All assets except for cash would fall in price if markets return to fair value, according to a new paper published by US-based fund manager, GMO.
In the ‘Derisking goes beyond interest rate risk’ report, author Catherine LeGraw suggests institutional investors have underestimated “valuation risk” in their portfolios.
“We believe that the biggest risk is valuation risk: the risk of loss that is realized when expensive assets revert to fair value,” the study says. “This risk is critically important today as we believe stocks and bonds are expensive globally.”
As at the end of December 2014, a market cap-weighted global equities portfolio – similar to the MSCI All Countries Index – would’ve dropped 32 per cent based on GMO’s fair value analysis, the paper says.
LeGraw says while institutional investors have focused on containing interest rate risk, many have put valuation risk in the too-hard basket.
“We agree that it is difficult to time the market,” she says in the report. “However, with the long investment horizon provided by retirement assets, a solid valuation framework, a willingness to reallocate assets, and patience, we believe that investors can use valuation to drive better investment outcomes.”
Legraw says investors need to manage valuation risk by implementing a dynamic asset allocation strategy.
“A valuation-based dynamic asset allocation strategy could help to reduce valuation risk and mitigate the impact of a mean reversion scenario… while maintaining the ability to generate a positive real return,” the GMO report says.
GMO was founded by high-profile US investor, Jeremy Grantham.
