterly persuasive to
without causing a bubble it has escaped our attention.
everyone in Japan, but completely unpersuasive to almost
Conversely, only one of the conditions without the other
all of our clients. Seen through our eyes 10,000 miles
may cause an ordinary bull market but this is often not the
away, it seemed obviously overdone and dangerous, didn’t
case. For example, good or even excellent fundamentals
it? Even the 2000 bubble was really confined to TMT in
with tightening credit often result in a falling market.
the developed countries.
That these two conditions have been met now hardly needs
statistical support, so widely accepted have they become. But this time, everyone, everywhere is reinforcing one
Never before have all emerging countries outperformed another. Wherever you travel you will hear it confirmed
the U.S. in GDP growth over a 12-month period until that “they don’t make any more land,” and that “with these
now, and this when the U.S. has been doing well. Not growth rates and low interest rates, equity markets must
a single country anywhere – emerging or developed – keep rising,” and “private equity will continue to drive
out of 42 listed by The Economist grew its GDP by less the markets.” To say the least, there has never ever been
than Switzerland’s 2.2%! Amazingly uniform strength, anything like the uniformity of this reinforcement.
and yet another sign of how globalized and correlated
The results seem quite predictable and consistent. All
fundamentals have become, as well as the financial
three major asset classes – real estate, stocks, and bonds –
markets that reflect them.
measure expensive compared with their histories
Bubbles, of course, are based on human behavior, and and compared with replacement cost where it can be
the mechanism is surprisingly simple: perfect conditions calculated. The risk premium has reached a historic low
create very strong “animal spirits,” reflected statistically everywhere: last quarter we showed that by using our
in a low risk premium. Widely available cheap credit 7-year forecasts to create efficient portfolios for high,
offers investors the opportunity to act on their optimism. medium, and low risk levels, the return for taking risk had
Sustained strong fundamentals and sustained easy credit dropped precipitously from September 2002 until May of
go one better; they allow for continued reinforcement: last year. To be precise, the gap between our low and
the more leverage you take, the better you do; the better high risk portfolios on our 7-year forecast in September
you do, the more leverage you take. 2002 was 6.4% points and by May last year it was a paltry
0.8%. But in Australia last month it was pointed out that has been for some time.
we had missed the point, that all these portfolios included
3. Animal spirits and optimism are therefore high and
our expected alpha, which not surprisingly is higher for the
feed on themselves through reinforcing results and
risky portfolios (small cap and emerging) than it is for low
through being universally shared.
risk portfolios (cash and TIPS). So Exhibit 1 reproduces
the three points in time, using just the asset class forecast. 4. All global assets reflect this and are overpriced and
As of May last year we now show – drum roll – the first show, probably for the first time, a negative return to
negative sloping risk return line we have ever seen. Just risk taking.
think about it: if we are correct, the process of moving 5. The correlation in global economic fundamentals
all asset prices smoothly to fair value over 7 years (which is at a new high, reflected in the steadily increasing
is how we do our 7-year forecasts) will have resulted correlation in asset price movements.
in a world where investors are paying for the privilege
of taking risk! If you believed this data you should, of 6. Global credit is more extended and more complicated
course, put all your money in cash. In the real world, than ever before so that no one is sure where all the
unfortunately, even if you believed it with every fiber in increased risk has ended up.
your body, you could only have a little cash on the margin 7. Every bubble has always burst.
because the career risk or business risk of moving more
8. The bursting of the bubble will be across all countries
would be unsupportable.
and all assets, with the probable exception of high
So to recap and extend: grade bonds. Risk premiums in particular will widen.
Since no similar global event has occurred before,
1. Global fundamental economic conditions are nearly
the stresses to the system are likely to be unexpected.
perfect and have been for some time.
All of this is likely to depress confidence and lower
2. Availability of global credit is generous and cheap and economic activity.

Exhibit 1
Absolute Return Portfolios Over Time – The return to risk is shrinking
Higher Risk Portfolios
(more Emerging and International)
9%
7.8%
8%
Expected Real Return without Alpha

9/2002 Frontier
7% 6.3%
6% 5.5%
Lower Risk Portfolios
(more Fixed Income) 6/2003 Frontier
5% 4.4%
3.8%
4% 3.3%

3%
2.2% 2.1%
2% 5/2006 Frontier
2.3%

1%

0%
3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Risk (Annualized Volatility)

Note: Based on GMO’s 7-year asset class return forecasts. These forecasts are forward-looking
statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Source: GMO As of 5/2006

