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INVESTMENT MISTAKES TO AVOID QUARTERLY LETTER 4Q 2021 The 2022 Edition EXECUTIVE SUMMARY As we turn over the page to a new year, there Ben Inker | Co-head of Asset Allocation are plenty of decisions that investors will need to make. We all want to make the right None of us, regardless of our skill and experience in investing, can be spared the pain decisions, but perhaps even more important caused by making mistakes. While we can all certainly learn from our mistakes, we are is to avoid making the wrong ones. So, in this often still tempted to fall into the next trap, especially at times when markets seem destined quarterly, I’d like to talk about some wrong to climb far beyond what reason dictates. Many of these mistakes might be avoided decisions that investors and investment by exercising the discipline of simply pausing to consider the potential pitfalls of your committees will be tempted to make at this investment decision. With contributions from my own experience and those of my GMO time. In each case, there is both a specific colleagues, I present a handful of mistakes that the current investment environment seems mistake that we are seeing investors make currently and a more generalized type of to invite. While clearly not an exhaustive list, perhaps you will recognize yourself in one error that serves as an example of that and pause to consider how you might avoid a costly misstep. mistake. I’d argue that avoiding these specific mistakes now will spare investors Mistake 1: Piling into Growth and the U.S. and out of a lot of grief and learning to avoid these Chinese and Emerging Equities classes of mistakes will serve you very well Generalized Version: Riding Your Winners and Losing Faith in Your Losers in the long term.

In 2021 we saw a continuation of patterns long since established, with the U.S. equity market far outpacing the rest of the world and large cap growth again beating large cap value in the developed world.1 China’s clamping down on its tech giants – which had provided the U.S.’s strongest competition for growth investor enthusiasm – left plenty of investors feeling as if U.S. large growth was both the lowest risk and highest return version of equities. Not surprisingly, some are explicitly rethinking their commitment to emerging markets in light of recent Chinese policy shifts (which we think is a mistake) and more are simply failing to rebalance their portfolios out of their winners and into their losers.

The bias this creates is compounded by the fact that the growth exposure of many active managers has gradually crept up over the past few years as they chase performance as well.2 Rebalancing back to your previous regional targets must be the bare minimum move to make. The rising weight of the U.S. in global indices at a time when its valuation premium Things were notably different in small caps and emerging, is the highest in decades actually argues for more active reductions in U.S. exposure than however. In MSCI EAFE, small value beat small growth by simply keeping its weight in line with that of, for example, MSCI ACWI, which currently 3.3%; in MSCI Emerging, value beat growth by 12.4%; and in has weights of 61%/26%/13% in the U.S., EAFE, and emerging regions, respectively. Using the U.S., the Russell 2500 Value beat Russell 2500 Growth by a stunning 22.7%, albeit a piece of that was driven by our estimates of fair value, those weights would be 49%/33%/18%, which is the biggest strong returns in a handful of meme stocks that ceased difference between market-cap-weighted and fundamentals-weighted versions of this being "value" long before they exited the value indices. global benchmark since the height of the Japan bubble more than 30 years ago. Even passive portfolios effectively have more growth and Of course, to many investors, having an overweight to U.S. equities seems not merely more U.S. than they used to. The growing U.S. weight in global equity benchmarks is clear to see. The growth bias harmless but actually risk-reducing, given that the U.S. has performed better in most is a subtler issue, given that value and growth indices are downturns over the last 15 years. It is natural to feel that any market that has recently done based on halves of the market, and on those grounds, well is less risky and those that have done poorly are riskier, but this turns out not to be the growth is rebalanced down to 50% of the total whenever the index is rebalanced. But given the outperformance case, as we can see in Exhibit 1. of growth stocks in recent years, that just means that some former growth stocks are pushed into the value half despite retaining their basic "growthy" flavor.

