Leading equities strategist at GMO warns about using ETFs in Barrons Interview

Scott Longley

a bird flying over a building

James Montier, one of the most widely followed equity analysts, has suggested that investors using passive funds have in effect "thrown in the towel". Montier also suggests that using funds such as ETFs are a "very strange thing to do at this particular point in time".

Montier is a strategist for the US-based asset management firm GMO, set up by Jeremy Grantham. Known for his acerbic commentaries and love of contrarian investing ideas including the championing of Keynesian economics, Montier has long been a dedicated value investor. But his latest comments in an interview with US financial newspaper Barrons are perhaps his most strident to date on the subject of passive investing. Montier is clearly not a fan of passive funds.

Here are some highlights from the long-from interview:

Barron's: Bonds are expensive, stocks are expensive. What's an asset allocator to do?

James Montier: Things just don't add up. One group has thrown in the towel and says 'if you can't beat them, join them. I'm just going passive and be damned.' (Passive investing) is a very strange thing to do at this particular point in time.

The US market is at its second or third most expensive point in history. So people are saying, 'I either don't understand the world anymore, or I don't think that valuation matters anymore,' which is a really weird thing to say. You're giving up the one piece of information that you know helps determine long-term returns.

You cannot describe yourself as an investor if you are going passive. You are welcome to call yourself a speculator, but you honestly can't say you care about expected returns if you are going passive at this time.

For those standing against the tide, there are a couple of challenges. One, how much pain can you take? The US has been an incredibly strong market for a number of years, so going passive is classic returns-chasing behaviour. How do you manage the pain? Nothing in the precepts of being a value investor tells you about the path or the timing. It just tells you about the final destination. The light at the end of tunnel is that the more that people buy on the basis of market cap, the greater the opportunity for active managers.

Barron's: You have also taken Warren Buffett to task.

JM: All these years I have looked to Warren Buffett as a beacon of hope. Two months ago, he said that equities look cheap, relative to interest rates. It seemed like a dreadful thing to say. It might be true only if you believed there was absolutely no mean reversion — in that case you'd be looking at a 3 per cent real return from equities, zero from bonds, and, say, minus 1 or 2 per cent from cash.

But here was a man who, using his favourite valuation indicator of market cap to gross domestic product, pointed to the tech bubble of 2000 and said it was insane. Using the same indicator, he pointed out when to buy equities in late 2008, early 2009. Here we are within a hair's breadth of the levels in 2000, and he is saying equities are cheap. I don't think it's true. There are plenty of reasons why interest rates are not related to performance — very low rates haven't stopped a 50 per cent decline in Japan. So I'm sticking to dead heroes now — Ben Graham and John Maynard Keynes.

Barron's: Yet even your colleagues aren't dismissing the premise that this time is different.

JM: One of the great joys of being at GMO is that conflicting views are encouraged. When somebody like Jeremy Grantham says there's a plausible case that mean reversion might take 20 years, not seven, I'm going to listen, and try to persuade others, including Jeremy, that Jeremy is wrong. Information lies in the divergence of opinion. Jeremy and I arrive at the same terminal point: you end up with low returns. Jeremy says bubbles are best characterised by excellent fundamentals irrationally extrapolated. In the classic manias — the TMTs (the tech, media, and telecom bubble of 2000), the Japanese new era — everybody believes this time it's different.

Jeremy says we don't have that, that the world is worried, not euphoric, and therefore this isn't a bubble. My perspective is that we have a bubble of complacency, and people are acting as if there are no risks, while I see a world full of them, from slowdowns in China to a eurozone crisis to Fed tightening. Pretty much all assets look to be priced for perfection. Effectively, people have just said: 'I have no choice but to go and invest.'

I call it the foie gras bubble, where you're being force-fed risk assets. Jeremy is talking about extrapolation of return. I'm talking about underestimation of risk.

Barron's: How do you build a portfolio under these conditions?

JM: You stop trying to build so-called optimal portfolios, which are a very strong statement about your belief in the state of your knowledge — that your expected returns are going to be this, which to me is absurd. You build a robust portfolio that can survive lots of different outcomes — a world where Jeremy is right and it takes 20 years for mean reversion, or one where I'm right and the markets revert considerably faster.

There are four things you could do: first, concentrate your portfolio, own the one thing that will generate returns, which to us are emerging markets, with a strong value tilt. If you are Rip Van Winkle and go to sleep for 30 or 40 years, you will wake up and your portfolio will probably be just fine. But most people have a three-year time horizon.

Second, sidestep the problem, look away from listed assets and seek alternatives like private equity, hedge funds. The problem is that alternatives aren't magic beans with uncorrelated sources of return. They are different ways of owning standard risks. Private-equity returns look very much like public equity, plus or minus leverage, so they're not really diversifying. Hedge funds in aggregate look like a put-selling strategy. And it is not non-correlated when equity markets fall apart.

Third, use leverage. The problem there is that leverage can never turn a bad investment into a good one, but it has the potential to turn a good investment into a bad one by forcing you to sell at just the wrong point in time.

Fourth, to quote Winnie-the-Pooh, never underestimate the value of doing nothing. Patience is a virtue.

Barron's: What does that translate into?

JM: A sensible portfolio has a sizeable amount of dry powder: bonds, T-bills, TIPS (Treasury inflation-protected securities). You have to say: 'Look, I know cash is giving me a lousy return, but it has an option value that comes in when there are dislocations in markets.'

Now, the risk of that strategy is clearly that this time is different and there is no more volatility. Then take your equity risk mainly where you are getting paid the most for it — emerging market value stocks. There are also different ways of owning low standard risk. Merger arbitrage is a way of owning equity that has a very different duration profile. Equity duration can be 25 to 50 years, but merger-arb duration is six-12 months. If you use leverage, use it sparingly.

Barron's: Please share your expectations for returns.

JM: For US equities, around minus 3 per cent, minus 4 per cent a year, driven by mean reversion. Both price/earnings ratios and profitability are high and will revert to normal over seven years. The S&P 500 is the world's worst equity market because it has such an appalling return forecast. Europe is about zero, Japan is zero to mildly negative.

Then you get good old emerging markets at 4 per cent, and emerging markets value at 6.5 per cent a year for the next seven years, in real terms. Bonds are an appalling investment. The current yield on the US 10-year is 2 per cent and change, and expected inflation over the next 10 years is 2 per cent and change, so I'm expecting a near-zero return. That's why it's a difficult time to be an asset allocator, because historically when risk assets are expensive, safe-haven assets provide somewhere to sit and wait. Today, they don't, because of the way that the central banks have applied their policies.


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