GMO 2 Quarterly Letter – April 2007

 9. Naturally the Fed and Fed equivalents overseas will of water that rise and fall with the power of the jets. The
move to contain the economic damage as the Fed did force of the jet can be likened to economic and financial
last time after the 2000 break. But the heart of the conditions. The more nearly perfect the fundamentals
last bubble, the NASDAQ and internet stocks, still and the more generous the liquidity, the higher the water
declined by almost 80% and 90%, respectively. (The jet raises the ball. At maximum force the ball is as high as
heart of the bubble this time is probably private equity. it gets – a bull market peak. Then the jet is turned down a
In 10 years, it may well be described as the private little, so it still represents a nearly perfect set of conditions
equity bubble just as 2000 is thought of as the internet but just the very slightest bit less perfect than it was – the
bubble. You heard it here first!) jet is slightly lower and the ball falls. If bear markets start
in nearly perfect conditions, far above average but just a
10. What is wrong with this logic? Something I hope.
little worse than the day before, what chance do historians
11. Of course the tricky bit, as always, is timing. Most have of finding the trigger? It is lost in a second derivative
bubbles, like internet stocks and Japanese land, go nuance. And, by the time conditions are merely well above
through an exponential phase before breaking, usually average, the most leveraged and aggressive investors
short in time but dramatic in extent. My colleagues have registered the series of declines and are beginning
suggest that this global bubble has not yet had this phase to take evasive action. From here intelligent career and
and perhaps they are right. (A surge in money flowing business risk management creates the normal herding or
into private equity might cause just such a hyperbolic momentum, but in a seamless way as slight reductions
phase.) In which case, pessimists or conservatives in real conditions blend in with gamesmanship. Given
will take considerably more pain. Again?! all the uncertainties and the fact that conditions do not
weaken linearly but in uneven and unpredictable steps, is
This Time It’s Different it any surprise that we always miss market tops?
Yes, each bull market reflects its near perfection in a
Having said all this, what are the special vulnerabilities
different way, with most accompanied by claims of a
this time that might work over a period of time to reduce
golden new era. Today the apparently infinite and cheap
the near perfection of today’s market conditions? The first
supply of Chinese labor, a truly colossal U.S. trade deficit,
is easy: rising inflation. It constrains the Fed’s support to
and the sheer uniformity of easy money and strong
any weakening economy, and the U.S. economy is indeed
economics certainly give this one plenty of differences.
weakening. It directly lowers the traditional bond markets.
But under the surface capitalism eventually grinds pretty
Stocks may be real assets, but behaviorally it destabilizes
fine. The return to capital and the cost of capital sooner
stock investors and causes P/Es to fall. In the short term
or later get into line. Competition bids down returns.
it tends to depress profit margins as corporations relearn
Confidence to spend capital finally recovers. Profit
how to pass through any cost increases. It wreaks havoc
margins, at long last, become normal or even drop below
with housing and commercial real estate by lowering the
normal. The workings of competitive capitalism are, in
possible leverage and therefore lowering prices. And
the end, an irresistible force and that is why everything
perhaps most significantly this cycle, it lowers the feasible
always trends to normal and every very different bubble
leverage in private equity deals and places many deals
has always burst. And hey, if it happened in a smooth and
that can be done today out of reach, which in turn has dire
regular way, how boring our business would be.
effects on the current stock market.
What Is the Catalyst for a Break? The second possible catalyst is our old friend: profit margins.
Everywhere I went on my trip this was the question that They are currently far above average globally and they
followed my gloomy talk. But there usually is no catalyst will, of course, come down. A slowing U.S. economy and
that can be observed. We haven’t agreed yet on a catalyst fewer pleasant global surprises will put pressure on profit
for 1929, 1987, or 2000, or even the South Sea bubble margins. Possibly continued house price declines will slow
for that matter. On pondering the reason for the lack of a the growth of credit, and consumption will grow less fast.
catalyst I offer a thought experiment (or tortured analogy). There are leads and lags, and large retroactive changes to
A market in equilibrium can be likened to a ping-pong the profit margin data, so this factor is not so certain a death
ball sitting on a pool of water. You may have seen the knell to the bubble as is inflation, but a couple of years of
fun fair trick of having ping-pong balls sitting atop jets margin declines should do the job just fine.

