tag:www.capitalspectator.com,2008:/WM/5 2008-08-12T14:08:10Z Movable Type 3.33 tag:www.capitalspectator.com,2008:/WM//5.896 2008-08-12T14:03:35Z 2008-08-12T14:08:10Z

July/August 2008, Wealth Manager For one wealth manager, bonds are the only game in town. By James Picerno Asset allocation? Don’t even think about it, says Stan Richelson of the Scarsdale Investment Group, Ltd., a Blue Bell, Pa. wealth management...

July/August 2008, Wealth Manager
For one wealth manager, bonds are the only game in town. By James Picerno Asset allocation? Don’t even think about it, says Stan Richelson of the Scarsdale Investment Group, Ltd., a Blue Bell, Pa. wealth management shop that he runs with his wife, Hildy. The only sensible strategy, he insists, is all bonds, all the time, for all clients. ]]> Bonds: The Unbeaten Path to Secure Investment Growth (Bloomberg, 2007), which he co-authored with Hildy. For some perspective on his wary way of thinking, he cites the so-called “Black Swan” risk, a reference to two books by Nassim Taleb—Fooled By Randomness and The Black Swan—that explore the causes and consequences of unpredictable events and how they can wreak havoc on the best laid plans of mice, men and naive investors. In a recent interview with Wealth Manager, Richelson elaborated on his bond-besotted investment philosophy, poking his finger at a few sacred cows along the way. “You’ve never heard this point of view spoken so forthrightly and with such passion,” he asserts. Richelson’s approach to investing may be atypical, but that alone doesn’t make it right, or wrong. It does, however, make it interesting, all the more so when you consider that Richelson has been around the career block a few times. Having worked for a large Wall Street law firm as well as several large corporations, this tax lawyer is well acquainted with the finer points of high finance. Perhaps he favors bonds because of his experience in the financial industry—-or in spite of it? Q: In your book, you effectively dismiss asset allocation by advocating an all-bonds strategy. Isn’t that a touch radical? A: Let’s first talk about the book’s intended audience, which is the individual investor. We’re talking to the man-in-the-street who’s being seriously beat up by the financial services industry, and he has limited options. He can’t do all the things that the Harvard Endowment can do [i.e., invest in conventional and alternative asset classes such as venture capital]. What can an individual do? He can invest in stocks, he can invest in bonds, he can make believe he’s investing in real estate by buying REITs—which aren’t real estate. He could go into exotic stuff and pay enormous fees that he doesn’t see or know about. He can speculate in gold and other commodities, and of course he’ll get his timing wrong. Q: What about mutual funds? A: Yes, of course, but depending on which ones he’s in, he might pay loads. And if he’s buying small or foreign stock funds, he’s going to pay fees that, according to [Vanguard’s] Jack Bogle, are somewhere between 2 percent and 8 percent every year in addition, probably, to a front-end load. And an advisor may be laying another 1 percent on top of that. Q: Eight percent? Presumably you’re referring to charges over and above the stated expense ratios? A: Yes. Consider a small-cap foreign equity fund. Some of the fees are disclosed—management fees and expenses. But what you’re not seeing are things like the trading spreads and the brokerage commissions. Add taxes and bad timing to the expenses, and the investor’s cooked. He’s never going to make any money in equities. He doesn’t know what he’s doing when he’s buying real estate. What is he left with? I think he’s left with bonds, and I’m talking about individual bonds. We’re in Pennsylvania, so if you buy a 10-year Pennsylvania muni at new issue, and you sit with it for 10 years, there are no taxes and there’s no bad timing. The first chapter of our book lays out this argument, which says that stocks have not outperformed bonds for the hypothetical individual if you adjust for taxes, expenses and bad timing. If you risk adjust for stocks and bonds, you see that bonds are a much better deal. Q: Just to be clear, you’re not saying that bond indices outperform stock indices. A: No, but I’m saying that the man-in-the-street can’t get those [stock index] returns. No individual has ever gotten the Ibbotson 10 percent return on equities because investors pay taxes and fees, even if they don’t suffer bad timing. Q: On the other hand, what kind of return can investors expect from a muni bond? Inflation adjusted, doesn’t the long-term outlook for returns for munis look grim? A: It is grim; that’s the whole point. Everyone wants to say that you can average 10 percent after fees, taxes and so on [in stocks]. The people of modest means are screwed. If bonds are going to give them 4 percent to 4.5 percent tax free, how is anyone going to retire on 4.5 percent tax free? But you’re not going to do any better in the other asset classes. It’s all razzle dazzle and smoke and mirrors. The face of reality is this: If you can get 4 percent after tax [with bonds], I don’t think the man-in-the-street is going to do better by going into 10 asset classes. Q: Some might say that the grim outlook you just outlined by way of munis strongly suggests that the solution is holding a multi-asset-class portfolio comprised of, say, ETFs? A: We’re going to see about ETFs. Wait ‘til another Black Swan of 1987 shows up, and then we’re going to see if ETFs work. So far, they haven’t been stress-tested. Q: Doesn’t the risk of a future Black Swan event strengthen the case for broad diversification via multiple asset classes, as opposed to just one, as you recommend? A: And you think the man-in-the-street should educate himself [on investing in multi-asset-class portfolios]? Q: Let’s assume an investor is sufficiently educated, or hires competent financial help. In that case, what do you think about the concept of multi-asset portfolios? A: I reject the concept. The whole idea of asset allocation is to maximize return and reduce risk. I’m starting with the safest investments, so I don’t need to reduce risk. All you can say is that I’m missing out, possibly, on future returns, which may or may not be there. In fact, I have a different way of looking at bonds. We have some very substantial clients, but we don’t “perform.” Nobody asks us for performance figures. Nobody asks, “What’s your performance over the last three, five or 10 years?” We don’t do performance. What we do is cash flow. With cash flow, you buy a 10-year bond yielding 4 percent and you know what the cash flow will be. When the bond comes due, and you reinvest, you’re going to get more or less cash flow [relative to the previous bond’s cash flow]. The world we live in is different than any world you’ve ever heard of. We say, “If you’re looking for performance, go find someone who’ll trade.” On the other hand, we’re going to get you the yield to maturity; we’ll get you the best price; and, we’re going to charge you a very low fee. That’s the world we live in. We don’t live in the world that you write about and that everyone else lives in, with all the correlations and bell curves. I reject all that. I don’t think the bell curve is worth anything; I don’t think standard deviation tells you anything. Q: What’s the basis for your investment philosophy? A: Have you read The Black Swan? That’s what we believe. Taleb’s Black Swan analysis underlies our entire way of investing and presenting ourselves to the public. We believe that you should be invested in the safest stuff because the rest of the stuff can’t be trusted because of the Black Swan risk. Taleb recommends in The Black Swan that you essentially put 85 percent [of assets] in Treasury bonds. With the remaining 15 percent, open yourself up to positive Black Swans—in other words, the really risky stuff in the hopes of getting a positive Black Swan, of getting a windfall. Essentially that’s what we do, although I didn’t come to this view from reading his book. Q: Isn’t focusing so heavily on bonds the equivalent of making an active, highly concentrated bet? A: Yes. We’re saying, “I don’t trust [other strategies] for my retirement.” I’ve invested, aside from a little venture capital stuff, all of our money in the same bonds that we recommend to clients. I reject asset allocation and instead I’m investing in what I perceive as the safest asset class. We’ve become financially independent, without taking any risks. Q: Doesn’t concentrating investments in the “safest” asset class insure that you’ll do poorly over time because of inflation? A: You’re right. Q: What can you do to overcome that head wind? A: I save more money. Inflation isn’t going to be kind to any asset class. Q: What about gold or oil? A: Do you recall gold doing nothing for 20 years? Q: Wasn’t that a function of low inflation? A: No, it’s supply and demand. For some reason, gold fell out of favor. You could make a lot of technical reasons about why, but I don’t believe in any of that. There were more sellers than buyers; nobody was interested in the stuff. I was never interested in gold; it doesn’t pay me a return. So, to your question about whether inflation is going to eat you up? Yes, inflation’s going to eat up everybody, which means that you need to save more money.]]> tag:www.capitalspectator.com,2008:/WM//5.887 2008-07-29T12:50:23Z 2008-07-29T12:56:12Z

July/August 2008, Wealth Manager Will "new and improved" indices enhance asset allocation? By James Picerno If you build better indices, the possibility of enhancing asset allocation strategies naturally follows. Why, then—in a world that’s minting a new generation of benchmarks...

