质量异象执行摘要

THE QUALITY ANOMALY QUARTERLY LETTER The Weirdest Market Inefficiency in the World 4Q 2023 Ben Inker | Asset Allocation EXECUTIVE SUMMARY As GMO launches its first ETF, GMO U.S. Quality (NYSE: QLTY),1 it seemed like a good time to share my thoughts on the market inefficiency that the strategy seeks to exploit ­– the quality anomaly. The basic goals of any active investor are to achieve higher returns and/or lower risk than a passive portfolio. These goals are, or at least should be, in conflict with each other. If financial markets were efficient, it would be impossible to sustainably achieve higher returns without taking on additional risk. And any portfolio that embodied lower risk would pay for it with lower long-term returns. At the highest level, markets basically work this way. Government bonds and cash are lower risk than high yield bonds and equities and have delivered lower returns across almost all markets and most time periods. But within risk assets, things get weird. Within both stocks and high yield bonds, you have historically been able to achieve both higher returns and lower risk by owning the highest quality “ securities in those universes. This quality anomaly has been around for a long time and exists within multiple subsets of the equity universe. And for what it is worth, their opposite numbers have also been mispriced – low-quality stocks and CCC (and below) bonds have underperformed their broad If you were going to have universes despite their obviously greater downside in bad economic times. In an investing world one permanent bias in where most trade-offs are difficult, this one is pretty easy. If you were going to have one permanent your equity and high bias in your equity and high yield bond portfolios, it should be in favor of high quality.

yield bond portfolios, it should be in favor of The mispricing of quality high quality. You may recall our spring edition of the Quarterly Letter, in which Tom Hancock and Lucas White wrote at some length about the quality anomaly in the stock market.2 My goal in this piece is to expand on their work and show that the quality anomaly exists within multiple areas of the stock market and in the high yield market as well. But to start, it is worth a brief recap of some of my colleagues’ data. Exhibit 1, taken from their piece, shows the pattern of return and volatility for the highest and lowest quality quartiles of the MSCI ACWI stock index.

EXHIBIT 1HIGH AND LOW QUALITY STOCK PERFORMANCE 12% 11% High Quality Annualized Return 10% 9% 8% 7% Low Quality 6% 5% 10% 12% 14% 16% 18% 20% Annualized Volatility For more information on our launch of QLTY, read our As of 12/31/2022 | Source: MSCI, GMO press release.

The high-quality and low-quality portfolios are based off the MSCI ACWI Index returns. GMO uses a See The Quality Spectrum: Stability in an Unstable World proprietary quality model and defines high-quality companies as those with high profitability, low profit (May 2023). volatility and minimal use of leverage. Low-quality companies are the inverse. High-quality and low-quality groups are based off quartiles within the MSCI ACWI Index.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p2 The fact that high-quality stocks have had lower volatility than low-quality ones should not come as a surprise to anyone. But their relative performance is another matter. In an efficient market, those risky low-quality stocks should offer a higher return to compensate for their higher risk, and owners of high-quality stocks should pay for their lower risk in the form of a lower long-term return. The fact that the highest quality quartile of the market has outperformed the lowest quality quartile by 4% per year is utterly counterintuitive, astonishing, and demands to be incorporated when building sensible equity portfolios.

“ You might be tempted to think that this is some historical exception that is unlikely to repeat. But if we look at the performance of high- and low-quality bonds within the high yield universe, we see a strikingly similar pattern.

BB bonds have had excess performance over comparable Treasuries EXHIBIT 2: BB AND CCC BOND PERFORMANCE that is almost 2% per 3.5% Excess Return vs. Equivalent year better than their 3.0% BB Bonds CCC brethren and have 2.5% done so with half the 2.0% Treasury Bond volatility. 1.5% 1.0% CCC Bonds 0.5% 0.0% 0% 2% 4% 6% 8% 10% 12% 14% 16% Annualized Volatility of Excess Return Data from 1988-2023 | Source: Bloomberg, Barclays Point, GMO BB bonds and CCC bonds are the Bloomberg BB U.S. Corporate Bond Index and the Bloomberg CCC U.S.