Quarterly Letter – April 2007 3 GMO

The First Quarter’s Stress Test in an extended decline the extra value in emerging would
In late February we had a spot of trouble in the subprime materialize as it did in 2002. And if the market recovered,
market. (“Subprime …” – it already begins to sound emerging would storm back. This time we took unexpected
familiar. Haven’t we always talked about it?) And a pain in our fixed income investments, which in many of
Chinese red herring arbitrarily jumped in with a 9% our asset allocation accounts had risen to 50%. We knew
market decline in one day, for no related reason. The that in general our fixed income portfolios tend to prosper
combined effect was to create an echo of last May, where as risk premiums narrow, whereas our equity accounts
the carry trade pulls back for a few days and lets us see have a hard time, and vice versa. It was just a question of
where the vulnerabilities are. There is a tendency to degree. In asset allocation, in our desire to have more of
say, “Whoopee! We always bounce back! We’re armor fixed income’s enviable alpha, we had probably reached for
plated!” This seems like a bad idea. There is probably lots a bit too much of it to be compatible with the normal risk
of information in these minor shocks, which may prove avoiding preference of our asset allocation portfolios. On
useful for a major shock. Last May’s lesson, I believe, examination it really came down to having accumulated,
was not that emerging markets could bounce back, but that in the different portfolios, too much currency exposure,
they could decline by 25% in three weeks in the face of which in turn can get in the way of carry trade events. So
the best year fundamentally in emerging’s entire history. after long consideration of alternatives, we reduced the
What might the decline have been on bad news? A 50% currency alpha exposure. It may be an over-reaction, and
decline in 3 weeks? It just let us know the potential pain you can never know for certain at the time (and indeed
in really bad risk-liquidity events. I suggest taking a close risk taking in general continued to prosper in the first
look at one’s entire portfolio on each of these shocks and quarter), but I don’t think so.
checking for leaks in the boat – unexpected effects.
I urge our clients to take a detailed look at all their
In May of last year emerging was a big holding for us, portfolios’ responses to these two jolts, for sometime
but there was no real concern because we believed that sooner or later the shots will not be across the bows.

Disclaimer: The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed herein
are those of Jeremy Grantham and GMO and are not intended as investment advice.

Copyright © 2007 by GMO LLC. All rights reserved.