July/August 2008, Wealth Manager
Will "new and improved" indices enhance asset allocation? By James Picerno If you build better indices, the possibility of enhancing asset allocation strategies naturally follows. Why, then—in a world that’s minting a new generation of benchmarks at a record clip—isn’t there more discussion of the opportunities for improving portfolio design? Whatever the answer, it’s not for lack of choice. ]]> Wall Street Journal op-ed in 2006. And while the prospects for the new indices continue to be hotly debated, that hasn’t stopped several high-profile academics and consultants from throwing their intellectual weight on the side of the fundamental indices. Nobel Laureate Harry Markowitz of portfolio-optimization fame has written in favor of the idea. So has Jack Treynor, one of the originators of the 40-year-old capital asset pricing model (CAPM), which is the basis for using cap-weighting as the default choice for index design. But that was then. There’s a new kid in town, and it’s time to upgrade, Treynor, Markowitz and others advise. Investors who agree can choose from a growing list of products tied to equity indices that distinguish themselves by shunning market-cap weighting. Extending the fundamental indexing concept to other asset classes is reportedly also under study. As a result, revising asset allocation strategies may be the next big thing in indexing. Meanwhile, old habits still die hard in 21st century finance. Cap-weighted equity indices remain the overwhelming preference for strategists who favor betas in money management. A half century of financial economics isn’t easily overturned— although that doesn’t stop some from trying. And no one is trying harder than Robert Arnott, chairman of Research Affiliates in Pasadena, Calif. Three years ago, Arnott and two co-authors laid out their case for an equity index that weights stocks based on book value, sales, cash flow and dividends (“Fundamental Indexation,” Financial Analysts Journal, March/April 2005). This foursome, the paper asserts, goes a long way in correcting the “pricing errors” embedded in cap-weighted indices. As evidence, the paper cites a back test that shows the fundamentally weighted index for U.S. stocks outperformed a comparable cap-weighted benchmark by an annualized 197 basis points for the 43 years through 2004, and with similar volatility to boot. Reportedly, the source of the superior performance in the Fundamental Index concept comes from sidestepping cap-weighting’s bias for holding overvalued growth stocks at the expense of undervalued value stocks. “Mathematically, cap weighting assuredly gives additional weight to stocks that are currently overpriced relative to their (unknowable) discounted future cash flows (the true fair value) and reduces weights in stocks that are currently trading below that true fair value,” Arnott and his associates write. (A brief digression: Research Affiliates has claimed its Fundamental Index label is a registered trademark, thus the firm’s preference for capitalizing the name.) Like most new ideas in finance, this one has spawned its share of dissent and debate. Much of the criticism is less about the results than about labels—namely, that fundamental weighting is really value investing by a different name. Recent issues of the Financial Analysts Journal highlight some of the more pointed critiques, which in turn have elicited rebuttal from the defenders. (See “Fundamentally Flawed Indexing” in November/December 2007 FAJ; and “Why Fundamental Indexation Might—or Might Not—Work,” as well as letters to the editor in March/April 2008 FAJ.) The jury may still be out on this debate, but as a business, the fundamental benchmarking idea is rolling along. A mere two- and-a-half years old, the first fundamentally weighted index ETF (PowerShares FTSE RAFI US 1000, NYSE: PRF) had net assets at a tidy $850 million as of this past March, according to Morningstar Principia. Globally, roughly $20 billion in ETFs, mutual funds and other accounts track Research Affiliates’ indices, which now come in a rainbow of broad market, industry, domestic and foreign equity indices offered through several product vendors. There’s also an expanding list of ETFs based on other fundamentally oriented indices, including a suite of funds weighted by dividends and earnings via Wisdom Tree, which claims the aforementioned Jeremy Siegel as senior investment strategy advisor. And the new players keep coming, such as RevenueShares Investor Services, which earlier this year launched a trio of ETFs that weight stocks by revenues. Meanwhile, Arnott says that Research Affiliates is considering an expansion of the firm’s indexing methodology to bonds. Farther down the road, REITs and even commodities are possibilities, he tells Wealth Manager. Looking down that road, one can imagine building multiasset class portfolios exclusively with fundamentally weighted indices. In turn, that suggests moving asset allocation to the next level, so to speak. In fact, the next level has already arrived for global equity portions of asset allocation. If the new indices live up to the billing, their use in asset allocation holds out the possibility of boosting stability and visibility in the overall portfolio relative to building portfolios with cap-weighted indices. The reasoning is tied to the basic proposition of fundamentally weighted indices and their claim of offering a smoother ride and higher returns than cap-weighting. If this enhancement proves durable, more of the rebalancing work that’s now typical—and perhaps necessary—with cap-weighted indices will come pre-packaged in fundamentally weighted benchmarks. The implied rebalancing bonus of fundamentally weighted indices may come in handy, given the evolving state of investment theory. As discussed in the May 2008 issue of Wealth Manager (“Back to the Future—Again,” p. 66), the finance literature now supports the case for a relatively dynamic asset allocation. That’s based on the accumulating evidence in the academic literature that expected returns are predictable to a higher degree than previously recognized. Markets go to extremes at times, which means that prospective risk premia fluctuate. Higher dividend yields, for instance, imply higher expected returns, and vice versa. The point is that allocations to the various asset classes should rise and fall in accordance with the current fundamental outlook. The source of the higher predictability is hotly debated. Some say it’s a function of market flaws or investor irrationality. Others speak of a revised efficient market hypothesis that offers a fluctuating risk premium driven by economic fundamentals. In either case, the implication for investment strategy is clear: Asset allocation should be dynamic to capitalize on the return predictability. In contrast, an older view of modern portfolio theory and EMH suggests keeping asset allocation static, based on the assumption that markets are completely unpredictable, and so expected return is constant. Not so, financial economics now counsels. Markets are not completely predictable, of course. But expected returns are partially visible, we’re told, which implies that asset allocation should be partially active. Certainly that’s true for asset allocation strategies using cap-weighted indices, which are susceptible to the extremes of market conditions and investor sentiment. But what if we’re using fundamentally weighted benchmarks? These indices are designed for a smoother ride with a comparable and perhaps higher return relative to cap-weighted benchmarks. Certainly in the case of Research Affiliates’ indices the intent is to provide a more efficient sampling of the economy’s footprint via a diversified basket of stocks. All things equal, running asset allocation strategies with fundamentally weighted ETFs and mutual funds implies a less-active rebalancing program compared with cap-weighted products. Arnott and two Research Affiliates associates have considered the strategic possibilities in The Fundamental Index: A Better Way To Invest (Wiley, 2008). As the graph on the previous page—from the book—illustrates, Fundamental Index strategies are said to offer three basic opportunities to “reshape return expectations” when the benchmarks replace cap-weighted indices by: 1) lowering risk without lowering expected return, or 2) raising expected return without raising risk, or 3) raising risk levels by increasing equity allocation but without increasing downside risk. Assuming Fundamental Indexes deliver as promised, all of the above are possible because of the enhanced stability in capturing the equity market’s expected return. In short, a strategic use of Fundamental Indexes implies a lesser degree of active asset allocation compared to the use of cap-weighted indices, while remaining true to current academic thinking. It’s a bit ironic that the Fundamental Index ideal revives the case for more stability in asset allocation. Recall that relatively stable, unchanging asset allocation strategies apply only under the old view of market efficiency—i.e., market prices equate with fair value. Fundamental Indexing rejects the old view of market efficiency. Yet this solution leads one back to an asset allocation approach that’s closer in spirit to a world defined by a classic definition of market efficiency. In some respects, what’s old is new again. Ironic, perhaps, but not necessarily surprising. We’re told that Fundamental Indexing effectively seeks to reinstate some of the pricing efficiency in the capital markets that is lost with cap-weighted indices. If true, it should be no wonder that asset allocation via Fundamental Indexing offers the potential for bringing us closer to a less-dynamic strategy than would be appropriate with cap-weighted indices. So far, so good. But the question remains: Will fundamentally weighted indices live up to their marketing? Yes, the analysis by Arnott and others is compelling. At the same time, the history of empirical research is littered with studies that, in varying degrees, performed better on paper than in the real world. Will fundamental indexing fare any better? Unfortunately, it’s still too early to say. Just as the first experiments in indexing required time to prove their worth in the real world, so too must fundamental indexing go through economic-cycle stress testing, with actual dollars on the line. In fact, the testing is unfolding as we speak. Stay tuned. ]]> tag:www.capitalspectator.com,2008:/WM//5.867 2008-06-23T13:26:46Z 2008-06-23T14:10:59Z

June 2008, Wealth Manager If you think TIPS are the last word in inflation-linked government bonds, think again. By James Picerno Inflation respects no political border, which means that targeting inflation-linked bonds on a global basis is a natural for...