The chart would actually look similar if I plotted raw Corporate Bond Index, respectively. BB and CCC bond excess returns calculated by subtracting the returns returns of the two groups, but the comparison wouldn’t be of equivalent duration Treasuries. fair as it mixes two sources of return and risk (duration and credit exposure) with very different characteristics.

4 Since CCC bonds tend to have shorter maturities than BBs, we need to make a duration adjustment There is a little hand-waviness to this, I’ll admit, but not a to properly compare them, but the pattern is every bit as striking as it is in equities.3 BB bonds have lot. Default is not the only bad thing that can happen to a bond. It can also be downgraded. While about 1% of BBs had excess performance over comparable Treasuries that is almost 2% per year better than their default in a given year, perhaps 8.5% will get downgraded, CCC brethren and have done so with half the volatility. and those downgraded bonds invariably fall in price when the downgrade occurs. CCCs have the consoling feature It is worth recognizing that this is an insane result. It’s not just that CCC bonds are more volatile that in the absence of actually defaulting, rating agencies generally don’t bother with CC or C ratings and even when than BBs, they are hugely more economically sensitive. On average, about 1% of the BB universe those ratings are used, there isn’t that much price action defaults in a given year, and that might rise to 2-3% in a recession. CCCs, on the other hand, see on average since CCCs are already very low-quality bonds.

Upgrades happen as well, of course, with 7-8% of high defaults of over 10% in an average year, and that default rate can rise into the 30% range and yield bonds getting upgraded in a given year. CCCs have beyond in a tough default cycle.4 For that kind of downside in bad economic times, CCCs really the advantage that they basically only get upgrades, not downgrades. BBs, though, have a nice feature of their own. do need to deliver higher long-term returns for them to be an appealing investment – but they are If a BB bond gets upgraded, it graduates out of the high seldom priced to do so. yield universe and becomes ownable by a new group of investors that cannot own lower rated bonds. That gives Given this, the immediate question is why anyone would not bias their equity and high yield debt an extra boost to those upgraded bonds (i.e., “rising stars”) that no other rating cohort enjoys. portfolios toward high quality? At GMO, we do exactly that. The GMO Quality Fund, for example, 5 only owns stocks in the top tier of quality across the global equity universe. As a result, we strongly There is no guarantee that that smaller fundamental impairment will lead to better market performance in an believe that the Quality Fund should suffer less fundamental impairment in the event of a severe economic downturn. If the high-quality stocks are trading economic downturn than would be the case for the market as a whole.5 While in a rational world at too large a premium to the rest of the market, their such a feature would also suggest that the portfolio should struggle to keep up with the broad relatively small fundamental impairment still might be a bigger disappointment to investors than the larger hit the market in the long term, neither our 20 years managing the Quality Fund nor the longer history of rest of the market will take. Not even high-quality stocks high-quality stocks in our databases nor the current valuations of the quality group or their portfolio are protected against material overvaluation. suggests that the market is anything close to rational on this front.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p3 Quality within more cyclical groups But it’s not only in the very highest quality tier of stocks that quality is an advantage. You could make a reasonable argument that the places where higher quality is most essential are within the more cyclical areas of the market.6 The greater financial strength of the higher quality companies in these sectors allows them to take advantage of opportunities that arise in bad economic times when their competitors are more concerned with mere survival. Exhibit 3 shows the performance of high- and low-quality stocks within the global cyclical universe.