GMO 4 Quarterly Letter – April 2007

 GMO
SPECIAL TOPIC
April 2007

Letters to the Investment Committee XI*

Let’s All Look Like Yale
Part II: Yale Meets Goldilocks
Jeremy Grantham

Summary of Part I relative overpricing in coming years. Certainly in the last

Last quarter I made the point that a continuously large five years the outperformance of these categories has been
flow of funds from the traditional assets – U.S. stocks and extreme. Here is just a sample.
U.S. bonds – towards diversifying assets – everything Cumulative Performance of S&P 500 and
from emerging markets equity to infrastructure and Other Assets from 3/31/02 to 3/31/07
private equity – was almost certain. This quarter it is time
to look at the effects of this revolution in asset allocation S&P 500 35.5%
on individual asset categories. Russell 2000 68.1%
U.S. Low Quality Stocks 72.7%
First of all, it is important to realize that the “let’s all
Int'l. Small Cap Stocks1 191.8%
look like Yale” effect is not the only important driver of
asset allocation. The other extremely important issue Emerging Equities2 221.4%
is the effect of sustained global liquidity combined
Lehman Brothers U.S. Government 28.1%
with sustained rapid global growth, which has created
an unusual Goldilocks effect where the economic and U.S. Junk Bonds 63.9%
financial world are “just right,” which in turn has led to Emerging Country Debt3 87.0%
an unprecedentedly low risk premium across all assets Other than commenting on the broad outperformance of
(see the first section of the quarterly letter) and broadly these newly desirable areas, a few categories bear special
overpriced assets. mention, either for their unexpectedness, such as timber,
or for their potential dangers.
These two quite separate effects – Yale and Goldilocks
– interact. The Yale centrifugal force unfortunately often Let us start with timber. This has gone from an obscure
coincides with the drive towards riskier assets stimulated asset favored passionately 10 years ago by a dozen or so
by Goldilocks. Prime examples of this would be emerging institutions thought to be eccentric, to a fashionable new
country debt and equity and private equity, all both risky frontier 5 years ago favored by an incremental handful
and diversifying. There are, in fact, few examples of of avant-garde institutions, to a hot asset class today
intrinsically conservative investments where only the that is at least considered by most larger endowments
Yale effect holds. The obvious example would be forestry and foundations. The impact on this small asset class
holdings, where even alone the diversifying effect has been – in 2000 Microsoft’s market cap was larger than all the
enough to dramatically change the pricing. The worst world’s forests (what a nice arbitrage that would have
effects, though, should rationally be at the intersection of been!) – was of course spectacular. The discount rate used
these drivers to high risk and exotic diversification, and in evaluating forest properties was as recently as 3 years
this is where we should expect to see the most extreme ago about 8.5% in the U.S. and over 10% in New Zealand.
* The Letters to the Investment Committee series is designed for a very 1 S&P/Citigroup EMI World ex-U.S.
focused market: members of institutional committees who are well 2 S&P/IFCI Composite
informed but non-investment professionals. 3 JPMorgan EMBI Global +
This was a ridiculously high real return for an asset whose roll (said to be in “contango”). The data was moderately
virtues included that it was exceptionally diversifying – it convincing, but not very convincing. But combined with
has had a history of rising in all great equity bear markets undoubted diversification benefits and the institutional
– and in the context of a diversified forest portfolio, very drive to have their portfolios be new and improved, the
safe: if the sun shines and it rains, the trees grow about total package was deemed by some to be attractive. The
on schedule. The discount rate today with forestry’s new final straw for breaking down resistance was the surge in
popularity and the general desperation to find high returns growth rates of developing countries led, of course, by
has fallen to barely over 5% and 6.5%, respectively, in the the all-time monster growth story – China. Incremental
two countries. This represents both a wonderful windfall demand for commodities from these new sources of
for existing owners (Harvard was rumored to have sold major growth has changed the relationship between
most of its U.S. forestry holdings in one big transaction) technology improvements and demand so profoundly that
and a heart-breaking loss of a great opportunity for asset most commodities now probably have price trends that
allocators like us. are moderately up – say, 1 to 1.5% real a year. In the long
term, this shift from a downward drift to an upward drift
Other commodities have changed perhaps even more is very important. In the short term, recent great strength
profoundly. Their attractiveness hinged on great in most commodities may have already discounted this
diversification characteristics. Both bonds and stocks change for the next 20 years.
are hurt by unexpected inflation – nominal bonds suffer
directly and stocks suffer behaviorally – investors The rush of new investors drawn to commodities in the last
are unsettled and P/E ratios fall. In glorious contrast, 3 or 4 years has, in addition, pushed up the prices of the
commodities are positively correlated with inflation, and commodity futures in relationship to the commodity itself,
in a real inflationary crisis their prices are likely to rise perhaps by a lot: it may have permanently changed the
far more than the rate of inflation as a scarcity of inflation shape of the futures curve so that few if any contracts may
protecting investments rapidly develops. This attractive now routinely pay long investors to roll. In a neat irony the
case for commodities was formerly held back not only by flood of new money attracted by the ability to roll contracts
unfamiliarity (and hence more career risk) but also by the profitably may have ended that condition forever!
well known dreary track record for price increases. As Venture capital is a tough market these days that always
The Economist magazine has periodically reminded us, has plenty of competition, and I’m not going to kick
the 100 year history in just about all commodities has been someone when they’re down other than to say that the
of falling real prices, in the range of 1% to 1.5% a year returns have been poor now for quite a few years. In any
as productivity gains have exceeded the naturally rising case the flood of new money is for the time being more or
marginal costs of deeper wells and second-class land, etc. less passing them by, which is a relatively good sign, for
This argument was countered by what we can call the it is worth remembering that the size of the yearly cohort
Goldman Sachs case: that there has been, notwithstanding of investors is the largest determinant of future returns:
falling commodity prices, a positive return to buying small inputs predicting good future returns and vice versa.
commodity futures. This theory is based on original There is nothing that suppresses the success of a brilliant
observations by my usual hero, Keynes, that speculators new idea more completely than having 12 nearly identical
who bought futures were rewarded by producers who start-ups.
were laying off their risks.
Infrastructure is the most recent area to attract rapid
The intellectual case seems a little unconvincing since increases in capital partly, no doubt, in response to other
speculators by no means only go long – I am still personally opportunities becoming overpriced. In some of these pools
short copper as we speak – but the historical numbers were the fees, both declared and submerged in the complex
not bad. Rolling long positions in the futures seemed financial structures, go on and on so that infrastructure has
historically to have good returns comparable to equities if become an extremely appealing proposition to the managers.
you weighted your positions heavily to oil contracts, say And the supply of funds is such that infrastructure can
equal to their relative market value, or if you only invested appear in odd places, bidding up, for example, the pricing
in contracts that typically paid you to roll (contracts said of very large forestry deals (although it’s not clear from the
to be in “backwardation”). Many contracts however were early deals if they would know a tree if it bit them on the
not typically priced this way and cost the speculators to leg). As always, the effect of the much increased supply

