GMO's Grantham: How to Protect Your Job and Your Clients' Money

"Good client management is about earning your firm an incremental year of patience,” says Jeremy Grantham of GMO Capital Management, noting that the goal for investors should be to not underperform bear markets.

(April 25, 2012) — It is imperative that long-term investors display patience to weather market volatility while not underperforming in bear markets, explains Jeremy Grantham, the co-founder of Boston-based investment firm GMO Capital Management, which in 2006 predicted the housing crash.

The result: protection of investors’ jobs and their clients’ money.

The central truth of the investment business is that investment behavior is driven by career risk, according to Grantham. Career risk, he says, drives market volatility, and thus, it is imperative that long-term investors have the patience to wait about three years to see if an investment strategy will payoff.

The market moves 19 times more than is justified by the underlying economic engines, according to Grantham, fueled by career risk and a lack of long-term thinking. According to Grantham’s most recent quarterly letter, the prime directive within the investing business is first and last to keep your job. “To do this…you must never, ever be wrong on your own,” Grantham explained. Therefore, to prevent this, professional investors pay ruthless attention to what other investors in general are doing.

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“This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest,” according to Grantham.

This herding mentality explains the discrepancy between a remarkably volatile stock market and stable GDP growth. Thus, in order for investors to survive betting against bull market irrationality, they should satisfy three conditions, Grantham outlines. Firstly, investors should allow a generous margin of safety and wait for a real outlier before making a big bet. “Too big a safety margin and we are leaving too much money on the table. We are probably protecting our jobs rather than attempting to maximise our clients’ return,” he says. “Too narrow a safety margin and clients may fire us, as some have done in the past.”

Second, investors should try to stay reasonably diversified.

Third, according to Grantham, investors should never use leverage.

“The cardinal rule is to not underperform in bear markets. And though it may be a cardinal rule, there are, as we all know, no useful guarantees in our business,” he concludes.

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Pro·vo·ca·teur, [pruh-vok-uh–tur]: Noun, a person who provokes trouble or incites dissension, as an instigator, fomenter, agitator, or rabble-rouser; also called ‘agent provocateur.’

The word, we think, very much jibes with the personality of aiCIO—a relatively young magazine, eager to spark strong discussion and debate within the institutional investor community. Our conferences in New York, London, and Sydney are a success in our eyes when there is at least one shouting match. We are eager to hear from readers disagreeing with angles we highlight in our news stories, and the reasons behind their strong opinions. In the same vein, we are delighted when readers email us with questions, asking for a particular whitepaper we highlight or expressing their enjoyment over stories, validating our efforts to provoke thought among the world’s largest investors.

It seemed natural, then, to create a new section of the magazine: Provocateur. These stories are titled by a single question. With multiple sides, they spark disagreement. By way of example, one issue we tackle in this inaugural section is the trend of asset managers competing with investment consultants, who are increasingly flocking toward the discretionary consulting space. In June 2011, NEPC revealed that amid growing client demand, the consulting firm was making its way into the field of discretionary consulting. Similarly, in March of this year, Rocaton Investment Advisors joined the outsourced CIO bandwagon, approving its first discretionary consulting client. “We need to be competitive,” Robin Pellish, Rocaton’s CEO, said following the announcement, acknowledging the generally low-margin consulting environment. The question: What will be the future of consultants and fund managers potentially fighting over the same turf—that turf being lucrative contracts with pension clients? Elizabeth Pfeuti, our London-based European Editor, writes, “Slight disgruntlement over a move by investment consultants to drive more revenue in the tough times of the financial crisis, when investors were afraid to move from their agreed portfolios, has turned into something altogether more bloody—and there’s no letup in sight.”

The new section is another example of our mission to seek your thoughts, opinions, and ideas—an example of our status as journalists and editors not to be removed and aloof, but to be in the trenches making sense of the investing landscape and having fun with it. Let this new section serve as a reminder to not sit back and take things for what they are, but to question, oppose, and criticize. So be a whistleblower. Call us with ideas and leads. And if you hear a viewpoint you disagree with at our conferences, stand up and—politely but with gusto—voice it. Just no shoe throwing, please.

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–Paula Vasan