Wealth Managertag:www.capitalspectator.com,2010:/WM/52010-03-05T15:15:00ZMovable Type 3.33INCLEMENT WEATHER FOR JOBStag:www.capitalspectator.com,2010:/WM//5.13222010-03-05T14:57:04Z2010-03-05T15:15:00ZIt’s the weather, they say. The loss of 36,000 jobs in last month’s nonfarm payroll count may have been a victim of the snow, the Labor Department advises with this morning’s release of the February employment report. The unemployment rate,...
February employment report. The unemployment rate, at least, was unchanged last month, albeit at a high 9.7%.]]>
told Bloomberg Television. “We’ve got positive jobs growth in there, we just can’t see it” because of the “weather effects,” she asserts.
Maybe we've been snow blinded, but The Economist's Free Exchange blogger this morning isn't quite so upbeat in reaction to today's employment report: "…a sideways movement in labour markets is a setback at this point. The economy must create over 100,000 jobs per month just to keep up with population growth, and it should be averaging monthly payroll increases of over 250,000 to reduce the unemployment rate at the same pace as in the first year of the 1983 recovery."
Upbeat or not, all of this leaves just one choice: Hoping for a spring thaw with the March numbers. Meanwhile, if we take the February report at face value, we're looking at a familiar trend in the employment picture: low-level losses and the tantalizing possibility that gains are near. But not yet. Damn those winter storms.
Save for last November's 64,000 rise in nonfarm payrolls, 25 of the last 26 months have shed jobs. The red ink for nonfarm payrolls now stands at 8.4 million lost jobs, according to the Labor Department.
As for February, the losses were relatively light, compared with the carnage in the first half of 2009, but that's increasingly a thin reed for those trying to rationalize the numbers du jour as the moment of rebound slips ever forward.
At best, it was a mixed bag for last month's employment changes among the various subgroups that comprise the total nonfarm payroll number. Construction suffered the biggest hit, unsurprisingly, given the weather, losing 64,000 positions. The services sector almost but not quite picked up the slack, posting a 42,000 rise. But that masked the negative trend within the services sector last month, with one dubious exception. Indeed, the big winner among services firms in February came in temporary help services, which added nearly 48,000 jobs last month. Every bit of gain helps, of course, but that's not exactly the corner of the economy where expansion breeds bullish sentiment at this point.
Overall, there's a growing risk that the labor market will languish for an extended period. The big losses, perhaps any loss in nonfarm payrolls is behind us. But that's not good enough to begin the hard work of laying the foundation for even modest economic growth in the near term. More than two years after the Great Recession began, the labor market is still suffering, albeit suffering due to a lack of job creation. It's not obvious that this risk is factored into the crowd's sentiment, but another month or two of moving sideways in the labor market and there may be hell to pay.
Meantime, we'll be watching the weather forecasts. March has come in like a lamb and so the month may go out with a meteorological panthera leo.
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ARE TIPS BROKEN?tag:www.capitalspectator.com,2008:/WM//5.10002008-12-29T16:01:13Z2008-12-29T16:06:22ZSeptember 2008, Wealth Manager Has the Treasury market stumbled in anticipating inflation? Does it even matter? By James Picerno Inflation is upwardly mobile again, or at least it was before the financial crisis exploded. Pricing pressures may fade until the...
September 2008, Wealth Manager Has the Treasury market stumbled in anticipating inflation? Does it even matter?
By James Picerno
Inflation is upwardly mobile again, or at least it was before the financial crisis exploded. Pricing pressures may fade until the economic and financial ills stabi¬lize. Regardless of inflation’s future path, the jump in consumer prices in the past several years seems to have caught inflation-indexed Treasuries, a.k.a TIPS, off guard. That has led some observers to question the bonds’ merits as inflation hedges. But such worries are misplaced even though TIPS have been less than dependable as a window on prospective inflation.
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What, then, are we to make of the fact that this real-time measure of anticipated infla¬tion was running in the 2.0%-to-2.8% range (based on 10-year Treasuries) for the five years through the end of August, as the chart above shows? That’s well below the reported 3.5% annual rise in the consumer price index (CPI) over the same time frame.
The government bond forecast for inflation looks even worse if you consider that the reported annual rate of inflation has been steadily rising in recent years, save for a year-long break through the summer of 2007. As of this past August, CPI rose 5.4% for the previous 12 months—or roughly twice as high as the average inflation forecast embedded in Treasuries for much of the past five years.