Investment Mistakes to Avoid: The 2022 Edition | p2 EXHIBIT 1: 3-YEAR PERFORMANCE OF COUNTRIES RANKED BY TRAILING PERFORMANCE 1.5% Annualized 3-Year Subsequent 1.0% 0.5% 0.0% Performance vs. Average Country -0.5% -1.0% -1.5% Bottom Third Middle Third Highest Third “Whether we are looking at trailing 1- or 3-year Data is from 1970 to 2021 | Source: GMO, MSCI Trailing 1-Year Return Trailing 3-Year Return Data is across the U.S., U.K., Germany, France, Australia, Japan, Hong Kong, and Canada. performance, the former laggard countries wind Whether we are looking at trailing 1- or 3-year performance, the former laggard countries up being the winners, wind up being the winners, and the previous high-fliers underperform. The U.S. may feel and the previous high- like the safer bet given its strong performance, but history suggests otherwise.

fliers underperform. The tendency to ride winners and cut losers is also tempting within your active manager The U.S. may feel like roster. It is completely natural to feel more confident in your managers who have just had the safer bet given its a great few years and entertain doubts about those who lagged. In round numbers, no one ever fires a manager after strong performance, whereas lagging managers rightly live in strong performance, fear of the axe. I discussed the impact of this on investor portfolios a few years ago,3 here but history suggests illustrated in Exhibit 2, which shows the performance of managers who were fired by otherwise. institutional investors in the three years prior and subsequent to being fired.

EXHIBIT 2BE READY FOR PERIODS OF UNDERPERFORMANCE 3-Year Cumulative Excess Returns 4.2% -4.1% Pre-Firing Post-Firing Source: Amit Goyal and Sunil Wahal, "The Selection and Termination of Investment Management 3 Firms by Plan Sponsors," August 2008 Q4 2017 GMO Quarterly Letter, "Don’t Act Like Stalin!" Data reflect cumulative excess returns for investment managers terminated for performance-based reasons.

Investment Mistakes to Avoid: The 2022 Edition | p3 Teasing out the difference between skill, luck, and style for active managers is far more of an art than a science, but the instinct to ditch the managers who have recently disappointed “ has often proved painful.

And the most obvious driver of style-driven differences for managers in recent years has ...value is in the fifth been the question as to whether they lean more toward value or growth. I don’t want percentile relative to to spend too much time on this one given that every second piece I have written in the last couple of years has been about how attractively positioned value is, but it does bear history. If it were to go repeating that value is still very cheap relative to growth. Exhibit 3 shows the valuation of to its historic average value versus growth in the U.S. as of the end of 2021; value is in the fifth percentile relative valuation versus growth, to history. If it were to go to its historic average valuation versus growth, that would entail that would entail outperforming growth by approximately 68%.4 outperforming growth by approximately 68%.

EXHIBIT 3VALUATION OF U.S. GROWTH VS. U.S. VALUE Relative Valuation of Cheapest 50% of U.S.

1.4 1.3 1.2 December 2021 1.1 5th Percentile 1.0 0.9 Stock Market vs. Expensive Less Average 0.8 0.7 0.6 0.5 0.4 0.3 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017 2021 As of 12/31/2021 | Source: GMO Composite Valuation Measure is composed of price/sales, price/gross profit, price/book, and price/economic book. Value and growth groups are both sliced over 12 months.

Things generally only get very cheap by virtue of underperforming, though. And while value managers had a somewhat better year in 2021 than they have had in a while, their trailing performance tends to pale in comparison to growth-oriented managers. Not only does that mean those growth managers will take up a bigger portion of your portfolio if you haven’t rebalanced, but it also is a very natural instinct for your confidence in your managers’ skill to follow their relative performance, so you may be tempted to fire outright some value-oriented managers, thereby enhancing a growth bias in your portfolio. That looks like an even more dangerous mistake than such a move would normally be.

Mistake 2: Piling into Private Equity and Venture Capital Generalized Version: Trying to Copy the Portfolios of Recently Successful Institutions As I review this in mid-February, value has had quite a nice start to the year, having outperformed growth in the U.S.