GMO 2 Letters to the Investment Committee XI, April 2007

 of funds has been to take formerly handsome risk-adjusted recently was a quiet backwater in terms of talent flow.
returns down quickly to the lean and mean. With an increased inflow of more talented people, the
standard of competition rises and rises until … well, to
Hedge funds are getting to be an old topic, but make for be honest, I’m not quite sure how the story does end.
a remarkable story. An esoteric $35 billion enterprise What for sure does not end soon is the flow of money, for
15 years ago with 800 funds serving rich individuals has a survey released last quarter based on interviews with
turned into a $1.2 trillion enterprise with over 8,000 funds large institutions said that these institutions expect to
and numerous funds of funds increasingly owned by triple their hedge fund holdings in 4 years, which would
institutions as well as individuals. The trillion is leveraged make institutional hedge fund holdings larger even than
several times and turns over far more frequently than those of individuals.
‘old-fashioned’ money, so that the percentage of trading
represented by hedge funds has been said to be closing in Private equity has been growing in the last 3 years even
on 50% of U.S. equities. The effects of this flood of money faster than hedge funds with the leading firms leap-frogging
are numerous and significant. Hedge fund investing does each other in the size of new funds raised, with several
not change the iron rule of investing: it is a zero sum game already well over $10 billion. The dirty secret here is
minus the fees and the trading friction. The total cost of that their ‘2 and 20’ fees are not justified by any positive
regular long-only investing has averaged about 1% for alpha (or outperformance of the asset class) at all. But,
institutions (½ fees and ½ transaction costs) and about 2% unlike traditional equity investing where outperformance
to individuals (⅓ fees, ⅓ transaction costs, and ⅓ selling is mainly dependent on style, and therefore mean reverting
costs). Hedge fund fees are of course a tad higher: typically with good performance typically followed by bad, in
about 1.5% fixed fee plus 1% transaction costs (typically private equity, returns are in complete contrast very sticky:
ignored and often much higher) plus at least 20% of all there is a huge and remarkably consistent difference
the profits (including the risk-free rate that can usually between the best and the worst of them, so this is an area
be had free of charge). Today let’s assume a 5% risk-free where endowments and others with the resources, talent,
rate and 4% outperformance for a total performance fee and pull have exercised those advantages. Accordingly,
of 1.8%. The total fees thus reach 3.3%, and the total the early moving and skillful institutions have picked
costs including transactions total 4.3% for institutions, the better managers that are now largely closed. These
or almost twice the ‘slippage’ for long-only. Thus, the better managers have produced wonderful performance in
first consequence of increased alternatives, especially the range of 20% to 30% compounded per year. In stark
hedge funds and private equity, in a world that remains contrast, the larger, later arrivals have barely averaged a
mercilessly a zero sum game is an incremental drain return that is even positive. More to the point perhaps, the
on total assets. The second effect is on the availability cap-weighted average is at best, depending on the analysis
of alpha (or outperformance) to the winners in the poker you read, equal to the S&P 500. It does this, however, by
game. Increased hedge fund money absolutely does not sometimes leveraging over 4 to 1 in today’s market. 2 to 1
increase the available inefficiencies. They at best stay leverage on the S&P 500, let alone 5 or more would have
the same, so the same inefficiency is now exploited by produced a much higher return, order of magnitude 21%
more aggressive alpha-seeking dollars and is therefore compared to 14% max for private equity (source: Private
spread thinner. This effect of increased competition is Equity Performance: Returns, Persistence and Capital Flow
also not by any means confined to hedge funds only, but by Steven N. Kaplan and Antoinette Schoar, November
is also affecting long-only investors. There is a nice irony 2003). However, fees of ‘2 and 20’ charged on 21% could
here too: that the institutional drive into these new, more account for this gap, so there may not actually be a negative
expensive vehicles may also lower the return available alpha pre-cost – lucky investors! (Although there probably
to those of their existing long-only managers fortunate is.) LBOs are thought by several academics, in fact, to
enough to have a positive alpha. be a modest destroyer of real value. But let’s be friendly:
the case for private equity creating societal or long-term
But it is not only the case that the dollars chasing alpha economic value at a company-by-company level is modest,
increase. The other, closely related but clearly separate and the case for the average invested dollar returning more
effect is, as mentioned last quarter, the enhanced flow of than an equivalent leveraged S&P return is non-existent.
bright and even brilliant people drawn into our industry What the industry on average offers is freedom from the
by the sometimes vast fees, and hence salaries, that until traditional margin calls that on a similarly leveraged equity