EXHIBIT 3HIGH AND LOW QUALITY WITHIN GLOBAL CYCLICALS 10% High Quality Cyclicals 8% Annualized Return 6% Low Quality Cyclicals 4% 2% “ 0% 0.10 0.12 0.14 0.16 0.18 0.20 0.22 Annualized Volatility ...the advantages of relatively high quality Data from 1995-2023 | Source: MSCI, GMO exist within pretty much GMO uses a proprietary quality model and defines high-quality companies as those with high profitability, low profit volatility and minimal use of leverage. Low-quality companies are the inverse. every group of stocks one High quality and low quality are the top 25% and bottom 25% of MSCI ACWI. Global cyclicals are can contemplate. defined as the GICS Energy, Materials, Industrials, Consumer Discretionary, Financials and Real Estate sectors of MSCI ACWI.

If you are looking for the stocks with the very lowest vulnerability in bad economic times, we believe limiting your focus to the very highest quality stocks is the path to go down. But the advantages of relatively high quality exist within pretty much every group of stocks one can contemplate. This is particularly notable in one notoriously low-quality area of the market, U.S. small cap stocks.7 As we pointed out in GMO’s last quarterly letter,8 the rise in interest rates and changes in U.S. tax policy have created a particular issue for highly levered U.S. companies, and U.S. small caps have substantially increased their leverage since the Global Financial Crisis.

GMO’s Quality Cyclicals Fund, launched in 2020, was designed to exploit this advantage. While current profitability for the average U.S. small cap company is very good relative to their 7 history, the group is highly cyclical and their profits generally dry up quickly in an economic It’s a less acute problem in the rest of the developed world, generally speaking. While interest rates have gone downturn. Exhibit 4 shows the profitability of U.S. small caps over time. up significantly everywhere apart from Japan, no other country has enacted the tax changes the U.S. did, and in most of the world small caps are less levered than they are in the U.S. Japan is a double outlier on this, since not only have interest rates not gone up much in Japan, but Japanese corporates have continued to de-lever over the past decade, such that the average listed Japanese non-financial has almost no net debt. UK small caps are the most similar to the U.S., as they too have levered themselves up substantially in the past 20 years and interest rates have gone up sharply there as well.

See Beyond the Landing: The Macro Risks Still on the Runway (September 2023).

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p4 EXHIBIT 4: RETURN ON CAPITAL OF U.S. SMALL CAP STOCKS 14% 12% 10% 8% 6% 4% 2% 0% 1983 1987 1991 1995 1999 2003 2007 2011 2015 2019 2023 Data as of 10/2023 | Source: Worldscope, Compustat, GMO U.S. small caps are the smallest 33% of U.S. publicly traded companies by market capitalization.

Were small caps to see a similar fall in profitability as they have seen on average across recessions, the ability of a typical small cap company to cover its interest payments would become quite challenged. Biasing a U.S. small cap portfolio toward higher quality issuers makes a lot of sense from a risk standpoint, as long as it doesn’t interfere too much with the expected returns. As Exhibit 5 shows, the historical data makes a quality bias within U.S. small cap stocks look like a complete no-brainer.9 EXHIBIT 5: HIGH AND LOW QUALITY WITHIN U.S. SMALL CAPS 14% High Quality Small Caps 13% Annualized Return 12% 11% “ 10% 9% Low Quality Small Caps 8% In our asset allocation 7% portfolios today, our 6% 10% 12% 14% 16% 18% 20% 22% 24% biggest equity bet is deep Annualized Volatility value ­– the cheapest 20% Data from 1983-2023 | Source: Worldscope, Compustat, GMO of stock markets. U.S. small caps are the smallest 33% of U.S. publicly traded companies by market capitalization. GMO uses a proprietary quality model and defines high-quality companies as those with high profitability, low profit volatility and minimal use of leverage. Low-quality companies are the inverse. High quality and low quality are the top 25% and bottom 25% of stocks within the small cap universe, respectively.