“That’s a pretty significant disconnect,” says Ben Thomp¬son, a principal at Samson Capital Advisors, a New York-based fixed-income boutique catering to high-net-worth and institutional clients.
Does that mean the market-based inflation forecast is irrelevant? Or, perhaps prospective inflation is a lot less threat¬ening than recent history suggests? The sharp drop in crude oil prices this past summer, along with a weakening economy, certainly suggests that pricing pressures are set to ebb.
No one can say for sure, of course. Only time can make definitive judgments about the accuracy of market predic¬tions, leaving investors to decide on a prediction. Meanwhile, this much is clear: The track record of inflation relative to the Treasury-based outlook for prices leaves plenty of questions, including: Is the TIPS market a defective asset class? If so, should investors rethink the use of inflation-indexed Treasur¬ies as a strategic holding in a diversified portfolio strategy?
No, at least not based on the seemingly erroneous infla¬tion forecast spawned by Treasuries in recent years. Even if the Treasury-TIPS spread is faulty, it’s not obvious that the problem is tied to inflation-indexed Treasuries. Yes, the market-based forecast of inflation arises from yields on two series of government bonds, but the burden of proof isn’t equally distributed.
Recall that TIPS offer investors an opportunity to lock in a real (i.e., inflation adjusted) yield for the life of the bond. If you bought a newly issued 10-year TIPS with a 2% coupon, you’re guaranteed to receive that real yield for the next de¬cade if you hold to maturity. Inflation may subsequently soar to hyperinflation or fade to deflation, but the 2% real yield remains intact. To the extent that government guarantees on bonds are reliable in this world, the TIPS real yield is as dependable as it gets.
TIPS, to restate the obvious, are immune from inflation (as defined by CPI). That’s the basis of their appeal. Not so for conventional Treasuries, which only guarantee a nominal pay¬out. TIPS, then, are a hedge on rising inflation; a security that allows investors to lock in a real current yield. But how does one square that utilitarian profile with the poor track record of inflation forecasting via Treasuries?
“It’s definitely the case that [the Treasury-TIPS spread] underpredicted the inflation we’ve seen over the last few years,” says James Hamilton, an economist at the University of California at San Diego.
Yet a defective inflation forecast isn’t a death sentence for TIPS’ inflation-hedging capabilities. Anticipated or not, TIPSinvestors are compensated for any higher-than-expected infla¬tion. As CPI’s pace rise, so too do TIPS’ payouts—an adjust¬ment that’s business as usual for maintaining a real yield.
The future will offer no less an opportunity to hedge infla¬tion, regardless of the accuracy—or inaccuracy—of the overall Treasury market’s predictions. In fact, opportunistic investors should be hoping that the Treasury market continues to soft pedal the risk of future inflation.
“If you think inflation over the next 5 to 10 years is going to be higher than the breakeven yields seem to say, then you should be buying TIPS and dumping the nominals,” Hamilton advises. “If you think that TIPS are underestimating inflation, they’re a good buy because you think they’ll go up [in price] and experi¬ence a bigger [nominal] capital gain than the market expects.”
Recall that buying TIPS locks in a real yield, meaning that the nominal yield fluctuates with the CPI trend. That opens the door for bigger-than-expected nominal returns with inflation-indexed Treasuries if the market underprices infla¬tion’s potential.
Imagine it’s August 30, 2003, and you’re considering the breakeven spread for conventional and inflation-indexed gov¬ernment bonds. At the time, the Treasury spread anticipated inflation at just below 2.2% for the decade ahead. Halfway into that forecast (by the end of August 2008), reported inflation was running at about 3.7% a year for the previous five years—or more than two-thirds higher than forecast in August 2003.
The 2003 prediction turned out to be wrong, at least at the five-year mark. Yet it’s worth pointing out that the 2003 forecast looked like a reasonable guess at the time. Consumer prices rose just 2.2% for the year through August 2003, or virtually identical to the Treasury breakeven spread at that point.
Reasonable at the time, perhaps, but it still looked wrong in August 2008. But if you think that an erroneous inflation pre¬diction weighed on TIPS as an investment from 2003 through 2008, think again. Consider that the five-year trailing returns for the TIPS-focused Vanguard Inflation Protected Securities mutual fund (VPSIX) handily beat its investment-grade bond counterparts. Even substantially lengthening average maturity and duration in a portfolio of conventional Treasuries was ef¬fectively a wash against outdistancing TIPS.