Of course it makes sense to try to learn from successful investors, and a number of by 8-10% depending on the indices used. While the speed of the move has been shocking to some, the idea that such endowments have reported eye-popping returns from their private equity investments a move is overdone strikes me as silly. After all, 10% is an over the past year. But piling into the assets that made "the smart money" the most presents awful lot less than 68%, and the valuations of value stocks two kinds of problems. First, the institutions that did best after the fact are generally those are still very cheap versus history, if slightly less cheap than they were a few weeks ago. that had the largest allocations to the markets that happened to do best. As we saw in 5 analyzing Mistake 1, leaning into those historically strong-performing markets is likelier https://www.ai-cio.com/news/mit-brown-endowments- than not to be a mistake. But beyond that problem there is a deeper one. It is one thing to report-over-50-returns-for-2021/ see that MIT made 55% in fiscal 2021 and had 43% of its endowment in private equity.5 Investment Mistakes to Avoid: The 2022 Edition | p4 It is another to have the resources and access to be able to build a portfolio equivalent to MIT’s. Particularly in the case of private equity, many investors are focused on putting money to work to capture a presumed "illiquidity premium," whereas the more experienced players understand that strong returns are only likely to come from the best managers and that there is really no such thing as generic exposure to "private equity" in the first place.6 Beyond that, allocations to illiquid assets require changes to the way you manage the rest of your portfolio. An allocation that might seem perfectly manageable when markets are flying can turn into a millstone around your neck if markets should fall back to Earth while the required capital calls continue to come in.

Private equity can be reasonably thought of as a levered version of active equity management.

This is arguably less true in venture capital, where the companies involved are too immature to be listed in the equity market. But for "LBO-type" private equity, which is where the largest 6 amounts of capital are deployed, both the entry and exit points for most investments are the In most asset classes investors can now get cheap public equity markets. This doesn’t mean that private equity managers cannot deliver superior exposure via index funds of one kind or another. That is obviously impossible in the cases of private equity returns, but it does mean that they are not doing so by earning any so-called "illiquidity or venture capital, where all investment is active premium," since the illiquidity is self-imposed. Superior private equity managers do not earn management. Attempts to get broad exposure through an illiquidity premium, but rather generate alpha through exploiting inefficiencies in the fund of funds are actually more expensive than investing fund by fund, making such funds closer to the opposite of public financial markets.7 For the best managers, that alpha can more than cover their high an index fund, rather than the equivalent of one. Even if an fees as well as the substantial costs involved in this type of investing, but the fees and costs investor were dead set on investing across the manager do not drop meaningfully as one goes from the top quartile managers to the bottom quartile universe, many managers in the space have more demand managers.8 Those investing in this space, particularly at a time like today when valuations than capacity and turn down most prospective LPs, and the administrative and accounting costs of having a large are frothy and capital is abundant, need to be confident that they have both the skills to number of LP investments really does add up. find better managers and that those superior managers – who are having no trouble raising capital and largely get to choose their LPs – are interested in having them as clients. MIT Mostly, these will have to be in the equity markets, given that a large driver of returns is going to be from having has an experienced investment team with proven manager selection skills and a reputation acquired companies for less than their true value or selling that makes them a sought-after LP. For investors who cannot say both of those things, their them for more than their true value. It is also possible that portfolios would be well served by reflecting that difference. the oversight of public companies is lacking, and private equity managers can ensure the companies are simply managed better. Additionally, private equity managers Mistake 3: Assuming that Assets that Made it through the can also exploit inefficiencies in the debt markets, where lenders may not demand sufficient premia for taking on Pandemic Well Carry Low Fundamental Risk credit risk or may not be willing to exert their ability to take Generalized Version: Excessive Faith in the Results of the Last War control of troubled companies. I’m not arguing that any of these inefficiencies are implausible, just that none of them While I like to think that people have enough understanding of the unique nature of the represent an actual illiquidity premium. And certainly none Covid event not to assume it is the template for future market falls, I still hear people talk of them are likely to be helped by throwing ever-increasing sums of money into trying to exploit them. about growth stocks being inherently more protective in an economic downturn while 8 pointing to 2020 as evidence for this. Though that particular argument seems hard to take One of the interesting features of private markets is that too seriously, I have a lot of sympathy for investors who fall into this basic trap because it is there is surprisingly little agreement as to what the actual one I’ve fallen into myself. After our value-driven asset allocation process managed to avoid returns to the "asset class" have been. This haziness is further complicated by the fact that the IRRs quoted by losses in the internet bust and substantially cushion losses in the Global Financial Crisis,9 managers and investors are not equivalent to compound I fell into the trap of believing that cheaper assets would reliably prove less risky in market returns for traditional asset classes where investors can downturns. This certainly proved not to be the case in the pandemic, where cheaper assets control their cash flows in and out. But generally speaking, the median returns for private managers have not been not only fell more on the way down but also rose less fast in the recovery. But the basic issue particularly special over the last 10 to 20 years relative to is a broader one than what happened in a particular market downturn. There is no single public market equivalents, and anything below median has definition of "risk" that one can rely on to tell you how an asset will do in a bear market. An been pretty unimpressive.