Quality and value In our asset allocation portfolios today, our biggest equity bet is deep value ­– the cheapest 20% of stock markets. As I wrote in June, value stocks generally do fine in recessions,10 but that hasn’t stopped us from wanting to ensure our deep value portfolios are fundamentally well positioned should an economic downturn come. The trade-offs here are a little more complicated, however. If the reason we favor deep value today is because it is so cheap relative to its history, we need to be 9 careful that in biasing the portfolio toward higher quality value stocks we aren’t systematically buying GMO launched the Small Cap Quality Fund in 2022. into a portfolio that is less attractively priced. The general pattern of high and low quality within value See Value Does Just Fine in Recessions (June 2023). stocks looks pretty much the same as it does for all the other groups, as shown in Exhibit 6.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p5 EXHIBIT 6: HIGH AND LOW QUALITY WITHIN U.S. VALUE STOCKS 16% High Quality Value 15% Annualized Return 14% 13% 12% 11% Low Quality Value 10% 9% 8% 10% 12% 14% 16% 18% 20% 22% Annualized Volatility Data from 1983-2023 | Source: Worldscope, Compustat, GMO U.S. value stocks are the cheapest half of the largest 1,000 U.S. companies on a composite valuation model. GMO uses a proprietary quality model and defines high-quality companies as those with high profitability, low profit volatility and minimal use of leverage. Low-quality companies are the inverse. High quality and low quality are the top 25% and bottom 25% of stocks within the value universe, respectively.

It could still be the case that today, tilting a value portfolio toward higher quality stocks makes it materially less cheap relative to the market. Happily, that isn’t the case. Exhibit 7 shows the valuation relative to normal for two versions of U.S. deep value. The first is the traditional cheap price/book portfolio popularized by Fama and French.11 The second is the version of value that we use in GMO’s U.S. and International Opportunistic Value Funds, where we are both adjusting company income statements and balance sheets for distortions and giving credit to higher quality companies for their higher expected long-term return on capital.

EXHIBIT 7RELATIVE VALUATIONS OF CHEAPEST 20% OF U.S. LARGE CAP STOCKS WITH AND WITHOUT QUALITY ADJUSTMENT 1.30 GMO Quality-Adjusted 1.20 Valuation Model 1.10 1.00 0.90 Price/Book 0.80 0.70 0.60 1983 1988 1993 1998 2003 2008 2013 2018 2023 Data as of 10/2023 | Source: Worldscope, Compustat, GMO Eugene Fama and Kenneth French's 3-factor model was Price/book is the cheapest 20% of the largest 1,000 U.S. stocks by market capitalization. Quality-developed in 1992 to describe stock returns as a function adjusted value is a blend of value models used by the GMO Opportunistic Value portfolios that of market excess return, the outperformance of small vs. adjusts value metrics according to the quality of companies derived from GMO’s proprietary quality large companies, and the outperformance of high book/ market vs. low book/market companies. model. Both groups are measured on a blend of valuation models and adjusted for their average valuation over time.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p6 Both deep value groups look very cheap versus history. While it could have been the case you needed to buy low-quality value to find a group trading much cheaper than average, that is not at all “ what we find. Our quality-adjusted valuation model is as cheap versus its history as price/book is, and its average company quality is much higher, as shown in Exhibit 8. Investing isn’t supposed to When you can get be easy, but even within deep value the calculus seems awfully straightforward. When you can get higher quality without higher quality without having to pay more, why on earth wouldn’t you?

having to pay more, why on earth wouldn’t you? EXHIBIT 8: QUALITY RANKING VS. MARKET FOR DEEP VALUE GROUPS 2.0 Average Quality Decile Ranking of Quality Adjusted Value 1.0 0.0 -1.0 Deep Value Portfolios vs. Market -2.0 -3.0 Price/Book -4.0 1983 1988 1993 1998 2003 2008 2013 2018 2023 Data from 1/1983 to 9/2023 | Source GMO Price/book is the cheapest 20% of the largest 1,000 U.S. stocks by market capitalization. Quality-adjusted value is a blend of value models used by the GMO Opportunistic Value portfolios that adjusts value metrics according to the quality of companies derived from GMO’s proprietary quality model. Both groups are being measured on their average quality relative to the overall market on a measure where the lowest quality company would get a -5.5 and the highest quality company would get a +5.5.