The proof that TIPS can shine even when the Treasury spread forecast stumbles also comes from a more direct com¬parison of performance via inferring returns based on current yields on August 31, 2003. The 2.29% real yield for 10-year TIPS on that date proved superior compared to the 4.45% for the current yield on the nominal 10-year Treasury—if we fast forward five years and adjust for inflation. Indeed, a 4.45% nominal yield fades to 0.85% after CPI’s pace for the five years through August 31, 2008.
If TIPS have done relatively well in the wake of a flawed inflation forecast, who pays the price for the error? Owners of conventional Treasuries, of course, as the inferred real yield analysis above suggests.
“TIPS have proven to be a great inflation hedge because the market forecast for inflation, represented by the [yield] differ¬ential has been so consistently wrong,” says Timothy Wilhide, comanager of The Hartford Inflation Plus Fund. “It’s not the TIPS market that’s wrong; it’s the nominal market that’s overly optimistic on inflation,” at least as far as reported CPI goes.
There are a number of theories about why the conventional Treasury yield remained so low in the face of rising inflation. The so-called global savings glut that channels foreign export earnings into Treasuries is one idea; others are rising demand for the safe harbor of Treasuries and optimism that inflation will soon cool.
Whatever the reason, it doesn’t change the fact that TIPS function in two capacities. As a partner with conventional Treasuries, TIPS offer a real-time forecast of inflation. TIPS also provide the opportunity to secure a real yield. It’s debat¬able if a given real yield will suffice, but to the extent it does, there’s no reason to question its reliability.
Well, almost no reason. There’s debate about whether the underlying inflation benchmark adequately compensates for pricing pressures in the real world. But if you accept CPI (or tolerate it), TIPS are a tough act to beat. In fact, they’re the true investment benchmark for U.S. investors since they offer the only inflation-hedged yield guarantee that’s free of princi¬pal risk. Just remember: the guarantee ends there.
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CAN IT HAPPEN HERE?tag:www.capitalspectator.com,2008:/WM//5.9422008-10-21T13:44:47Z2008-10-21T13:49:37ZSeptember 2008, Wealth Manager The allure--and complications--of foreign exchange-listed hedge funds. By James Picerno Wealthy individuals and institutions dominate hedge fund investing, but the mainstreaming of these products rolls on. Strategies that traditionally have been available only in the shadowy...
September 2008, Wealth Manager The allure--and complications--of foreign exchange-listed hedge funds.
By James Picerno
Wealthy individuals and institutions dominate
hedge fund investing, but the mainstreaming
of these products rolls on.
Strategies that traditionally have been
available only in the shadowy world of privately offered
hedge funds are increasingly popping up in mutual funds
and exchange-traded products. A recent example is
JPMorgan’s June launch of the first exchange traded note
that hugs a 130/30 index—a popular long/short strategy
in the alternative investment space. There’s also a growing
list of so-called publicly registered hedge funds and managed
futures funds with relatively low minimums.
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Whatever U.S. investors think of the idea, listed hedge funds
are a growth industry. The rising level of assets under management
is one clue. Another indication of the trend is the rising
presence of listed hedge funds in stock market benchmarks.
As of this past May, eight of the London-listed funds of hedge
funds had sufficient size and trading liquidity to earn
a spot in the FTSE U.K. All-Share index.
The basic design of listed hedge-funds is
akin to a U.S. closed-end fund. As a result,
market prices can and do fluctuate around net asset value,
which creates an extra layer of opportunity, as well as risk in the
form of discounts and premiums.
There are a number of investor-friendly features with listed
hedge funds, but what’s in it for the issuers? First is the ability
to transfer the redemption burden to the secondary market
for trading shares. That’s a potentially large benefit for funds
holding illiquid investments, since it allows management to
minimize, if not eliminate, the potentially destabilizing task of
meeting large redemption requests at awkward moments.
Marketing is another plus. Some institutional investors,
including some pension funds, are prohibited from buying
unlisted securities. By listing hedge funds on exchanges, managers
can broaden their investor base.
Yet hedge fund managers that go the exchange route don’t
go all the way. According to ABN AMRO, all managers with
listed funds raise the bulk of assets by means other than
floating shares.
Despite the plusses, U.S.-based investors should not dive
into the pool of listed hedge funds blindly—if at all. Taxes and
foreign currencies are complicating factors. Another potential
problem: Some listed hedge funds shun U.S. investors.
“There are a number of companies that formally state that
there must not be any U.S. investors on the shareholder register,”
says Mark James, who follows listed hedge funds for ABN
AMRO in London.
