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BULLS & BEARS: High risk doesn't always translate into high returns

May 21, 2007

Previously, we were discussing Jeremy Grantham's brash newsletter about global bubbles (found at www.gmo.com). His frank talk is a bit stunning to me.

Grantham's expertise is in analyzing the relative values of various asset classes and arriving at estimates of their future returns. And he has reached an unprecedented conclusion: Over the next years, higher-risk investments will earn poorer returns for investors than lower-risk investments. Historically, investors have been compensated with higher returns for taking on more risk.

In the second section of his letter, Grantham goes on to discuss the danger lurking in the riskier investments that are the fancy of today's institutional investors. This part of his letter is titled "Let's All Look Like Yale," a reference to the herd mentality that has developed as institutions pour money into alternative investments.

Grantham touches on how the flow of money into alternative investments has affected asset class valuations. This shift in money-away from standard stock and bond portfolios and into commodities, foreign equities, hedge funds and private equity-is a change in investment policy made popular by Yale and a few other early adopters.

He describes this effect on one unconventional asset-timber-in which GMO was an early investor based upon its excellent diversification properties and attractive upside potential. Grantham notes that in 2000, Microsoft had a larger market value than all the world's forests. With the flood of money into this asset class over the past seven years, timber is no longer a bargain. Grantham laments the loss of these unique, undervalued investment opportunities as a "global bubble," fed by liquidity and leverage, that has pushed up prices across the spectrum of asset classes.

Grantham devotes considerable discussion to today's "trendy" investments. Here, he confirms that investors have been diversifying into more unconventional investments, such as foreign equities, small-cap equities and commodities, all of which are real asset classes. But he then makes a key distinction: Institutional investors and their consultants are mistakenly treating investments in hedge funds and private equity as a separate asset class. Grantham stresses that these "alternative investment vehicles" are merely a repackaging of existing asset classes, only with higher leverage and higher fees.

In bold, Grantham pens that the "dirty secret" is that the fees charged by alternative funds are not justified by any outperformance. He points out that by simply leveraging an S&P 500 index fund 2-to-1, an investor could have produced returns of more than 20 percent annually. (In other words, for each dollar you invest in the index, you borrow another dollar and invest it also.)

So how does Grantham see this movie ending? He suggests that the total return of this cycle of money into private equity and hedge funds will result in the fund managers' making a fortune and "the client probably makes some money but probably not commensurate with the risk." He states, "Above all, these fashionable, repackaged assets are still part of a zero sum game and their higher fees, in the end, lower returns."

In sum, Grantham's overall thesis is that investors should continue to reduce their expectations regarding future investment returns. In addition, investors who are stretching to earn higher returns by leaping into riskier investments could be in for some unpleasant surprises.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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