Quality within high yield The trade-offs in the high yield universe are a little more complicated, even if the basic performance pattern is the same. BB bonds are unquestionably a hugely better risk/reward trade off than lower rated high yield most of the time. On the other hand, they have a lot less beta12 to high yield than lower rated bonds do. The high/low-quality axis in stocks also has something of a beta impact, but high-quality stocks have a wonderfully asymmetrical upside/downside beta to the stock market, whereas low-quality stocks look positively toxic, as we can see in Exhibit 9. High-quality stocks have a slightly low beta in up months for the stock market, at 0.91. But in the down markets, that beta falls to 0.71. Meanwhile low-quality stocks only have a mildly higher-than-normal beta in up months for the stock market at 1.06, but it moves substantially higher exactly when you don’t want it to, rising to 1.23 in down months.

Beta is a measure of a portfolio's sensitivity to the market.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p7 EXHIBIT 9: UPSIDE AND DOWNSIDE BETAS FOR HIGH AND LOW QUALITY STOCKS 1.5 1.23 Beta in Up/Down Months 1.06 1.0 0.91 0.71 for Market 0.5 0.0 Upside Beta Downside Beta High Quality Low Quality “ Data from 1988-2022 | Source S&P, MSCI, GMO GMO uses a proprietary quality model and defines high-quality companies as those with high profitability, ...high-quality stocks low profit volatility and minimal use of leverage. Low-quality companies are the inverse. Upside beta and downside beta are beta to the MSCI ACWI Index during up months and down months, respectively. outperform low-quality stocks in down In May, Tom and Lucas posited that the mild underperformance by high-quality stocks in up months by over three markets might help explain the quality anomaly, since investors are particularly obsessed with times the amount they keeping up with the market in good times. They might be right, but the beta difference of high and low quality in good times is actually pretty small, at 0.15. In down markets, the difference explodes underperform in up to 0.52. That means high-quality stocks outperform low-quality stocks in down months by over months! three times the amount they underperform in up months!13 It’s an astonishingly favorable trade-off that I can’t imagine any investor would want to pass up.

In high yield, the betas are much more symmetrical, as shown in Exhibit 10.

EXHIBIT 10: UPSIDE AND DOWNSIDE BETAS FOR BB AND CCC BONDS 1.5 1.36 1.41 Beta in Up/Down Months for 1.0 0.78 0.82 High Yield vs. Treasuries 0.5 0.0 Upside Beta Downside Beta BB CCC 13 Data 1988-2023 | Source: Bloomberg, Barclays Point, GMO To be clear, I’m talking about returns relative to the market.