That’s not an obvious obstacle, since U.S. investors can
generally find a way to buy whatever they want on foreign
stock exchanges. In fact, the Greenwich, Conn.-based Interactive
Brokers recently confirmed for Wealth Manager that
trading London-listed hedge funds was just a keystroke away
for U.S. clients.
Taxes and forex, however, are not so easily resolved. “My
current understanding is that U.S. investors should not
invest in listed funds in taxable accounts,” advises Mebane
Faber, portfolio manager at Cambria Investment Management
in Los Angeles. The trouble stems from what’s known
as passive foreign investment companies (PFICs). Given the
rather harsh treatment for U.S. investors regarding PFICs, it’s
best to own listed hedge funds in tax-deferred accounts, such
as an IRA, he says.
None of this discourages Faber, who reports that he’s
looking at LSE-listed hedge funds as possible investments
for Cambria’s high-net-worth clients. He cites the usual
hedge fund charms, such as bringing diversification to a
portfolio of conventional assets. Meanwhile, with listed
funds “You get around a lot of the problems you otherwise
have with [non-listed] hedge funds,” he explains. “There are
no liquidity issues, there are no lockups, and there’s a lot
more transparency.”
That leaves the foreign exchange issue. Purchases of London-
listed hedge funds necessarily clear in sterling. Unless
you’re interested in making a bet on the pound, buying an
LSE-listed fund requires an offsetting forex hedge. Fortunately,
forex hedging is easy and inexpensive with options,
foreign currency ETFs and other products.
But let’s not kid ourselves: Even the most rabid U.S.-
based hedge fund advocates will probably never look at a
foreign-listed hedge fund—much less buy one. Given the
complications and risks of offshore investing even in the
21st century, perhaps it’s all for the best.
That leads to the question of why there are no exchangelisted
hedge funds in America. In search of answers, Wealth
Manager spoke with a number of sources, ranging from a
spokesman at the SEC to analysts and lawyers specializing
in hedge funds. A typical response: The hedge fund industry
isn’t interested in publicly floating shares of its investment
funds for U.S. investors.
“We as an association, and our members, don’t have any
interest in turning hedge funds into a retail product,” says Ben
Allensworth, senior legal counsel at the Managed Futures Association,
a Washington, D.C. trade group representing hedge
funds. “We think hedge funds work well when they’re sold to
sophisticated investors through private placements. That’s the
way the industry has developed over here, and we think that’s
the appropriate marketplace for it.”
Presumably, the preference is partly to protect John
and Jane Doe from undue risks in the marketplace. Well
intentioned, perhaps, but not entirely logical. Sure, there
are some aggressive hedge funds that court high risk; some
even blow up. But there is no shortage of ways for retail investors
to lose money in, say, levered and short ETFs, penny
stocks, forex trading accounts, and even blue chip stocks
that suddenly look a bit less blue.
If hedge funds are too risky for the average investor, then
so too are a fair number of mutual funds and ETFs. Indeed,
you don’t have to look far to find some mutual funds registered
under the Investment Company Act of 1940 that assume
comparable, and even higher levels of risk than some
of the hedge funds of funds listed in London.
No doubt some intrepid firm will one day breach industry
protocol and list a hedge fund on an American exchange.
Meanwhile, the lines between hedge funds and so-called conventional
investment strategies have blurred to the point that
real-world distinctions are often non-existent.
As for listing hedge funds in the U.S., the main criticism
from the industry seems less about protecting Joe Sixpack
than keeping the SEC at arm’s length in regulatory matters.
Restricting hedge funds to the privately offered niche helps
keep regulators at bay, but how this helps the average investor
is certainly not obvious.
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EXTREME BONDINGtag:www.capitalspectator.com,2008:/WM//5.8962008-08-12T14:03:35Z2008-08-12T14:08:10ZJuly/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.
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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.]]>
STRATEGIC POSSIBILITIEStag:www.capitalspectator.com,2008:/WM//5.8872008-07-29T12:50:23Z2008-07-29T12:56:12ZJuly/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.
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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.
]]>
LET'S GO GLOBAL (AGAIN)tag:www.capitalspectator.com,2008:/WM//5.8672008-06-23T13:26:46Z2008-06-23T14:10:59ZJune 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.
]]>
THE FINAL (SOCIAL) FRONTIERtag:www.capitalspectator.com,2008:/WM//5.8622008-06-16T13:54:28Z2008-06-16T14:03:55ZJune 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.
]]>
BACK TO THE FUTURE--AGAINtag:www.capitalspectator.com,2008:/WM//5.8452008-05-14T13:39:23Z2008-05-14T13:44:38ZMay 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.