June 2008, Wealth Manager
If you think TIPS are the last word in inflation-linked government bonds, think again. By James Picerno Inflation respects no political border, which means that targeting inflation-linked bonds on a global basis is a natural for investing strategy. It’s also timely. Pricing pressures are bubbling in economies around the world. Consumer prices in OECD countries (a proxy for the developed world) rose by 3.5 percent in the year through this past January—the highest pace since 2001. Inflation is also on the rise in emerging markets, including China, which reported an 8.7 percent jump in consumer prices for the year through February—up sharply from 2.7 percent for the same period a year earlier.]]> Q: Who are the leading sovereign issuers of inflation-linked bonds in the world? A: The U.S. is the largest issuer with a roughly one-third weighting in the index. The U.K. is second with about 20 percent; France is third at about 14 percent, followed by Brazil at around 9 percent. It trails off to Italy, Japan, Canada, Sweden, Germany, Argentina and on down. We also have versions [of the index] that cap the U.S. at 25 percent. In fact, we can customize the index any which way. For example, some investors might want an ex-U.S. version if they already have TIPS. We can slice and dice as you want. Q: How does your new index compare to global inflation proper? A: It depends on how you measure global inflation. For instance, many people are concerned about the BRICs—Brazil, Russia, India and China. The only BRIC representative in the index is Brazil, and it has a reasonably high weighting. If you look at Asia, which a lot of people target, you have Japan, Australia and South Korea [inflation linkers]. But you’re not getting a full and complete picture [of inflation with the index]. Instead, you’re getting a complete picture of the marketable securities that are available from the governments that have chosen to issue inflation-linked bonds. Q: How might the index change if more countries start issuing inflation-linked bonds? A: Our indices are designed so that if India, Russia and China come on board and start issuing inflation- linked debt, they easily will fall into the index. It’s a rules-based index, so it’s likely that [new bonds from those countries will] \drop in once you get sufficient size issuance. There were press reports a few years ago of India looking [at the inflation-linked bond market]. Russia said it’s probably not going to do anything for a few years. But over time we’d like to see the larger global economies all issue inflation-linked bonds, and when that happens, they’ll be added to the index. Q: It’s clear why investors buy inflation-linked bonds—hedging against higher inflation, for instance. What is a government’s motivation for issuing inflation-linked bonds? A: There are several incentives. First, it broadens the investor base and lowers your overall cost of debt financing. When you issue inflation linked bonds, you draw in more international capital. It also lends more credibility to your monetary policy because it sends a signal to the broader world that you’re serious about containing inflation. If you’re issuing inflation-linked debt, it’s more difficult to inflate your way out of problems, and so issuing the bonds lends credence to your monetary policy aims. It also allows for better monetary policy decision-making because it generates market-based expectations of future inflation. People are actually putting money down on inflation expectations [when they buy inflation-linked bonds]. And that’s believed to be more reliable than just surveys or forecasts [for predicting inflation]. The Federal Reserve and the European Central Bank use inflation-linked bond markets for expectations of future inflation, which then gets channeled into the monetary policy decision-making process. Q: An ETF has already been launched on a competing global inflation- linked bond index. Will the Barclays index also become the basis for creating securities? A: Yes. This, too, is an index that can be used for creating mutual funds, ETFs and other products benchmarked to it. We’re going to bring out products and distribute them via our institutional sales force as well as through the private bank channels to high-net-worth individuals. We’re also talking to asset managers, ETF managers—we’re looking for things like mutual funds and other products that will make the index more broadly available. Q: Is there a Barclays iShares ETF linked to your inflation-linked bond index on the horizon? A: That’s [a decision for] Barclays Global Investors. Although we have the same owner, that’s not us [Barclays Capital]. I will say that ETF products are proving quite attractive and successful, and I’d like see ETFs and mutual funds launched based on the index at some point. ]]> tag:www.capitalspectator.com,2008:/WM//5.862 2008-06-16T13:54:28Z 2008-06-16T14:03:55Z

June 2008, Wealth Manager Is modern portfolio theory compatible with socially responsible investing? By James Picerno Harry Markowitz’s 56-year-old portfolio-optimization theory may be middle aged, but it’s forever young in the service of tackling the investment challenge du jour....

June 2008, Wealth Manager
Is modern portfolio theory compatible with socially responsible investing? By James Picerno Harry Markowitz’s 56-year-old portfolio-optimization theory may be middle aged, but it’s forever young in the service of tackling the investment challenge du jour. ]]> * a large tracking error relative to the overall stock market or targeted benchmark * suboptimal portfolios á la Markowitz * investor SRI preferences that aren’t maximized Aperio claims to resolve all three, at least as far as anyone can, and in a tax-savvy wrapper to boot. “That’s what’s so appealing about the way we’re approaching [SRI indexing],” Geddes asserts. An added bonus is the enhanced transparency that flows from quantitatively profiling the opportunities—and limits— of balancing tracking error against a target index with customized SRI objectives. Since marginal improvement in one generally comes at the expense of the other, the trick is finding an acceptable equilibrium—one client at a time. “You can dial up or down your values system,” Geddes says of his firm’s portfolio strategy. “You can have a very strict values system with a lot higher tracking error, or we can show your specific value set at a high, medium or low threshold. Basically, our system’s telling you, ‘Here are your values at different value levels, and here’s what it costs in terms of tracking error.’” The crucial choice ultimately resides with the investor, who must decide how much his particular SRI agenda is worth in terms of replicating the target index. “If you want a higher social score, you’re going to have to pay for it with a higher tracking error,” explains Geddes. The good news, he tells Wealth Manager, is that Aperio’s customized SRI indexing strategy generally cuts tracking error in half while producing a modestly higher social score (roughly 10 percent to 20 percent higher) compared to competing SRI strategies, as the chart below illustrates. “The traditional approach [to SRI] is excluding the companies you don’t want, throwing them out, and cap weighting the rest,” Geddes says. That’s inferior, largely because it doesn’t control risk as well as Aperio’s strategy, he claims. No big surprise, perhaps, considering that risk management is MPT’s raison d’être. Geddes equates the relationship between SRI values and tracking error with a modified information ratio (a risk metric calculated as alpha relative to a benchmark divided by the standard deviation of the alpha). “Basically, we’re operating on a values ratio: Your SRI value score divided by your tracking error. Investors want the biggest improvement in SRI values for the smallest incremental cost of tracking error.” The front line of Aperio’s strategy is quantifying investor values in a way that meaningfully captures SRI views. The task starts with a questionnaire informed by a social research database from a firm such as KLD Research & Analytics, which ranks companies on various SRI factors. Aperio interviews investors on a series of SRI topics and runs the answers through a database to quantitatively model the results. The stocks in the target index are scored according to the client’s preferences. “It’s an imperfect process because you can’t quantify everything,” Geddes says of turning social scores into statistics. “You might have a hot-button issue that we don’t have data for, but generally we can get pretty far.” Investors, it seems, can have their SRI preferences without violating MPT. The message appears to be resonating with some wealth managers and institutional investors. Aperio manages $1.4 billion directly in separate accounts and consults on another $6.5 billion with institutions. One convert is Wetherby Asset Management, which reports that Aperio’s flexibility in portfolio design is a big attraction. “You can be as customized as you want in terms of investors’ wishes and still do your best to track an index,” says Debra Wetherby, CEO of her eponymous wealth management shop in San Francisco. “We’re able to specify how important the various tradeoffs are on a per-client basis” in terms of SRI values versus tracking error. The fact that Aperio doesn’t try to be all things to all investors impresses another client. “They’re a pure play,” says Jeff Colin, a founding partner of Baker Street Advisors, another San Francisco wealth manager. “Their depth of expertise, as a result, is on a par with significantly larger organizations. That’s attractive to me.” The broader lesson is that the warm and fuzzy world of SRI isn’t immune to the quant revolution, or fated to be incompatible with MPT. Anyone who thinks otherwise may want to give Aperio a call. ]]> tag:www.capitalspectator.com,2008:/WM//5.845 2008-05-14T13:39:23Z 2008-05-14T13:44:38Z

May 2008, Wealth Manager The financial literature now favors active asset allocation, but it's still risky. By James Picerno It has been fIve years since veteran investment consultant and celebrated author Peter Bernstein invoked the word “obsolete” to describe the...