High-quality stocks underperform the market by about Upside beta and downside beta are beta to the Markit iBoxx USD Liquid High Yield Corporate Index 0.3% in the average up month for the market and low during up months and down months, respectively. BB bonds and CCC bonds are the Bloomberg BB quality outperforms by about 0.2%. In down months, high quality outperforms the market by 1% on average and U.S. Corporate Bond Index and the Bloomberg CCC U.S. Corporate Bond Index, respectively. low quality underperforms by 0.8%. That’s an aggregate difference of 0.5% in favor of low quality in up months and 1.8% in favor of high quality in down months.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p8 BB bonds are extremely helpful in the down months for high yield bonds with a downside beta of only 0.82 versus a scary 1.41 for CCC bonds. But their underperformance in the up months is every “ bit as striking, with an upside beta of 0.78 versus 1.36 for CCC. This creates a trickier problem for high yield bond managers than the one equity managers face. BBs are a hugely better risk/reward trade-off than CCCs, but they also don’t act all that much like high yield. In terms of the underlying When Jeremy Grantham fundamentals of the companies issuing the debt, BBs are a lot more like investment grade bonds and Dick Mayo were than they are like CCCs. That is probably even more true today than it used to be given how picking stocks back in concentrated the investment grade corporate bond market has become in BBB-rated bonds, which the early 1970s, they now make up approximately half of the U.S. investment grade corporate bond universe against less than 10% in AAA or AA bonds.14 gave extra credit to high-quality companies This can put high yield bond managers in a bit of a bind if they want to deliver good long-term returns and build a portfolio that acts like a high yield portfolio. This was exactly the problem we because they already asked GMO’s fixed income team to solve when we asked them to build a liquid high yield bond knew that high-quality strategy in 2018. Their resulting portfolio spends the majority of its time with a higher average companies tended to do rating than the index, but if spreads on low-quality bonds are particularly attractive, it stands better than they were ready to shift that stance toward lower rated bonds. The strategy has made that shift on several occasions over the five years the team has been running it. As a result, we have been able to given credit for. combine a beta of approximately 1.0 to high yield with decent alpha and good risk mitigation.15 Today, with credit spreads surprisingly tight despite meaningful economic risks and CCC bonds trading substantially inside their fair value spread on our data, we have a pronounced high-quality bias within the High Yield Strategy, and given the risks we pointed out in U.S. corporates in our last 14 quarterly letter, we think such a bias makes a lot of sense for any investor who is not supremely As of August 2023, BBB bonds made up about 48% of the confident in their idiosyncratic abilities to analyze risky bonds.16 Markit iBoxx USD Liquid Investment Grade Index. AAA bonds were 1% and AA bonds were just over 7%.

15 Conclusion Specifically, as of November 2023, the High Yield Fund This is the part of the essay where I’d normally try to summarize my views on why the anomaly in has delivered an average annual outperformance versus the Markit iBOXX USD Liquid High Yield Index of 1.15% question exists. But in this case, I have trouble coming up with anything at all plausible that doesn’t net of fees since inception, with a beta of 0.96 and come down to “investors are weirdly stupid.” Financial markets are not supposed to work backward, outperformance in each of the meaningful drawdowns in the asset class since inception—there have been three and when one is looking at asset classes, they generally don’t. Government bonds reliably have drawdowns of more 3% since 2018 and we outperformed lower long-term returns than risky credit and stocks, and this makes perfect sense given how much on average by 1.15% (net) across them. better government bonds do in bad economic times. But within equities and high yield, things really Personally, I can’t help but think that such confidence seem to have worked exactly backward, and they have done so for a very long time. You have been on the part of high yield managers is at least partially able to get higher returns and lower risk by buying high-quality stocks and BB bonds, and the lower responsible for the quality anomaly in high yield bonds in the first place. Most high yield portfolio managers think quality stocks and CCC bonds have been a long-term disaster for investors. This is not merely an they (or the analysts working for them) are superior credit ex post observation. When Jeremy Grantham and Dick Mayo were picking stocks back in the early analysts. It would be a very strange career choice to have made if they did not think they were good at the job. And 1970s, they gave extra credit to high-quality companies because they already knew that high-quality if you think you are a really good credit analyst, the place companies tended to do better than they were given credit for. A decade later, when GMO created where your credit analysis will have the biggest impact on its first quantitative stock selection models to systematize what Jeremy and Dick had been doing your portfolio is in the lower rated segments. If 1% of BB bonds default in a given year and you can entirely avoid on a stock-by-stock basis, we built in a high-quality bias for the very same reason. those that do, you stand to outperform by something substantially less than 1% (defaulted bonds have a We have known about the quality anomaly for a long time. That doesn’t mean we are confident recovery of 50% or more in the long run). If you could own a portfolio of CCC bonds and entirely avoid those we know why it exists. We’ve found a few explanations that seem as if they might be part of the that default, the payoff in terms of outperformance is an answer, but nothing that’s entirely satisfying. Part of the high-quality effect in stocks seems to have order of magnitude higher. Truly brilliant credit analysts been driven by the underappreciated advantages of companies with significant monopoly power, are right to focus their time on the riskiest bonds. There are just a lot fewer truly brilliant credit analysts than there compounded by a general trend (until very recently) toward less regulation of dominant companies. are credit analysts who merely think or hope that they are And while that might help explain some of the quality advantage among the very largest companies, truly brilliant.