asset might be reasonably resilient to losses driven by economic weakness but very vulnerable Our Global Asset Allocation Strategy rose in 2000, 2001, to losses from a liquidity shock. My team tends to look at risk on three basic axes – depression and 2002 by 7.4%, 3.7%, and 0.9%, respectively, despite a risk, inflation risk, and liquidity risk – and there are no assets proof against them all. But it is traditional 65/35 MSCI ACWI/Bloomberg U.S. Aggregate not merely the fact that bear markets can be driven by different underlying economic causes portfolio losing -5.5%, -7.8%, and -9.4%, respectively, in those three years. In the Global Financial Crisis that creates trouble for believing your portfolio is proof against them. The characteristics the strategy lost 27% against a 35% fall for the 65/35 of a particular asset will also change depending on factors such as its current pricing. As an benchmark.

Investment Mistakes to Avoid: The 2022 Edition | p5 example, U.S. Treasuries were wonderfully protective in the Covid bear market of February to March 2020. That’s not a particular shock given that high quality government bonds usually provide windfall gains in sharp downturns. But what is also notable is that other high quality government bonds that had been strongly protective in prior equity bear markets were nowhere near as helpful. Exhibit 4 shows the return of various G10 government bonds in the Covid bear market against starting short rates in each market.

particularly striking to me is that the average U.S. Treasuries were far and away the best performers in the period, but what seems bond return in markets particularly striking to me is that the average bond return in markets where the short where the short rate rate came into the period zero or below was actually negative. Government bonds have historically been good performers in bad economic times, but a crucial driver for those came into the period results has been the fact that central banks were able to reduce interest rates in the face of zero or below was the downturn. When the starting level of interest rates made that impossible (or at least actually negative. inadvisable) in much of Europe and Japan, the previously reliable defensiveness of those government bonds disappeared.