May 2008, Wealth Manager
The financial literature now favors active asset allocation, but it's still risky. By James Picerno It has been fIve years since veteran investment consultant and celebrated author Peter Bernstein invoked the word “obsolete” to describe the policy portfolio, which encourages fixed weights for multi-asset class investing strategies. By contrast, dynamic asset allocation is the superior alternative, he argued in a widely discussed 2003 article in his newsletter Economics and Portfolio Strategy.]]> Sound familiar? The concept is at the heart of Graham and Dodd’s Security Analysis, the 1934 classic that formalized value investing, or buying securities at a discount to their estimated intrinsic value. The book focuses on individual securities rather than markets. But embedded in the strategy is the belief that the relationship between market price and intrinsic value is forever in flux, which means that expected return fluctuates, too. For those who agree, the intellectual leap to active asset allocation is only natural. Academics are inclined to agree in the 21st century, but not without rethinking certain aspects of modern portfolio theory as some have used it in the past. Notably, the intellectual evolution that now favors active asset allocation conflicts with the random walk theory (RWT), a particular version of the efficient market hypothesis (EMH). RWT, which helped spawn the indexing revolution, asserts that returns are 1) independent— meaning that yesterday’s return has no effect on today’s or tomorrow’s; and 2) returns are “normally” distributed over time, as per a gently sloping bell curve. Assuming the two assertions accurately describe market behavior provides statistical aid and comfort for fixed-asset allocation strategies premised on the idea that expected return is fairly stable. In fact, returns don’t strictly follow a random walk. So-called “fat-tail” distributions prevail, meaning that large price changes occur in the real world with far more frequency than a normal distribution predicts. That has been clear since at least Benoit Mandelbrot’s research in the 1960s, and over time the literature has only confirmed the point. The message is periodically repeated, often to deaf ears. Eugene Fama, who coined the term “efficient markets,” recognized the case for non-random distributions in his landmark 1965 paper that helped launch EMH. More recently, financial scold Bill Jahnke argued that a proper reading of finance literature leads to the conclusion that “the policy portfolio deserves to be buried” (The Investment Think Tank, Bloomberg, 2004). Indeed, the academic bibliography is now flush with 20-plus years of empirical studies showing that fundamental data (dividend yields, interest rates, etc.) offers a richer source for predicting returns than what was thought possible via the early conceptions of EMH that focused on price alone. For example, one line of research shows that returns are mean reverting in the medium to longer term, which implies predictability, and so asset allocation weights should change. Such notions clash with the random walk account of EMH. A modest degree of return predictability may be respectable in academic circles, but debate still rages about the underlying cause. One camp says irrational investors drive valuations to extremes. A competing view sees markets through the prism of an updated EMH: Expected returns vary in order to compensate for risk associated with the business cycle—a recession beta, if you will. Either way, the lesson is that some degree of dynamic asset allocation is warranted in a world where expected return cycles. How can active asset allocation coexist with notions of an efficient market? Economist Paul Samuelson, one of the intellectual fathers of EMH, has bridged the chasm by observing that markets can be microefficient and still be macroinefficient. In fact, the seeds of active asset allocation in the context of modern portfolio theory were planted long ago. After all, MPT’s founding document (Markowitz’s 1952 paper on optimal portfolios) allows for asset classes—“aggregates,” as he calls them—in portfolio construction. Meanwhile, the Capital Asset Pricing Model—the theoretical foundation for capitalization- weighted indexing—assumes shifting weights for assets, as per Mr. Market’s incessant repricing. And in the 1970s, some of the pioneers of the original index funds—Bill Fouse, for one—took the original but overlooked MPT ideas to heart and developed so-called tactical asset allocation, which eschews the principle of the policy portfolio. The chief inspiration for accepting some form of dynamic asset allocation is the market, suggests Bill Reichenstein, CFA and professor of investments at Baylor University. In a recent interview, he discusses an example drawn from the then-current market condition of the S&P 500—off roughly 14 percent from its high of last October. “From this point forward,” Reichenstein explains, “the risk premium that’s embedded in stocks is higher than the risk premium of a few months ago. There’s nothing inefficient about that. That doesn’t mean that the next three months are going to deliver well above average returns. What it means is that over the next five or 10 years, stocks will do a lot better than they would have if you would have started out three months ago.” Market excess becomes conspicuous from time to time, says William Bernstein, author of The Four Pillars of Investing. That was true in 1990, for example, when “a lot of people saw all the BS in the Japanese market,” which was trading at astonishing nosebleed valuations, he recalls. The past, of course, never fails to offer trustworthy guidance about what you should have done. Handicapping the future in real time is the challenge. Yes, the academics now counsel that returns are somewhat predictable, but at best it’s still only a partial solution because forecasting still entails risk. “The level of predictability [in equity returns] tends to be 25 percent, 35 percent,” says Reichenstein. That suggests that asset allocation strategies should be only partially dynamic—such as allowing for shifts in equity weights within a modest range without betting the farm on predictions, he advises. Even then, adding value to the portfolio assumes the strategist has the talent to correctly read the market’s signals and make portfolio adjustments at opportune moments. Nonetheless, while the academic literature shows that there is opportunity for generating alpha with dynamic asset allocation relative to a fixed policy, there are no guarantees. Expected returns vary, but that doesn’t mean everyone will profit from the trend. Perhaps, then, it’s no surprise to learn that even advocates of dynamic asset allocation recognize that the policy portfolio is still useful—even if it’s theoretically inferior. A fixed asset allocation can capture “a big part” of the results generated by a more active strategy, says Jim King, president and chief investment officer of National Penn Investors Trust Co., which manages money for high-net-worth clients. Bill Bernstein, too, says static asset allocation “isn’t a bad idea,” although he favors a dynamic approach for his client portfolios. Active asset allocation demands “industrial amounts of discipline,” he reminds. Taking advantage of higher expected returns and then pulling back when the outlook is less alluring is inherently a contrarian philosophy. “You have to buy when everyone else is selling.” Yes, mustering the discipline to buck the crowd can reap big rewards. One has only to consider Warren Buffett, Ben Graham and George Soros for inspiration. But such names tend to be the exceptions. Mediocrity or worse is still the likely result in money management generally. And that leads us back to the bedrock principle that was quantified all those years ago by Markowitz and his intellectual heirs: Risk and return are joined at the hip. Some things remain the same no matter what the academics say. ]]> tag:www.capitalspectator.com,2008:/WM//5.840 2008-05-07T13:59:42Z 2008-05-07T14:06:27Z

May 2008, Wealth Manager Seven fat years haven’t changed Matt Simmons’ bullish view of the world’s most important commodity. By James Picerno Sure, it’s easy to be an energy bull now—after seven years of rising prices. But it was a...

May 2008, Wealth Manager
Seven fat years haven’t changed Matt Simmons’ bullish view of the world’s most important commodity. By James Picerno Sure, it’s easy to be an energy bull now—after seven years of rising prices. But it was a lonely job in the late 1990s, when a barrel of crude oil changed hands in the $10-to $20-range.]]> Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy (Wiley, 2005). There are many who disagree, of course. The optimists say that there is still plenty of oil left, and that supply growth will match demand in the years ahead. Their reasons include the relatively untapped resources of so-called tar sands oil in Canada and elsewhere. And technology, they say, will also help squeeze more oil out of existing fields than was possible in the past. Perhaps, although Simmons’ sober outlook is finding a more receptive audience these days. Nor does it hurt his credibility that global crude production hit a peak in May 2005 at 74.298 million barrels a day, according to data published by the U.S. Energy Information Administration. As we go to press, the 2005 pinnacle still stands. So, what is Simmons thinking now? In a recent interview with Wealth Manager, he speaks candidly, including a forecast that the bull market for oil still has a long way to go. Q: What has been the reaction to your book’s somber view of Saudi Arabia’s oil supplies? A: I’ve had tons of feedback from people with various aspects of involvement in this story. That includes a surprising number of people who finally broke the silence within Saudi Aramco [Saudi Arabia’s government run oil company] by contacting me. About six months after the book came out, I’d heard that there had been an edict that if I was speaking at a conference, no one from Saudi Aramco could be on the program; I was persona non grata. Then, at last October’s Oil and Money Conference in London, I had an interesting encounter at the annual oil-man-of-the-year award. Mr. Jum’ah, CEO of Aramco, was being honored. I asked the conference host if I should show up because I thought I’d be a Darth Vader there. But he said, yes, of course you should come. And Jum’ah could not have been more charming to me. He said, “I’m so honored you could come. We know you’re our friend. Some of us don’t necessarily agree with all of the interpretations in your book, but you didn’t do it maliciously. You’re worried about us.” And in the middle of the award dinner, a guy comes up to me and says, “I’m the vice president in charge of all the new projects at Saudi Aramco, and I’ve got to tell you, I just finished your book and it’s fabulous.” Q: That’s surprising, considering that your book directly questions Aramco’s optimistic outlook for its crude oil production. A: What I’ve heard, from a variety of people, is that [Saudi Aramco executives] had heard and told each other that some stupid guy in Houston wrote a book that said Saudi Arabia had no oil left and, through stupidity and incompetence, the country destroyed its oil fields. Of course, the book doesn’t say that. It says that Saudi Arabia’s oil fields are too few, and they’re too old, and they’re applying more technology than anyone’s ever done to fight falling oil production. The other thing I’ve heard from a fair number of other people is that the culture within Aramco—and you could say the Middle East generally—is one of secrecy. Nor does anyone want to report bad news. In Aramco, going back to Dhahran [where Saudi oil was first discovered in the 1930s], the culture has been: Don’t talk to your neighbor about what you’re doing in the field. As a result, all of the people working on specific challenges [related to increasing oil production] didn’t have any idea that their problems weren’t unique, but instead were systemic to all the great fields. Q: Nonetheless, doesn’t Saudi Aramco still disagree with your book’s core thesis? A: The [Saudi] petroleum minister certainly does. But let me tell you about Dr. [Sadad Ibrahim] Al Husseini (a retired Saudi Aramco executive), who spoke at the Oil and Money Conference last fall. Afterward, someone asked me if I wrote his speech! Dr. Al Husseini was, until three years ago, the executive vice president of Saudi Aramco in charge of E&P [exploration and production]. He’s got a Ph.D. from Brown, and he’s been quietly saying that the world needs to realize that the Middle East is basically at its [oil-producing] peak. Q: What do you make of the relatively optimistic projections from Cambridge Energy Research Associates (CERA), an influential energy consultancy in the U.S.? The firm recently forecast that the decline rate in global oil production will be a relatively modest 4.5 percent, which is quite a bit lower than other predictions. The implication is that replacing old fields with new discoveries will be easier than you and some others expect. A: CERA’s view so starkly contrasts with my analysis that it’s almost like they’re talking about oil on Mars, and I’m talking about oil on Venus. I can’t understand where they get their numbers; I can’t reconcile what they report. They say the average worldwide decline rate is only 4.5 percent. Meanwhile, I did an exhaustive study...and one of the big conclusions is that we’re down to about 110 oil fields [in the world] that each produce 100,000 barrels of oil per day [bpd] or more. What’s more, very few [of the big fields] are new. But according to CERA’s study, they found 400,000 fields that produced on average 90,000 bpd. So one of us is totally wrong. Q: Any thoughts about why there’s such a chasm in your view versus theirs? A: Maybe they found some data that no one else has seen. But I’ve been a student of tracking field-by-field decline rates. We had a vivid reminder of the challenge when the chairman of Pemex [Petróleos Mexicanos, Mexico’s state oil monopoly] gloomily predicted that by the end of next year, production from Cantarell [one of the world’s largest oil fields] would be down to just over 1 million bpd from its peak of 2.2 million bpd in May 2005. [Cantarell’s November 2007 output was 1.28 million bpd.] By the way, in the same month, the world set an all-time record for global crude oil production at 74.3 million bpd [based on conventional crude output]. But I don’t think it’s possible to raise crude oil production. Another interesting fact is the stunning pattern that shows that we haven’t made any giant field discoveries that can produce 500,000 bpd, let alone 1 million bpd. The last 1 million bpd discovery was Cantarell in 1975, which ironically is now the second-largest field that’s declining most vividly. In fact, it’s been a long time since we’ve discovered a 300,000-bpd field. The last three great basins were discovered more than 30 years ago: Western Siberia in 1967, Alaska’s North Slope in 1968 and the North Sea in 1969. Meantime, all three have peaked. Q: A more optimistic school of thought reasons that the low oil prices in the 1990s were a disincentive to search for new supplies, and so we’re still dealing with that legacy. Meanwhile, the high prices of late are now spurring efforts to find new reserves, and therefore, higher production is coming. A: That was the case for a long time, but we’ve basically been back in the clover for seven years. Q: What about Saudi Arabia’s potential? Some analysts say that it has not been fully explored, and the possibility for big discoveries still exists. A: That’s true in a sense. Saudi Arabia can still explore in its deep waters and the Red Sea. They can still explore along their border with Iraq. And they say that they can still explore in their empty quarter, but so far the gas exploration there has been dismal. In the rest of the Arabian peninsula, they’ve searched as diligently as they can and, yes, they’ve found structures. But despite all the spending, none of the new structures discovered have hit the radar screen in terms of developing them. Q: Why is that? A: They must not have any potential for hydrocarbon production. Q: Meanwhile, global demand keeps growing. A: Despite a 10-fold increase in oil prices, demand didn’t slow. But demand growth in the United States is going to come to a dead halt because we literally can’t bring any more oil into our system, meaning our refineries, our import structure, pipelines. We’re basically capped out right now. Q: And that means... A: It means that prices will go up because inherent demand is greater than supply. The system is constrained. The big danger is that we keep doing what we’ve done too much of recently, which is basically drawing down our petroleum inventories to bridge the gap. Q: If the U.S. oil infrastructure is capped out, as you say, does that imply a ceiling on the country’s economic growth? A: No, it can still grow, but it’s going to have to shift into some other forms of growth. Our economic growth and oil demand growth aren’t necessarily highly correlated as they are in the developing world. It was only few years ago that economists said that if we ever had $30 oil, we’d have a recession. Do you remember that recession? Q: We seem to be in one now. A: If we are, it’s because of the subprime mortgages; it’s not because of $100 oil. We were kidding ourselves that we always had to have low oil prices to sustain demand growth. In fact, high oil prices didn’t impact demand. Q: Is that because the previous oil crises have been triggered by supply shocks whereas the latest bull market in oil is demand driven? A: Yes, and also because of the stealth growth that we didn’t see coming, which used up all our spare capacity. So now we don’t have any wiggle room. Did you see the statement [in mid-January 2008] when President Bush was in Saudi Arabia? Bush publicly asked for higher Saudi oil production. Then [Saudi Arabia’s oil minister] Ali al-Naimi gave Bush a big lecture that the markets don’t need any more oil, that the markets are well served, that demand will fall in the spring, etc. A couple of wire services reported something along the lines of: al-Naimi blows off Bush. That night on ABC’s “Nightline,” according to the transcript I read, Bush was asked why he didn’t tell the Saudis to give us the damn oil. And Bush said, you can’t force someone to give you something they don’t have. My guess is that Bush has been briefed that they [the Saudis] don’t have any spare capacity. They’re out. Q: So your book’s warning about Saudi Production nearing a peak remains intact? A: Yes. We shouldn’t be surprised when these fields go into decline. The uniqueness is their size; but they’re not a reservoir that never gets old. They’ve been working those fields as hard as they can. They should rest them. They bought into the same technology miracle that mesmerized the major oil companies. It was only five years ago that the major oil firms as a unit were telling analysts that they’d grow production by 5 percent to 7 percent a year— forever—and now their production growth is negative. They didn’t understand their decline curves. Q: Does the market agree with your general outlook? A: No. If it did, oil would be $200 a barrel. Q: Will we get to $200 oil? A: Sure, but I don’t know when. Meanwhile, I keep telling people that $100 for a barrel of oil is cheap. And they ask, “How can you say that?” Well, it’s 15 cents a cup. Do you know of anything else we can buy for 15 cents a cup?]]> tag:www.capitalspectator.com,2008:/WM//5.829 2008-04-17T13:34:46Z 2008-04-18T14:24:15Z

