Lost Decade Protection

GMO put out a paper in support of its GMO Benchmark Free Allocation Fund which has $3 billion in AUM. The fund has many symbols but I'll use GBMBX because it has a good long period to study. The premise of the paper is to isolate the periods where the basic 60/40 portfolio has had lost decades and they think we are in for another lost decade.

The paper defines 60/40 as 60% All Country World Index/40% Aggregate Bond Index. Here's the fund's asset allocation.

I took a stab at replicating it with the following.

I used client/personal holding BTAL for equity dislocation because the way the paper defined that exposure seems to be very close to what BTAL does; "100% deep value and 100% short extreme growth stocks." BTAL is long low volatility and short high volatility. The replication comes very close for as far back as GBMBX goes.

I would note that the replication has had a smoother ride and consistently smaller drawdowns but again, I think they are very close. The following chart they included led me to think they are positioning the fund as a core holding.

For the almost 13 years we can backtest the fund, the result from testfol.io doesn't corroborate the result they posted. FWIW, Portfoliovisualizer's result only going back ten years looks very similar to what we got with testfol.io. This next chart though seems to position GBMBX as an alt.

I couldn't find where this was quantified anywhere. I think that the blueish part of the charts are equities, the sort of brown part is fixed income and the purple is GBMBX but the first circle looks like hedge funds, which we can replicate, plus GBMBX. If you can sort this part out with better clarity please leave a comment. 

I'm not sure I got the above allocations correct for Portfolios 2, 3 and 4 but that's how I see them. Portfolios 2 and 4 don't have a ton of differentiation from 60/40. Portfolio 3 has a smoother ride than the others and the Sharpe Ratio suggests the compensation of the smoother ride is adequate in relation to the lower growth rate but I am less convinced. 

We've got two different lengths of time studied due to using MBXIX as a hedge fund proxy. The CAGR for GBMBX ranges from 4.77% to 5.45% and the standard deviations clock in at 6.57% and 6.63% respectively. 

This last study gets to the point I wanted to make in terms of seeking out a simpler solution. Using ACWI keeps the equity exposure and benchmarking apples to apples. Managed futures has its struggles at times and does fantastically well other times and cat bonds are one of quite a few AGG substitutes we study here and that I use for clients.

GBMBX is not trying to keep up with domestic equities. It is trying to differentiate from or help diversify a 60/40 portfolio that uses global equities. In that light, it will not keep up with domestic equities when domestic equities are doing well and they hope that GBMBX will outperform domestic equities, and their version of 60/40, when things go poorly. If things go well as they do most of the time then GBMBX might function as a diversifier but that's probably all. If there is another lost decade then GBMBX will hopefully do well.

I am intrigued by the concept of Benchmark Free and the willingness to look different, differentiation is crucial to long term investment success. I think there's something to take away in terms of process on the point of differentiation and GMO's willingness to use alts but I think a better result can be had doing it ourselves. 

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