There is another argument I’m hearing today that makes a similar type of error, although it sounds a little different. This one is not so much about the performance of a particular asset or strategy as it is a point about the actual "riskiness" of risk assets. This premise argues that because central banks will ride to the rescue whenever financial markets are floundering, risk assets are not actually all that risky. However sharp the bear market, the likelihood of lasting losses is far lower than history would suggest, and long-term investors can afford to be more or less entirely invested in equities and other similarly risky assets. Conceptually this is exactly the kind of thinking that Hyman Minsky warned about – if this argument is believed it will encourage a build-up of risk that ensures that the argument will eventually fail, probably spectacularly so. But more specifically, it wouldn’t actually take everyone moving to 100% equities for this to prove disastrous Investment Mistakes to Avoid: The 2022 Edition | p6 thinking. All it takes is a situation where central banks have more pressing problems to worry about than what is going on in the stock market. Obviously, in a situation where inflation is stubbornly high, central banks may not be able to ease conditions even if financial markets fall. But even in the absence of an inflation problem, central bankers can only afford to ride to the rescue of financial markets when conditions in the real economy are at least as weak as they are in the financial economy. In the long bull run of the last 40 years that has almost always been the case. In a situation where the real “ economy is in good shape despite financial markets having troubles, the central bank might well have to leave the financial markets to their own devices and losses could take a ...after yet another year very long time to reverse themselves.10 of strong returns from traditional portfolios, Mistake 4: Using an Unrealistically High Expected Return investors really need to for Your Portfolio Generalized Version: Failing to Understand the Implications of the Historical Sources of Asset Returns look at their long-term This is a warning I have been giving for years now, and it’s one of those situations where the assumptions with an eye fact that I have been wrong in the shorter term makes me all the more likely to be correct to reducing them. in the long term, even if my ability to convince people has almost certainly deteriorated. But after yet another year of strong returns from traditional portfolios, investors really need to look at their long-term assumptions with an eye to reducing them. Actually, whether 2021 was a better than average or worse than average year depends on how you measure it. A 60/40 MSCI ACWI/Bloomberg Aggregate portfolio earned a return of about 10.2%. That is well above the 7.5% average over the last 20 years, but it was only 3.2% after inflation, and that is lower than the longer-term average. But 2019 and 2020 were very strong for the traditional portfolio as well and the three-year annualized return for 60/40 has been 14.3% annualized, or close to 11% real. Such strong returns make it tempting to assume that future returns to the portfolio must be higher than earlier assumptions.

But the primary driver of those strong returns has been rising valuations. On forecast P/Es, ACWI is about 45% more expensive than it was at the end of 2018,11 and the yield on the U.S. 10-year is 43% lower. It does not require any belief in reversion to the mean to understand that those higher valuations imply lower long-term returns. While it may be tempting to want to ignore the warnings of anyone who has been arguing in this direction for a while (i.e., me), the fact that valuations have continued to rise and returns therefore continued to be strong does not change the fact that all else equal, rising valuations necessarily imply falling future expected returns.

10 The math of bonds is simple enough that few actually believe returns will be anything like For anyone who has a hard time imagining how the real historical levels from here, but there seems to be lots of fantastical thinking with regard economy might do better than the financial markets, to more complex assets such as equities. But history is clear. There is no reason to believe consider a situation in which household balance sheets are strong and companies are scrambling to find workers, but the long-term return to equities will be any higher than the normalized earnings yield of rising wages are starting to either hit inflation or corporate equities. Exhibit 5 shows this in the case of the S&P 500. profit margins – i.e., the world in 2022.

Generally, I hate using forecast P/Es for measuring stock markets. Earnings forecasts are notoriously inaccurate and generally upwardly biased. But if I had used trailing P/Es some readers would have complained about Covid distortions and if I had used cyclically adjusted earnings various readers would have made a variety of different, probably conflicting complaints about why doing so was wrong. In this case, all three metrics led to very similar results, so I went with the one that seemed least likely to offend the sensibilities of readers.