April 2008, Wealth Manager Macroeconomic risk has been low for 20 years. Will the calm survive a stormy 2008? By James Picerno Recessions are inevitable. It’s the timing and depth of economic contractions that keep everyone guessing....

April 2008, Wealth Manager
Macroeconomic risk has been low for 20 years. Will the calm survive a stormy 2008? By James Picerno Recessions are inevitable. It’s the timing and depth of economic contractions that keep everyone guessing.]]> click to enlarge Source: U.S. Bureau of Economic Analysis, Wealth Manager The Great Moderation is visible in absolute terms, too. Examples include real (inflation-adjusted) declines in the quarterly GDP ranging from -0.5 percent to -1.5 percent during the recession of 2001, and -2 percent to -3 percent in the 1990-91 slump. That compares with quarterly dives of nearly -8 percent at one point in the early 1980s contraction and a 10 percent-plus loss in the 1957-1958 downturn. Business slowdowns are also shorter. The last two recessions lasted just eight months, or less than half as long as the average for all previous recessions going back to the mid-19th century. Fewer recessions necessarily translate into longer expansions. The growth periods leading up to the last two economic contractions lasted 92 and 120 months—considerably longer than the average 33-month expansion that prevailed from the mid-19th century through 1981, NBER reports. Additional evidence that the Great Moderation reflects fundamental economic change includes measures of labor growth, wage inflation and industrial output. All have become notably smoother and less volatile in recent years relative to history, reports a 2002 study by the National Bureau of Economics Research (“Has the Business Cycle Changed and Why?” by James. H. Stock and Mark. W. Watson, NBER Macroeconomics Annual: 2002). Consider the jobless rate, which has been swinging in a smaller and lower band compared to decades past. Between 1948 and 1983, U.S. unemployment varied from 2.5 percent to more than 10 percent— a spread of 750 basis points. But in the last 20 years, the jobless rate has fluctuated in a tighter, lower range of roughly 4.0 percent to 7.5 percent. Another striking feature of the Great Moderation is that the smoother macroeconomic ride is a global phenomenon among the developed nations. Echoing the American experience, GDP volatility in Europe, Japan and other mature economies dropped sharply in the 1980s, and has stayed low ever since. What’s behind all the calm? Several theories have been circulating, including improved inventory management, globalization and financial innovation that spreads risk. Another explanation is that the world economy has just been lucky. But the view favored in the academic literature is that central banks have learned a thing or two about keeping inflation under control. In turn, the enlightened supervision over the money supply has fertilized a strain of economic growth that’s more stable and enduring. Central bankers, unsurprisingly, aren’t shy about taking some of the credit. In a speech a few years ago, Federal Reserve Chairman Ben Bernanke (then a Fed governor) said that “improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation.” In fact, the Great Moderation was directly preceded by a sharp fall in the rate and volatility of inflation in the 1980s. A number of economists see a connection. “By achieving low and stable inflation, many analysts argue, monetary policy provides a favorable environment for economic activity generally,” advised a 2005 article in Economic Review, a journal published by the Kansas City Federal Reserve Bank. In addition to economic benefits, the Great Moderation has been cited as a catalyst for higher valuations in the stock market. The rise in equity market valuation in the 1990s and—to a lesser extent—the 2000s is a response to the fall in macroeconomic risk, says a forthcoming study in The Review of Financial Studies (“The Declining Equity Premium: What Role Does Macroeconomic Risk Play,” by Martin Lettau, et. al.). The reasoning is that investors accept a lower prospective equity risk premium (i.e., prices are higher) when economic risk declines. As the paper observes, “It would be surprising if asset prices were not affected by this fundamental change in the structure of the macroeconomy.” Indeed, the U.S. stock market’s priceearnings ratio as of this past January was still in the mid-20s, which is generally the highest in the past 150 years, save for the bubble peaks of 1929 and 2000, according to Yale professor Robert Schiller’s Web site (aida.econ.yale.edu/~shiller). Meanwhile, long-term interest rates are hovering near 40-year lows. Now the obvious question: If lower economic risk rationalizes a lower equity risk premium, might the reverse apply at some point? Answering “yes” seems reasonable. But if GDP volatility scaled its old heights, last seen in the early 1980s, investors may demand a higher premium on stocks as compensation, implying that equity prices would have to fall and perhaps stay low for an extended period. The idea that economic tranquility eventually gives way to a more perilous environment isn’t new. Economist Hyman Minsky, for example, famously observed that stability is unstable. The seeds of higher risk are planted in periods of calm, he advised, because investors pursue higher risk in good times to the point of excess. Eventually the cycle turns, risk is repriced and the lure of easy money is re- placed by a fear of loss, a reversal that lays the foundation for the next boom. On that note, consider that inflation volatility— a key factor associated with the Great Moderation—has been rising recently. Chart 2 shows that inflation volatility recently jumped to levels last seen in the early 1980s, when economic volatility was much higher. Is the rise in inflation risk a harbinger of higher macroeconomic risk, too? click to enlarge Source: U.S. Bureau of Economic Analysis, Wealth Manager The Great Moderation may come under attack from other corners, warns Robert Dieli, an economist who heads the consultancy NoSpinForecast.com. By his reckoning, much of the smoothing in the U.S. business cycle is linked with growth in the foreign outsourcing of the manufacturing sector, which suffers relatively volatile boom-bust swings compared with the calmer services sector that now dominates the American economy. “In the old days, recessions were nothing more than giant inventory cycles,” he explains. Thanks to the growing use of industrial capacity in the developing world, “we’ve been reducing the size and importance of manufacturing,” Dieli says. That, in turn, has smoothed the economic cycles. Along the way, the American economy has become more entwined with the economies of China, India and the developing world generally. The relationship has proven mutually beneficial so far, although the short history of the new world order of globalization only reflects the good times. A study by the International Monetary Fund last October noted that last year, China was the single-biggest contributor to world growth, followed by India in second place and the U.S. in third. Indeed, China’s economy grew more than 11 percent last year—roughly four-times faster than that of the U.S. and Euro region. When growth is robust, it’s easy to overlook the fact that emerging market economies are more volatile compared with the developed world. Upside economic volatility, after all, pleases everyone. But the volatility may not moderate when the cycle turns, as it inevitably must. The challenge, Dieli says, is that the increased dependence on emerging markets hasn’t been stress-tested. The fear is that a sharp downturn in other emerging markets may transmit economic shock into the developed world, effectively ending the Great Moderation in the process. The notion that the emerging markets have decoupled from the U.S. is just a theory, of course, and an unproven one. It’s also a theory on which the Great Moderation’s fate rests, says Quincy Crosby, chief investment strategist at The Hartford. “One of the things we’re going to find out, over the next year or so,” she predicts, “is whether the decoupling thesis that would extend the Great Moderation is a viable thesis after all.” ]]> tag:www.capitalspectator.com,2008:/WM//5.821 2008-04-07T13:37:28Z 2008-04-07T14:32:30Z

