A cheap portfolio of cheap assets

While nothing is always true in investing, it’s generally the case that buying cheap assets gives you a better prospect of higher future returns.

With bonds the relationship is clear. Lower bond prices mean higher yields – and your starting yield with a bond is an excellent indicator of the return you’ll ultimately receive.

With equities and other assets, the relationship is muddier, but still broadly true. Cheaper buys you future cash flows at a lower cost. Hence you should earn a higher return on your investment.

The track record of value investing beating growth over the long-term is testament to this truth.

But caveats abound!

Value doesn’t always outperform, even broadly. And many individual cheap shares do terribly. By the same token, a particular expensive company might prove to be the next Amazon. There also exists a ‘quality factor’ – a cohort of costlier companies with strong operating metrics that beat the market, at least on a risk-adjusted basis, despite their higher valuation.

Oh, and price is a terrible short-term timing tool. Even over ten years, its forecasting ability is weak (if better than the alternatives.) Expensive shares can get more expensive.

All that said, when you invest in a frothy bull market with high valuations (1999 or 2021) you’ll usually do much worse compared to when you invest in a lowly-rated market (2003 or 2009).

How expensive assets become cheap assets

The obvious question for the wannabe Scrooge McDucks among us is: what are cheap assets today?

Well like the aesthetics of a mullet, cheapness is somewhat in the eye of the beholder.

But it’s not controversial to say that prices (and hence valuations) came down sharply with the wealth destruction of 2022.

With these lower prices should come higher expected returns. (Not guaranteed. Expected).

Who says so? GMO says so

Tracking, crunching, and forecasting such returns across all asset classes is a full-time job. It’s handy then that one very respected shop – GMO – makes its output public.

And the good news is these often-gloomy guys seem much more chipper in 2023.

In a recent quarterly letter, GMO’s co-head of asset allocation Ben Inker first looked back to the end of 2021. Most assets then seemed priced to deliver little gain (return) for the pain (volatility):

Again, expected returns are not set in stone. But if you were a betting person, all that clustering below the 0% real1 return line would have given you the willies.

True, GMO was notoriously gloomy for most of the past decade – during much of which time the US market continued higher on a tear.

But the firm’s warnings were at least somewhat vindicated by the rout in global assets in 2022.

Cheap assets in 2023

The good news is last year’s crash means GMO’s new forecasts are much rosier:

As you can see, there’s now plenty of stuff expected to deliver decent-ish gains over the next seven years, at least according to GMO.

At a glance we can see that most of the risk-to-return line – imperfectly fitted though it is – now sits above the 0% mark.

Also, notice how the slope of the line has steepened? This shows that in GMO’s view, investors can more confidently expect to be rewarded for investing in riskier assets.

Rejoice?

Indeed – but not quite by turning the party dial up to ’11’.

Firstly, lots of these expected returns are still quite miserly compared to history.

Worse, GMO continues to see kegs of disappointment-powder stashed beneath the global market in the shape of expensive US assets.

The US makes up 60% of a typical global index tracker fund. So US equities mired below that 0% waterline might curb expectations for huge global tracker fund returns for the next few years.

GMO’s fund full of cheap assets

But what if instead of our beloved global tracker funds, we went went naughty and tried to only own the stuff that GMO reckons is priced to deliver a stronger return?

Well as a fund shop, GMO provides its clients with just that in the shape of portfolios that accord with its forecasts.

In his letter, Ben Inker flags up what one such fund now holds according to GMO’s ‘Benchmark-Free Allocation Strategy’:

Do you like what you see? Then you can buy into GMO’s fund and hopefully profit.

That is… you can buy into that fund if you have a minimum of $25m to invest. (And £10 leftover to pay for a stiff drink afterwards.)

But fear not!

I did it my way

For the rest of us mortals, I’ve had a bash at approximating a similar portfolio that uses investment trusts and ETFs accessible to UK investors.

Please remember the result is just for fun and (possibly) educational purposes.

It is not a close replication of GMO’s strategy. And it is definitely not investment advice.

Cheap tricks

I’ve made several executive decisions in creating this portfolio, most of which we could debate:

• I’ve used low-cost ETFs where possible.

• In a couple of cases a better vehicle to my mind was an investment trust.

• Some elements of the strategy (especially the structured products and liquid alternatives) are hard to replicate as a UK private investor. (Even US investors have seen mixed results with ETFs that implement the strategies). I’ve fairly arbitrarily picked a couple of relevant ETFs for this slot.

• GMO’s global value versus growth allocation is a long/short strategy. We can’t easily replicate that. Instead I made a (smaller) allocation to global value and increased the holdings in the small cap ETFs. Hopefully this will capture most of the benefit from any continued re-rating of value versus growth (/the market), albeit without the downside protection of shorting growth.

• There will be overlap in the underlying portfolios of the ETFs. (GMO states it gives resource stocks a low direct allocation specifically because they feature in many other positions.)