Letters to the Investment Committee XI, April 2007 3 GMO

portfolio would sooner or later ruin you. As long as you substantially more diversified than they are today. The
can make your quarterly interest payments in private equity flood of institutional money moving into foreign and
deals, you are okay. There is, however, a little snag. If our emerging equity and alternatives will mean that these
7-year forecast were to turn out right – it just might happen assets will be looking for excuses to be overpriced for
one day – then U.S. equities would return minus 1.4% real they will, more often than not, be on the right side of
per year as P/Es decline modestly over 7 years to their supply/demand imbalances. Conversely, the sources of
long-term average and profit margins decline substantially funds – U.S. blue chips and U.S. bonds – will be in the
to theirs (standard GMO assumptions). The T-bill rate reverse position and will mostly be lower priced relative
would, in contrast, likely be about +1.5% real, and average to fair value than the trendier ‘newer asset classes.’ An
borrowing costs about 2.5% higher than that, or about ominous report from Greenwich Associates, an investment
+4% real. The incremental cost of debt at 4 to 1 leverage research firm, in The Wall Street Journal of April 12,
comes to over 2% a year even after tax deductions. 3.5% 2007 confirms just how powerful this asset movement
a year loss is not normally a disaster, but with only 20% is. 24% of institutions expect to lower their allocation to
equity, it wipes out all value in 6 years, other things being U.S. active equity portfolios versus only 4% that intend
equal! In real life the losses would be hidden for a while increases. But for private equity the increase intentions
by selling divisions, reducing research and advertising, are 34% and the decreases 2%. It almost can’t compute,
and, above all, by treating depreciation charges as profit but it will be exciting trying.
rather than necessary rebuilding costs. So the leveraged
Of course in the longer run all assets are worth replacement
deals, even if GMO’s forecasts were correct, would last
cost and supply/demand imbalances do not change that.
longer than expected before defaulting, but only at the
Ben Graham famously said that in the short run the market
cost of hollowing out the acquired companies. And some
is a voting machine, but in the long run it is a weighing
managers would exit so fast by unloading their company
machine. In this sense replacement cost is Ben Graham’s
that the clock ticking against them would have had little
‘weighing machine’ and supply/demand his ‘voting
time to tick, and any hollowing out would be harder to spot,
machine.’ Every time the supply/demand imbalance
although usually still there. But for slow movers, default
is interrupted, even if only for a short time, prices will
will probably be common. The good news for the managers
trend towards fair value or replacement cost, sometimes
is that they still get their 2% fixed fees. The good news for
quite slowly and sometimes very fast indeed. So we are
the investors is that at least there would be no carry! The
probably in for an extended period of mispricing, usually
effect of the current flood of money riding the wave of
in favor of the trendy assets, but with reactions that will
diversification and currently cheap and available debt will
sometimes likely be dramatic.
also serve to push initially high prices even higher. The
real shocker here is the asymmetry of returns. The first It is also worth remembering that some of these trendy assets
deal is good: the managers make a fortune and the client are real asset classes like foreign and emerging equities,
does well. The second deal is good: the manager makes a small cap equities, and timber. Others, like hedge funds
second fortune (usually a bigger one on a larger fund) and and private equity, are merely the existing asset classes
the client does well. The third deal is a bust: the manager repackaged at higher fees, with less regulation and much
makes 2% and the client loses a bundle. Total returns: the greater leverage. They are not new asset classes and should
manager makes two fortunes and 2%; the client probably be reclassified into their component parts, as I’m sure they
makes some money but probably not commensurate with will be routinely in a few years. Above all, these fashionable,
the risk. And this is known as alignment of interest, repackaged assets are still part of a zero sum game and their
apparently so lacking in public companies. I wonder what higher fees are, in the end, your lower returns.
this alignment would look like. The really difficult task for investment committees is
to steer a careful course between increasing beneficial
Summary diversification while being aware of the landmines caused
In general, more diversification is better than less. And by the intersection of the widespread move to risk taking
it is as near a certainty as things get in investing that 10 and the trendiness of exotic investments. All in all we
years from now institutional funds in aggregate will be should fasten our seat belts. It’s likely to be a bumpy ride.
Disclaimer: The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed
herein are those of Jeremy Grantham and GMO and are not intended as investment advice. Copyright © 2007 by GMO LLC. All rights reserved.

GMO 4 Letters to the Investment Committee XI, April 2007