March 2008, Wealth Manager Who’s the newest player in the alternative investing business? Vanguard, of course. By James Picerno Mention the name Vanguard and while several images come to mind in the world of money management and fund companies, alternative...

March 2008, Wealth Manager
Who’s the newest player in the alternative investing business? Vanguard, of course. By James Picerno Mention the name Vanguard and while several images come to mind in the world of money management and fund companies, alternative investing probably isn’t among them. Low-cost indexing? Sure. Several well-regarded actively managed mutual funds? Yep, those too. And a growing list of ETFs targeting conventional betas? Absolutely. ]]> How about market neutral? Whoa, market what? That’s not associated with the Vanguard of popular lore, is it? It is now. Late last year, the money management behemoth expanded its strategic horizons by adopting the former Laudus Rosenberg U.S. Large/Mid Capitalization Long/Short Equity Fund, now rebranded as the Vanguard Market Neutral Fund. The “reorganization” of the fund, according to Vanguard’s press release, pairs the existing manager, AXA Rosenberg Investment Management LLC, with the Vanguard Quantitative Equity Group. Strategically speaking, the fund remains more or less the same. Like many long/short portfolios, Vanguard Market Neutral focuses on buying stocks that are considered undervalued and shorting those identified as overvalued—all the while keeping longs and shorts balanced, thus the tag of market neutral. The fund fishes in domestic waters in the mid- and large-cap space. As an added bonus, Vanguard reports that it has lowered the expense ratio relative to the price tag under the previous sponsor, Charles Schwab Investment Management. Vanguard is adopting one of the oldest products focusing on market neutral strategies in a mutual fund wrapper. It doesn’t hurt that the fund has distinguished itself at times, including its delivery of robust returns during 2000 to 2002, a period when stocks generally were tumbling. But why has Vanguard decided to jump into the alternative investment space now, and with this fund? When a company as large and influential as Vanguard moves beyond its core competency of standard betas and conventional money management, the decision invariably attracts attention and raises questions. The rising popularity of alternative investing in general (hedge funds being the obvious example) probably figured into Vanguard’s thinking. In any case, we just happen to be in the questions business and, to be frank, we’re also a little curious. Until now, one could be forgiven for thinking that Vanguard was immune to all the portfolio-engineering strategies that have become increasingly common. So, what’s changed? In search of an answer, we called Vanguard’s Joe Brennan, principal of the firm’s portfolio review group which selects and oversees managers for the company’s products. Q: Your new market neutral fund is Vanguard’s first alternative strategy portfolio sold publicly. Is the company’s investment philosophy changing? A: No, because we’ve always been in favor of diversification and low costs. And that’s exactly what this fund represents. Alternative strategies are mainly diversifiers—there’s no magic there. They’re set up in a way that the return series is unrelated to the traditional asset classes. We’re proponents of that for portfolio construction reasons. We also believe that any investment strategy should be able to overcome its cost hurdle. We’re bringing this fund out with an expense ratio that won’t be a headwind to the alpha. I’m not sure that’s the case with all the alternatives in the marketplace. Our expense ratio is low and probably will be the lowest in the marketplace. Q: How low is low? A: It’s a little tricky. The stated expense ratio for the investors’ shares is 200 basis points and 190 basis points for institutional investors. But those numbers include what’s called the expense for short-sale dividends, which are about 150 basis points. So what the shareholder is really experiencing for expenses is 50 basis points, which is the operating expense ratio for the investors’ share class. In other words, there are factors on the long side of the portfolio that offset the 150 basis points on the short side. In one of our regular long funds, if you look at the gross and net returns, the difference is roughly the expense ratio. In this case, the expense ratio is 200 basis points, but the difference between the gross and net returns is 50 basis points, which is the equivalent of the operating expense ratio. So it’s the lowest of its kind, and we’re proud of that. Q: Is this the first time Vanguard has “adopted” an existing fund? A: We’ve done adoptions before. We have three funds that were adopted, meaning that we took them over as the fund sponsor from the prior sponsor, and so the shareholders become Vanguard shareholders and the fund becomes a Vanguard fund. In this case, the advisor, AXA Rosenberg, remains on board, and we’re adding our quantitative equity group as the second advisor. Q: Why offer a market neutral fund now? A: We were contemplating launching this type of fund on our own. At the same time, there was an opportunity to adopt a fund from an advisor [AXA Rosenberg] we know well—an advisor that runs money for us in other portfolios. So the stars aligned with respect to adopting a fund that we were thinking of launching anyway. Meanwhile, the fund meets a client need; we think it’s a good long-term solution because it’s a diversifier. We think it will have a lot of appeal to institutions, endowments, foundations as well as high-net-worth clients who are looking for another diversifier. Q: Has Vanguard managed market neutral funds previously? A: We didn’t have a fund for public purchase, but we were running the strategy, although we didn’t have clients in the strategy. We test a lot of strategies in-house before offering them to shareholders. Q: Some might say that this is a marketing decision, and that Vanguard’s jumping on the alternative-investing bandwagon. A: Again, we think the market neutral fund is another diversifier for clients. We’re not going to offer something because it’s hot or a fad—that’s not our style. In fact, when we publicly announced our plans last August, there were a lot of articles about quantitative managers and long/short funds hav- ing a lot of trouble. If anything, our timing was against the grain of what was popular. But this is something that was thought through carefully, and it had nothing to do with the current market environment. Q: Your market neutral fund is quantitatively managed. Is that a new approach for Vanguard? A: We’ve embraced quantitative management for some time. We have our own internal quant group as well as relationships with four external quant managers. Some of our largest funds are quantitatively managed, including a big chunk of Windsor II and a piece of our Explorer fund. Q: There’s a $250,000 minimum for the market neutral fund—why so high? A: The natural buyer for this fund is an institution that’s looking for a diversifier and low volatility, but isn’t particularly sensitive with respect to taxes. So, we thought the higher minimum was appropriate for the target market. All else equal, if the natural buyer is an institution, the fund has better economics if the minimum is higher. Q: Sounds like no one will confuse the fund with a tax-efficient portfolio. A: I wouldn’t necessarily recommend this for taxable assets because of what will be thrown off from the gains, which are realized relatively quickly because of the turnover with the longs and the shorts. The turnover will be relatively high, probably ranging between 100 percent and 200 percent [a year]. When you get up into that turnover range, it’s probably not as tax efficient as some other options. So, the fund’s really better for tax-sheltered assets, endowments, pension funds, or an individual with a very large tax-exempt portfolio looking for a diversifier. Q: Why are the fund’s assets so meager? as of this past October, the fund held just $14 million, according to Morningstar. A: One of the reasons is that Schwab had three market neutral funds and they were probably more interested in one than another. So Schwab was interested in talking to us about adopting the fund. We’re hoping it grows, and with the lowering of expenses and the quality management, I’m sure it’ll attract investors. [The Laudus Rosenberg long/ short adopted by Vanguard was formerly a member of Schwab’s Laudus family of funds. In fact, Schwab had intended to shut down the fund because its strategy was similar to two other Schwab funds, a Schwab spokeswoman told Bloomberg News last September.] Q: The appeal of adopting this fund boils down to what? A: The manager [AXA Rosenberg Investment Management LLC], certainly. It’s a manager running two other portfolios for us. We could have and would have started a fund like this anyway with this manager and an internal team at Vanguard. But it’s just easier to have the shell already created. And, yes, it had a low amount of assets, but it’s easier to get a fund off the ground that already has assets. Q: Morningstar labels it a long/short fund, and by that standard its trailing threeyear returns looking middling. A: You should compare it against a market neutral universe. Keep in mind that the long/short universe includes funds that don’t match their longs with their shorts, so they can be net long or net short. Our fund is run as a complete offset in terms of the amount of longs and shorts. So, if you look at the fund in terms of the Lipper market neutral group, it’s almost at the top of the category. For the three years through November 30, 2007, the fund was up 9.16 percent annualized versus the category’s 4.09 percent. The way to think about this fund is its attempt to isolate the manager’s alpha generated by both the long and short positions. The fund’s return will be a cash return plus or minus the alpha—alpha that, hopefully, is a plus, and in fact has been a plus so far. Meanwhile, the correlation for this type of strategy is very low with a general stock or bond portfolio. tag:www.capitalspectator.com,2008:/WM//5.799 2008-03-04T13:57:20Z 2008-03-04T14:26:53Z

March 2008, Wealth Manager Is it also smart as a strategic portfolio holding? By James Picerno Foreign exchange can be a quandary for investment strategy. Currencies generally suffer an expected return of zero in the long run, a shortcoming that...