• I’ve picked some funds more relevant to UK investors – notably the high-yield debt fund – that can be expected to further change the returns from what GMO sees. (On the other hand, we wouldn’t have to pay GMO’s fees!)

• I’ve made allocations in increments of 5%. Finer weighting is spurious for our purposes.

• I do not have an encyclopedic knowledge of ETFs. There are other choices to pretty much all the funds I’ve selected. Some will be cheaper. Feel free to share your suggestions in the comments.

Also note GMO is based in the US and in certain cases (say for fixed income) currency factors may be influencing whether or not something is included in its portfolio.

Bottom line: this is a cheap portfolio of cheap assets inspired by GMO. It’s not a slavish copy.

Do I need to stress again this is just for fun?

The cheap assets portfolio: 2023

Here is what I came up with.

Portfolio of cheap assets for a UK DIY investor

Asset	Security: Ticker	Weight
Global value	iShares Edge MSCI World Value: IWFV	15%
Emerging value equities	iShares Edge MSCI EM Value: EMVL	20%
Japanese small value	iShares MSCI Japan Small Cap: ISJP	10%
European small value	iShares MSCI European Size Factor: IEFS	10%
Resource stocks	Blackrock Energy and Resource Trust: BERI	5%
Cyclical quality	iShares World Quality Factor: IWQU	5%
Emerging debt	iShares JP Morgan $ EM Bonds: SEMB	5%
High-yield / distressed	iShares Global High Yield Bonds: GHYS	10%
Low volatility	iShares World Min Volatility: MVOL	5%
Momentum	iShares Momentum Factor: IUMO	5%
Macro trading	BH Macro Global Trust: BHMG	10%

Source: Author’s research

As I’ve stressed, this portfolio rhymes with the GMO one. It isn’t a replica.

More notes on the selected securities

I’ve mostly chosen iShares ETFs for simplicity. Other ETFs are available.

I chose a general small cap Japanese ETF rather than say a Japanese value-tilted active fund. So we’ve lost the value tilt here. But broad Japanese equities look cheap to me.

I couldn’t find an ex-USA global value ETF. Also hard to allocate to is the tiny ‘US Deep Value’ slot. I might have further increased the global value ETF, but that has 40% in US equities. Instead I again increased the allocation to small cap and emerging market value ETFs.

A commodities investment trust covers resource stocks. With an income bias, it should tilt to value.

Cyclical quality is an odd GMO-bespoke factor I believe. I went with a general quality factor ETF.

I rounded up both resources and high-yield because too-small allocations are pointless.

The thorniest issues were the structured products and liquid alternative allocations.

Liquid alternative ETFs – which basically attempt to wrap an investing strategy into a tradable fund – are not popular in the UK or Europe. Some recent launches here have already delisted.

In the end I arbitrarily plumped for a couple of fairly-applicable iShares ETFs.

The first is a global minimum volatility ETF. It doesn’t seem to have achieved very low-volatility to me. Still, unusual times. More problematic – given GMO’s expected returns – is its 60% US weighting.

I also added a momentum ETF. This, alas, is flat out US-focused. But it should at least have the advantage of being in what’s recently winning. (The downside will come in reversals of trend).

Both of these ETFs are very debatable. Another option would be a multi-factor ETF such as the JPMorgan Global Equity Multi-Factor ETF (JPLG). But it felt more useful to break things out.

Finally I added a chunk of the UK-listed macro hedge fund BH Macro Global. This investment trust has a record of diversifying portfolios, especially in recent years. However I dialed down the exposure to 10%. There’s a lot of idiosyncratic risk when you invest in a costly managed fund.

Could you hold your nose and these cheap assets?

Would I buy this portfolio today?

Well, no. For starters I have my own ongoing active investing adventures to get on with.

Creating it has been an interesting exercise though. It’s revealed to me how relatively expensive my own portfolio probably still is, even after it went through the wringer last year.

It’s also made me wonder whether I shouldn’t rejig things a bit to include some cheap value, and more emerging market assets.

Can you imagine owning such a wildly-off benchmark fund, with all the attendant emotional drama if and when things don’t go according to plan for a while? Let us know below!

But I don’t think anyone sensible would suggest even GMO’s ‘proper’ fund should be the only thing an investor should own. It’s diversified in that it owns a bunch of different and hopefully-cheap assets, but it’s not a proper diversified portfolio constructed to reduce risk.

Also remember GMO’s real-life strategy will be dynamically managed. If value got expensive, say, it would trade it for cheaper growth. The fund wouldn’t hold its allocations indefinitely.

That will make evaluating how my Frankenstein copy performs a rather quixotic endeavour.

Nevertheless, I think unless the market goes totally bananas (sorry, technical jargon) the allocations should be good for a year or so before rebalancing is required.

Perhaps we’ll check back in 2024 to see where we’re at – and what we’d change?

1. That is, inflation-adjusted. [↩]