Investment Mistakes to Avoid: The 2022 Edition | p7 EXHIBIT 5: FUNDAMENTAL RETURN TO S&P 500 AGAINST EARNINGS YIELD PROXY 100,000 10,000 1,000 1880 1895 1910 1924 1939 1953 1968 1983 1997 2012 “ Return of S&P 500 Fundmental Return of S&P 500 Normalized Earnings Yield Idealized Return ...even assuming As of 12/31/2021 | Source: Robert Shiller, GMO that today’s P/Es are sustainable, rising valuations cannot be a The gray line on the chart shows the return investors would have achieved had the real return to the S&P 500 each year been its Shiller earnings yield. The blue line shows the sustainable source of actual real return of the S&P 500, and the green line shows the "fundamental return" of the returns. S&P 500 – the return that came from dividends and real earnings growth. Neither the green nor the blue line have kept up with the gray, and this is true across almost every equity index we have decent data for. Therefore, taking the normalized earnings yield as an upper limit for sustainable equity returns is probably the fairest assumption.12 Investors in the S&P 500 have benefitted historically from rising valuations – the stock market trades at a much higher P/E today than it did a century ago, or even a decade ago. But even assuming that today’s P/Es are sustainable, rising valuations cannot be a sustainable source of returns. The sustainable source of returns is the income and earnings growth that investors receive, and those sources will deliver less when prices are high relative to earnings. That is a particularly sobering fact to realize today, as the normalized For this purpose, the traditional "Shiller P/E" should suffice earnings yields are near their lows – 2.5% for the S&P, about 4% for the international for calculating a normalized earnings yield. While the developed markets, and a more encouraging 5.8% for emerging markets. Given current critique that it is impacted by changing payout policies is regional weights in global stock market indices, that makes for a disquieting 3.3% weighted a fair one, switching to a "total return Shiller P/E" actually lowers earnings yields, which then have to be adjusted average. If we generously considered the equivalent expected real return to be 0% real upwards to arrive at a figure equivalent to the traditional for bonds,13 the expectation for a 60/40 portfolio comes out at a disheartening 2%, which version. The differences are, in any case, pretty small in only rises to 2.5% for a more aggressive 75/25 equity/bond split. Even if you wanted to earnings yield terms, and across most markets, including assume that today’s record profits across most of the world are "normal" and earnings yields the S&P 500, sustainable returns have been meaningfully lower than the Shiller earnings yield, which allows for correspondingly higher than the normalized versions, those sustainable real returns would some wiggle room before there is a need to make any only increase to 2.6% for 60/40 and 3.2% for a 75/25 split. All of that is a far cry from the upward adjustments.

5% real return assumption most investors use as a rule of thumb and are counting on in Given that real yields on government bonds are universally their investment and spending decisions. We believe this dismal situation can be improved substantially negative as of year-end 2021, 0% real is an by biasing your equity book away from the U.S. and your non-equity book toward liquid almost manically optimistic assumption. alternatives rather than long-term bonds, but making a big difference in expected returns It may seem counterintuitive to say that a bear market requires a willingness to look very different than the traditional portfolio, and that is very will improve expected returns for a period that includes hard for most investors. Achieving 5% real or even close to that in the coming 10 to 20 years the bear market, but over longer periods the superior is going to require either a large dose of alpha or a severe bear market in the near future compounding effect of lower valuations trumps the losses that allows for much lower average valuations for stocks and bonds over the long run.14 that got you to those lower valuations. That only works if the bear market comes quickly so that the average valuation over the period can be as low as possible despite the high initial valuation.

Investment Mistakes to Avoid: The 2022 Edition | p8 Ben Inker Conclusion Mr. Inker is co-head of This is by no means an exhaustive list of the mistakes investors will be tempted to make this GMO’s Asset Allocation year. When I sent out a request to colleagues at GMO for suggestions of mistakes they saw team and a member investors making or contemplating, I got a list far too long to do justice to in a single letter. of the GMO Board of Some of them were inspired by moves that GMOers had seen investors make recently, but Directors. He joined GMO in 1992 following the completion of his B.A. in some seemed to be inspired by mistakes that they themselves have made over the years. Economics from Yale University. In his years None of us are immune to making investment mistakes, and investing does seem to be an at GMO, Mr. Inker has served as an analyst for area where there are lessons that usually cannot be taught, only painfully learned on one’s the Quantitative Equity and Asset Allocation own. I don’t imagine that this piece will change that basic truth, but as you find yourself teams, as a portfolio manager of several making decisions about your portfolio to position for 2022 and beyond, at least spend a equity and asset allocation portfolios, as moment to ask yourself whether you are falling into one of these classes of investment co-head of International Quantitative Equities, mistakes. No matter how fast markets are moving, taking a little time before pulling the and as CIO of Quantitative Developed trigger on a decision to try to ensure it is a well-reasoned one is unlikely to be a mistake. Equities. He is a CFA charterholder.

Disclaimer The views expressed are the views of Ben Inker through the period ending February 2022, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

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