GMO monthly issues their "7‐Year Asset Class Real Return Forecasts" for 10 - and, beginning this month, 11 - asset classes. Their method is fairly simple: assume that things - P/E ratio, profit margin, sales growth and dividend yield - will revert to "normal" over the next
5-7 years and sketch the line from here to there. The "real" part is that you deduct the effect of inflation from the resulting "nominal" returns.
Several scholars have examined their predictive validity and found it to be pretty robust. One, examining projections from 2000-2010 then comparing them with Vanguard index funds concluded:
The correlation between the GMO predicted returns and the Vanguard realized returns for equities, bonds, and all assets taken together are 0.954, 0.959 and 0.677 respectively. (Tower, 2010)
Others found that even when the absolute values are off (i.e., GMO was too pessimistic during the frothier parts of bull markets), the relative values are right: GMO's top-ranked asset class tends to outperform its second-ranked class, and so on. Ben Inker, their chief strategist, claimed a 94.
5% accuracy (2012).
As recently as September, the real return projections were
negative for every asset class except cash. They were
least negative about the emerging markets. The newest projection released today begins to factor-in the effect of the recent market turbulence.
Bad news: cash remains the most promising US asset class, with US equities in the red over the next
5-7 years and US fixed income breaking even.
Good news: there is one asset class now poised for historically exceptional returns,
emerging market value equity. GMO projects a 7.7% annualized real return for EM value, well above the historic 6.
5% real return in the US stock market. Emerging equity, as a whole, is the second-highest asset class (4.4% real) and emerging debt (2.8%) is third. The one caveat: these asset class return projections are not risk-adjusted; that is, there's no suggestion about how much volatility you'll need to accept in return for your hoped-for 7.7% real.
Traditionally value investing in the emerging markets has been painful and, mostly, unprofitable. Managers at Seafarer and elsewhere argue that structural changes in the emerging markets - largely marked by local investor activism - has fundamentally changed that equation and that long-ignored value plays offer ... well, exceptional value. As a result, there are relatively few EM value funds though their ranks are growing.
Based on YTD performance (as of 11/21/18), here are the top 10 EM value funds available to domestic investors:
- BlackRock EM Equity Strategy
- American Beacon Acadian EM Managed Volatility
- ICON EM
- T. Rowe Price EM Value
- Schwab Fundamental EM Large Company Index Fund
- Pzena EM Value
- Dreyfus Strategic Beta EM Equity
- State Street Disciplined EM
- SA EM Value
- Seafarer Overseas Value
Pzena, T Rowe and Dreyfus sport five-star ratings from Morningstar. Dreyfus and T Rowe have also earned Great Owl designations from MFO for their consistently top-tier risk-adjusted returns. State Street and SA (for Strategic Advisers, a set of funds offered to certain Fidelity clients) trail with two-star ratings. BlackRock and Seafarer are relatively new funds.
On the your choices in the upcoming December issue of Mutual Fund Observer.
Take care,
David