17 the quality effect among small companies is at least as pronounced – and small firms (even the Cause and effect problems are tricky in this case. Insofar high-quality ones) are not really monopolists. The highest quality companies are also particularly as the outperformance in those industries is driven by the high-quality firms in them, you could make the argument concentrated in a handful of industries – Health Care, IT and Communications Services in particular that it’s not the industries, but the high-quality firms within – and those industries have generally outperformed over the past few decades.17 But the high-quality them, that have done well. effect within cyclical industries has been quite strong, so even that can’t possibly be the whole story.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p9 Ben Inker The most plausible argument I have come up with for why high quality doesn’t underperform as Mr. Inker is co-head of theory says it should comes from the incentives of portfolio managers. Active equity managers are GMO’s Asset Allocation paid to try to outperform the broad market. If there was a stock that they were convinced would team, a member of underperform the market in the long run, it would be an unappealing holding even if they believed the GMO Board of the underperformance was a rational trade-off for lower fundamental risk. You could make a similar Directors and a partner argument in the high yield bond market. If BB bonds generally underperformed riskier bonds, of the firm. He joined GMO in 1992 following many high yield investors would have a hard time holding them, or at least they would want to the completion of his bachelor's degree in own a smaller weight than their benchmarks. In a world where the preferences of active stock and Economics from Yale University. In his years at GMO, Mr. Inker has served as an analyst for bond managers set pricing, you could therefore come up with a reasonable behavioral argument the Quantitative Equity and Asset Allocation as to why high quality is not priced to underperform. But that explains neither why high quality teams, as a portfolio manager of several outperforms the market, nor why lower quality stocks and bonds do as poorly as they do. Behavioral equity and asset allocation portfolios, as explanations for that side of the anomaly tend to focus on the fact that low-quality companies tend co-head of International Quantitative Equities, to have a positive skew to their returns. That positive skew gives them something of a lottery ticket and as CIO of Quantitative Developed payoff pattern that people have shown to consistently overpay for. That can’t do much to explain Equities. He is a CFA charterholder. the poor performance of CCC bonds, however, as a risky bond’s return is usually negatively skewed.

There is no lack of academic literature on quality and related topics, and my apologies to any whom Disclaimer I’ve offended by not citing a particular paper. I can’t claim to have read everything, but I can say The views expressed are the views of Ben that I have yet to come across anything particularly persuasive as to why the anomaly exists. The Inker through the period ending December lack of credible explanations as to why high quality “should” outperform demands that we be alert 2023, and are subject to change at any to the fact that this might change in future. We aim to take a “trust but verify” stance with regard to time based on market and other conditions. our investment beliefs at GMO. It is dangerous to assume that the circumstances that caused your This is not an offer or solicitation for the favored securities to be attractive still pertain. In the case of the quality anomaly though, the plausible purchase or sale of any security and should change in circumstance almost certainly needs to involve investors bidding up the valuation of not be construed as such. References higher quality securities and bidding down the valuations of low-quality ones to the point where the to specific securities and issuers are for illustrative purposes only and are not fundamental advantages of high-quality companies are fully counteracted by their higher valuations. intended to be, and should not be interpreted As long as we see no evidence that this has already occurred, a move to that efficient pricing actually as, recommendations to purchase or sell constitutes an upside opportunity for higher quality stock and BB bond holders, since getting there such securities involves a windfall gain for high-quality securities as their valuations rise.