March 2008, Wealth Manager
Is it also smart as a strategic portfolio holding? By James Picerno Foreign exchange can be a quandary for investment strategy. Currencies generally suffer an expected return of zero in the long run, a shortcoming that raises questions about the strategic value of the asset class. But for shorter periods, forex risk can enhance portfolio diversification and boost risk-adjusted performance. Whatever their charms, currencies in pure form traditionally have had limited appeal for the wealth management business. To the extent that investment strategy for individual clients has embraced forex, it’s usually tapped indirectly—almost as an afterthought—through allocations to unhedged positions in foreign stocks and bonds. ]]> “I can think back to a time in the late 1990s when the dollar was all powerful, and everybody at that time—or a large majority of investors—was essentially dismissing the idea of having any assets outside the dollar,” recalls Kunal Kapoor, chief investment officer at Morningstar Investment Services. “Fast forward to today, and you have the reverse going on.” One reason that American investors are taking a fresh look at forex is because diversifying out of the greenback is easier, thanks to a growing list of currency-focused ETFs and mutual funds. More importantly, there’s a growing concern that the buck is susceptible to devaluation in the years ahead, a suspicion that’s been fueled by the dollar’s slump last year as well as various macroeconomic warning signs such as a widening U.S. trade deficit and a decline in individuals’ savings rates in America relative to other countries. Whatever the reasons, forex is attracting attention as a strategic holding. “Currency risk certainly intrigues us,” says Jerry Miccolis, senior financial advisor at Brinton Eaton Wealth Advisors in Morristown, N.J. “A currency play is something we’ve discussed and debated,” although the firm continues to favor unhedged positions in foreign stocks and bonds for owning currencies. At Main Management LLC in San Francisco, portfolios for high-net-worth clients may hold as much as 5 percent in a currency ETF that specializes in the so-called carry trade—holding currencies in countries with relatively high short-term interest rates and shorting the lower-yielding ones. Diversification is the selling point, says Kim Arthur, the firm’s CEO. He expects that PowerShares DB G10 Currency Harvest ETF (DBV) will earn equity-like returns and post low correlations with the stock market over time. Currencies were added to the strategic mix three years ago for individual clients of Lehman Brothers, reports Aaron Gurwitz, managing director of the portfolio advisory group at the firm’s private investment management division in New York. “Most prospective and current clients have a larger proportion of their investment portfolios denominated in U.S. dollars than we think advisable,” he says. “Generally, we recommend that U.S.-dollar- based clients have at least 25 percent of their investments in vehicles not denominated in U.S. dollars.” Gurwitz favors several strategies for accessing forex, ranging from unhedged foreign equities to structured notes that are indexed to the performance of one or more currencies. Lehman also uses a privately managed fund run by Samson Capital Management in New York. Samson’s currency program seeks to outperform the inverse of the U.S. Dollar index, a popular benchmark of the greenback as measured by the leading foreign currencies. The fund is notable because most of its investors are high-net-worth individuals. The dollar’s decline of late has aided the tactical allure of currency funds, but is there a case for a dedicated currency allocation as a long-term proposition? Yes, thanks to the evolution of the global economy, says Jonathan Lewis, a portfolio manager at Samson who chairs the firm’s investment committee. For decades after World War II, the United States was the undisputed “economic hegemon,” Lewis explains. Standing atop the world economy simplified the investment outlook for several generations of Americans. “One of the benefits was the wonderful experience of not having to worry about the rest of the world. The thinking was that you could be fully invested in U.S. dollar-denominated assets and capture the lion’s share of the world’s best opportunities.” In 2008, fewer investment strategists see America’s opportunities in the global economy in such starkly positive terms. To be sure, the U.S. remains the planet’s largest economy and by several crucial measures remains an attractive destination for capital investment. What’s changed has less to do with the decline of America, real or perceived, and more with the rise of competition—particularly in the developing world. Lewis emphasizes that America represents a large, but declining piece of an expanding investment pie. “The U.S. economy, while important and dominant, doesn’t reflect the opportunity set of all the best possible choices,” he says. As globalization expands its reach and influence, foreign assets should be reflected in investment portfolios. “If more and more of your basket of goods is coming from other places, you should, as a conservative investor, have some exposure to those places [for reasons that go] beyond whether or not you have an equity market outlook in those places.” The academic argument for always holding some foreign currency risk in investment portfolios dates to at least 1989 and Fischer Black’s “Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios” in the Financial Analysts Journal. Black offers a simple formula for estimating how much to hedge foreign currency exposure. The formula has three inputs, each calculated from the average across individual countries for * expected excess return on the world market portfolio (R) * volatility of the world market portfolio (V) * the average across all pairs of countries of exchange rate volatility (E) The data points are then analyzed as R - V^2 ----------- R – (1/2*E^2) The result produces what Black identifies as the “optimal hedge ratio,” or “the fraction of your foreign investments you should hedge.” The paper concludes that all investors, regardless of country, should hedge only a portion of their foreign investments. Why not hedge away forex completely? Because “taking some currency risk” boosts a portfolio’s expected returns, he advises. The challenge is deciding how much currency exposure is optimal. The answer partly relies on the risk and return objectives of the investor. The markets are a factor, too. Returns and volatilities fluctuate over time, and so Black’s hedging ratio varies, depending on the historical period chosen for analysis. In his paper, Black cites two examples drawn from slightly different stretches of market data in the 1980s. He writes that the two results for the recommended portion of a portfolio to hedge dollar exposure were 30 percent and 73 percent. That leads Black to warn, “Straight historical averages vary too much to serve as useful inputs for the formula. Estimates of long-run average values are better.” Estimating future input values is necessarily subjective, but the larger message is that no investment portfolio should be 100 percent hedged against forex risk. The reason is due to the fact that the rise of one currency relative to another is always larger in percentage terms than the percentage depreciation in the other. That leads to the conclusion that investors in any two currencies, for instance, can boost expected returns by holding both currencies. The phenomenon—known as Siegel’s paradox—was first noted more than 30 years ago by economist Jeremy Siegel (“Risk, Interest Rates, and Forward Exchange,” Quarterly Journal of Economics, May 1972). While there’s an academic case for always holding some degree of forex risk, most wealth managers prefer tapping currencies through unhedged foreign stocks and bonds. One motivation is efficiency. A 15 percent allocation to currencies proper, for instance, means pulling assets from somewhere else. “Whatever assets you use to place a currency bet, you don’t have to invest elsewhere,” says Brinton Eaton’s Miccolis. Alternatively, investing in unhedged foreign stocks or bonds delivers a currency and securities stake, effectively providing a two-for-one deal. “We get our currency diversification straight through equity index funds that we use,” Rick Ferri, founder and CEO of Portfolio Solutions LLC in Troy, Mich., tells Wealth Manager. “Direct [currency] overlays are fine if you’re managing very large sums of money.” Short of super wealthy individuals or institutional portfolios, currency diversification by way of unhedged stock and bond funds is the better choice, he asserts. Echoing Miccolis’ point, Ferri notes that pure currency allocations, and so-called alternative strategies in general, may incur an opportunity cost in the long run. Funding an allocation in currencies by taking it out of equities may look attractive on a short-term basis. “Yes, you may lower the overall risk of your portfolio,” he concedes, “but there’s a very good likelihood that you’ll also lower the return.” Nonetheless, there’s a bull market in bringing exotic betas and alternative strategies to the masses via publicly traded funds. But in his recently published The ETF Book (Wiley, 2007), Ferri counsels that there’s a risk that the expected diversification benefits may be offset by fees, inflation and a lower tax efficiency. Regardless, innovation in ETFs rolls on. “Hopefully,” Ferri writes, “the fees to invest in those products will be low enough so that they benefit buy-and-hold portfolios as well as an active trading portfolio.”]]> tag:www.capitalspectator.com,2008:/WM//5.783 2008-02-04T14:18:31Z 2008-02-04T14:57:06Z

February 2008, Wealth Manager It’s an election year, and politically charged tax talk is back. As an antidote, we offer a brief review of tax history. By James Picerno This being a presidential election year, taxes are topical all over...

February 2008, Wealth Manager
It’s an election year, and politically charged tax talk is back. As an antidote, we offer a brief review of tax history. By James Picerno This being a presidential election year, taxes are topical all over again. As an added incentive for chattering about fiscal matters generally, there’s a vigorously rising price tag for government programs— notably Medicare and Social Security—and questions about how to pay for the bills going forward. Indeed, the government budget is firmly in the red. As if that combination wasn’t sufficiently provocative and challenging, the Bush tax cuts enacted a few years back are set to expire in 2010 unless Congress intervenes. ]]> An obvious follow-up question: What are the major sources for the tax revenue? The single-largest font of payments to the IRS comes from individuals, who collectively accounted for about 43 percent of the total revenues in 2006. That’s about average since the early 1960s, as Chart No. 2 below illustrates. The second-largest revenue source comes from social insurance taxes, which include paycheck deductions for Social Security and Medicare. In fact, these taxes have been rising as a share of total revenues. In 1962, social insurance taxes represented 17 percent of payments to the IRS; in 2006, the share had surged to almost 35 percent. In a not unrelated trend, corporate taxes over that span have fallen, from around 21 percent of the revenue pie in 1962 to just under 15 percent by 2006. Collecting taxes is, of course, only a prelude to spending, which falls into two broad categories. On one side is what’s known as discretionary spending, a domain that exists at the mercy of Congress by way of its annual budget negotiations. Everything from funding the defense department to launching a new government study on the sex life of the bald eagle is subject to approval each year. Then there’s mandatory spending, which comprises the other major chunk of government expenditures. As the name implies, this is recurring spending that’s outside the usual budgetary review. Spending on Social Security and Medicare, for example, are mandatory programs. Although Congress ultimately decides the fate of mandatory spending, it tends to be enduring, in part because of politics and the fact that this slice of government largesse isn’t subject to the whims of the annual appropriations process that dictate discretionary spending. Comparing the two categories in terms of their respective shares of the economy reveals that discretionary has been losing ground to mandatory, as our third chart below shows. Mandatory programs have slowly but relentlessly come to dominate federal government spending. As a result, to the extent that Social Security, Medicare and other mandatory programs require more funding due to inflation and other causes, higher government spending is predestined. Finally, there’s the ever-contentious subject of tax rates for household incomes. We offer three perspectives: First up is the big picture as defined by the highest marginal income tax rates through time. As the fourth chart below depicts, the highest rate for households has wandered over the years. Back in the 1950s and 1960s, the wealthiest Americans were hit with rates as high as 91 percent. By that standard, the top rate of 35 percent for 2006 looked like a bargain. Chart No. 5 below considers the total effective Federal tax rates for households in the upper levels in recent history. (Effective tax rates are calculated by dividing taxes by comprehensive household income.) The effective Federal tax rate for households in the top 1 percent, for example, was 31.1 percent in 2004—just barely below its average since 1979, according to the Tax Policy Center, a Washington think tank. Finally, to round out our statistical tour of taxes, consider households at the bottom income levels. The effective Federal tax rates for the lowest quintile in 2004 was at its nadir for recent history, as you can see from Chart No. 6 below. The same is true for the middle quintile. All of which leads to the question of what’s in store for tax rates in 2009 and beyond? This much, at least, seems clear: Individuals will surely continue suffering the heavy lifting in terms of sending checks to the IRS. The great debate, once again, centers on the case for changing, if at all, the burden among the various income brackets. How progressive, in other words, should America’s tax system be? We predict a tidal wave of politically motivated responses coming over the next nine months. ]]> tag:www.capitalspectator.com,2008:/WM//5.762 2008-01-18T14:53:45Z 2008-01-18T14:55:19Z

January 2008, Wealth Manager Does thinking in risk-adjusted terms increase the supply of alpha? By James Picerno Alpha is widely viewed as a zero sum game, and so for every investor who beats the market, someone must trail it. If...

January 2008, Wealth Manager
Does thinking in risk-adjusted terms increase the supply of alpha? By James Picerno Alpha is widely viewed as a zero sum game, and so for every investor who beats the market, someone must trail it. If this balancing act accurately describes how the money game works, there’s a limited supply of alpha—which is to say something other than beta. And of this finite quantity, then only half is positive alpha. ]]> Bernoulli’s hypothesis challenged the era’s conventional wisdom for making decisions under conditions of uncertainty. Rather than picking the strategy that offered the highest expected value, Bernoulli’s model favored the highest expected utility. As a result, two people faced with the same decision and looking at the same data could reasonably come to different conclusions in Bernoulli’s world. Why? Because expected utility varies depending on a person’s preferences. Fast forward several centuries and utility theory figures prominently in the explanation of why tactical asset allocation (TAA) holds out the potential for raising expected returns with little or no corresponding rise in expected volatility. At first glance, the apparent free lunch appears to run afoul of modern portfolio theory, which equates higher return with higher risk. But here’s where utility theory steps in. “The linkage between risk and reward is not inviolate [in TAA] if a higher-return strategy has lower ‘utility’ than a more comfortable but less-rewarding strategy,” wrote Robert Arnott (head of Research Affiliates and Darnell’s predecessor at First Quadrant) in The Portable MBA in Investment (1995, Wiley). TAA doesn’t offer the so-called free lunch, but it “succeeds because total return and investor utility are not one and the same thing. When wealth is declining, most investors seek the solace of lower risk, hence lower exposure to risky markets,” Arnott advised. “Tactical asset allocation potentially enhances long-run returns without increasing portfolio risk, but at a cost of lower comfort, hence lower utility, for many investors.” Explained another way, raw performance numbers and risk-adjusted returns exist in parallel universes. Each has a distinctive set of rules and the two measures are related. But the calculus of investing that works smoothly in one universe can malfunction in the other. That, at least, is part of the explanation for the reason why alpha may not sum to zero. Yes, alpha ultimately balances out in the world laid out in Sharpe’s 1991 paper. But if you consider a more nuanced framework, the standard assumptions may not hold. Even so, the notion of alpha summing to zero in the return-only space provides a powerful warning that’s not easily dismissed. “When Bill Sharpe wrote ‘The Arithmetic of Active Management,’ the way he said it is indisputable: The average manager can’t outperform the average,” asserts Ronald Kahn, global head of advanced equity strategies at Barclays Global Investors in San Francisco. Kahn’s view is notable for several reasons. First, he and Richard Grinold share billing for the creation of the so-called fundamental law of active management, which quantifies the idea that generating alpha is dependent on opportunity plus skill and the frequency of its application. Although Kahn works at Barclays, the world’s largest indexer, he oversees research for the firm’s nearly $500 billion in active quantitative strategies. Kahn, in short, is a card-carrying believer in active management. Yet he also recommends caution for thinking that alpha’s supply may be greater than tradition suggests. In fact, he warns that after adjusting returns by some measure of risk, alpha probably sums to a negative number. The odds of producing positive alpha, in other words, may be less favorable than is widely assumed—even among the zero sum crowd. “I think that’s a healthy way to think about it,” he says. Another veteran investment strategist agrees. “You can have academic debates about whether alpha’s a zero sum game,” says Robert Jaeger, chief investment officer of EACM, a division of BNY Mellon that oversees $5 billion for institutional investors— more than half allocated to hedge funds. “But my working assumption and a guiding principle is that it is a zero sum game.” The hedge fund business, Jaeger adds, is no exception. Steven Foresti echoes Jaeger’s caution. “I wouldn’t be persuaded to abandon the zero- sum game idea,” says the managing director of research for Wilshire Consulting, a unit of Wilshire Associates. “I suppose you can make theoretical arguments that investors have different objectives. Some are laying off risk while others are trying to beat the market, for example. But in the aggregate, it really does come back to the ‘Arithmetic of Active Management.’” Foresti argues too, that the more competitive markets become, the more likely that alpha will sum to zero— especially over time. That doesn’t invalidate active management, but it does help keep investors sober about the nature of the game, he says. Recognizing that returns-based alpha sums to zero boils down to common sense, suggests Laurence Siegel, director of research in the investment division of the Ford Foundation, which favors active management for its $13 billion-plus portfolio. “You should know the rules of the game before you start to play,” he says. Otherwise, you shouldn’t be playing, he adds. But which set of rules? Each one is valuable for thinking about the limits and opportunities of investment strategy. One reminds that everyone can’t be above average; the other asserts that risk matters. Giving up one or the other seems hopelessly misguided. Alas, the two principles aren’t easily reconciled into one strategic vision. Perhaps one day a brainy financial economist will win a Nobel by figuring out how to integrate them. ]]> tag:www.capitalspectator.com,2008:/WM//5.761 2008-01-18T14:12:38Z 2008-01-18T14:52:53Z

January 2008, Wealth Manager A strategist discusses why alpha’s horizons may be broader than you think. By James Picerno Chess is one example, poker is another. But is investment alpha a zero sum game, too? Do the winners in money...

January 2008, Wealth Manager
A strategist discusses why alpha’s horizons may be broader than you think. By James Picerno Chess is one example, poker is another. But is investment alpha a zero sum game, too? Do the winners in money management always triumph at the expense of the losers? ]]> Many if not most investors accept the equilibrium of alpha as a zero sum game. And so it is for investment returns generated from a specific opportunity set, such as the stocks in the S&P 500. But what happens if we add risk into the equation? Does alpha still sum