Copyright © 2023 by GMO LLC. As a result, the case for building in a quality bias to your stock and high yield credit portfolios is All rights reserved. strong. Even today, at a time where we in the Asset Allocation team believe that deep value stocks are the best opportunity in equity markets, we see no need to compromise on quality to take advantage of the value mispricing. Higher quality deep value stocks are as cheap versus their history as more standard ways to define deep value are, making them an even more compelling buy in our view. But whether or not you agree with me about today’s value opportunity, I can’t imagine why any investor wouldn’t want to find a way to bias their equity and high yield portfolios in favor of high quality.

The Quality Anomaly: The Weirdest Market Inefficiency in the World | p10 Annualized Returns as of 9/30/2023 (Net, USD) Inception 1-Year 3-Year 5-Year ITD GMO High Yield Fund 6/25/2017 10.96% 2.70% 3.41% 3.76% Markit iBoxx USD Liquid High Yield Index 9.84% 1.30% 2.45% 2.71% Performance data quoted represents past performance and is not indicative of future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance data may be lower or higher than the performance data provided herein. To obtain performance information to the most recent month-end, visit www.gmo.com.

Net Expense Ratio: 0.46%; Gross Expense Ratio: 0.47% Net Expense Ratio reflects the reduction of expenses from fee reimbursements. The fee reimbursements will continue until at least June 30, 2024. Elimination of this reimbursement will result in higher fees and lower performance. Gross Expense Ratio is equal to the Funds Total Annual Operating Expenses set forth in the Funds most recent prospectus dated June 30, 2023.

Risks associated with investing in QLTY may include: (1) Market Risk - Equities: The market price of an equity may decline due to factors affecting the issuer or its industry or the economy and equity markets generally. Declines in stock market prices generally are likely to reduce the net asset value of the Fund's shares. (2) Management and Operational Risk: The risk that GMO's investment techniques will fail to produce desired results. (3) Focused Investment Risk: The Fund invests its assets in the securities of a limited number of issuers, and a decline in the market price of a particular security held by the Fund may affect the Fund's performance more than if the Fund invested in the securities of a larger number of issuers. For a more complete discussion of these risks and others, please consult the Fund's prospectus.

Risks associated with investing in the GMO High Yield Fund may include those as follows. (1) Management and Operational Risk: The risk that GMO's investment techniques will fail to produce desired results. (2) Market Risk - Fixed Income: The market price of a fixed income investment can decline due to a number of market-related factors, including rising interest rates and widening credit spreads or decreased liquidity due to market uncertainty about the value of a fixed income investment (or class of fixed income investments). (3) Credit Risk: The risk that the issuer or guarantor of a fixed income investment or the obligor of an obligation underlying an asset-backed security will be unable or unwilling to satisfy its obligation to pay principal and interest or otherwise to honor its obligations in a timely manner. The market price of a fixed income investment will normally decline due to the issuer's, guarantor's, or obligor's failure to meet its payment obligations or in anticipation of such failure. For a more complete discussion of these risks and others, please consult the Fund's prospectus.

An investor should consider the fund’s investment objectives, risks, charges and expenses before investing. This and other important information can be found in the fund’s prospectus. To obtain a prospectus please visit www.gmo.com. Read the prospectus carefully before investing.

The GMO ETFs are distributed in the United States by Foreside Fund Services LLC. GMO and Foreside Fund Services LLC are not affiliated.

The GMO Trust funds are distributed in the United States by Foreside Fund Services LLC. GMO and Foreside Fund Services LLC are not affiliated.

Worldscope, Compustat, and Barclays Point are data providers. Results are a representation of historical data and are no guarantee of future results. MSCI data may not be reproduced or used for any other purpose. MSCI provides no warranties, has not prepared or approved this report, and has no liability hereunder. Please visit https://www.gmo.com/americas/benchmark-disclaimers/ to review the complete benchmark disclaimer notice.