]]>
THERE WILL BE OIL?tag:www.capitalspectator.com,2008:/WM//5.8402008-05-07T13:59:42Z2008-05-07T14:06:27ZMay 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?]]>
STEADY AS SHE GOEStag:www.capitalspectator.com,2008:/WM//5.8292008-04-17T13:34:46Z2008-04-18T14:24:15ZApril 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 enlargeSource: 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 enlargeSource: 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.”
]]>
A SIGN OF THE TIMEStag:www.capitalspectator.com,2008:/WM//5.8212008-04-07T13:37:28Z2008-04-07T14:32:30ZMarch 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.
FOREX IS HOTtag:www.capitalspectator.com,2008:/WM//5.7992008-03-04T13:57:20Z2008-03-04T14:26:53ZMarch 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.”]]>
REMEMBRANCE OF TAXES PASTtag:www.capitalspectator.com,2008:/WM//5.7832008-02-04T14:18:31Z2008-02-04T14:57:06ZFebruary 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.
]]>
RETHINKING ZEROtag:www.capitalspectator.com,2008:/WM//5.7622008-01-18T14:53:45Z2008-01-18T14:55:19ZJanuary 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.
]]>
A QUESTION OF SUPPLYtag:www.capitalspectator.com,2008:/WM//5.7612008-01-18T14:12:38Z2008-01-18T14:52:53ZJanuary 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 to zero in risk-adjusted
terms? Not necessarily, at least
not all the time.
That’s the message from a small but
assertive group of investment strategists
including Max Darnell, a partner and chief
investment officer at First Quadrant, an institutional
money manager in Pasadena,
Calif. that specializes in quantitative strategies
including global tactical asset allocation.
A sampling of Darnell’s reasoning
appears elsewhere in this month’s issue
(see "Rethinking Zero" above) in a story
that explores the idea that the supply of
alpha may not be as limited as convention
suggests. After interviewing Darnell,
we decided that his extended comments
should receive a fuller airing on what is for
some a controversial subject.
Readers may or may not agree with
Darnell, but all strategic-minded investors
are likely to benefit from listening
in on the discussion. Alpha, after all, is
at the center of all investing. Some seek
it, others avoid it by design through indexing.
But one way or another, alpha has
everyone’s attention. Investigating the
nature of alpha’s existence in the investment
universe is likely to be a productive
debate, if only to test and perhaps
strengthen one’s assumptions about how
the capital markets operate.
What follows is a conversation on just
that, courtesy of Darnell, who joined First
Quadrant in 1991 as manager of derivatives
research, a post he held until 2000,
when he was named director of research
and, two years later, CIO.
Q: You maintain that alpha’s not a zero sum
game. Is that an academic view, or does
it also have relevance in the real world?
A: It’s more than an academic exercise. Depending
on how you answer the question,
it should make a lot of difference in terms
of how an investor sets his objective.
To make sure I don’t run into any terminological
issues, I’m using the term “alpha” loosely.
What I really mean is “value added.” When
people talk about alpha as a zero sum game,
they’re trying to figure out if they can do
something to add value. Technically speaking,
alpha should be referred to as idiosyncratic risk.
Q: Meaning something other than beta?
A: Yes, something other than beta. There are
really two basic ways to add value. You can
play the game of trying to improve your
returns through idiosyncratic risk. Or,
you can do it through the management of
beta across time. That is, you can vary your
exposure to beta over time, or you can arrange
the betas in a way that you expect
will lead to a superior outcome.
Real world examples include the endowment
funds of the Harvards and the
Yales of the world. They’re choosing a
configuration of betas and alphas that
work to their advantage vis á vis other
market participants. Foundations and
endowments can live with a longer time
horizon. They also have a smaller asset
size to manage than the biggest institutional
pension funds. So endowments
and foundations have flexibility and different
objectives that distinguish them
and allow them to take on risks that others
might not.
The sell-off in August is a recent example.
Consider two types of investors. One
has a relatively short-term horizon and
is unwilling to bear short-term liquidity
issues. Examples include some hedge
funds and individual investors who may
react with shorter-term horizons even
though they shouldn’t.
On the other side are the foundations
and endowments, which may see others
selling because of liquidity issues and
decide that it’s just a blip, a momentary
event. These buyers may have very different
objectives, and so they can wait for
a return of liquidity. Is a foundation or
endowment generating alpha or adding
value by buying assets that looked risky
to one person but didn’t look risky to another?
Absolutely.
Q: Because…
A: Because they recognize that they have a
set of differences that vary with other investors
and decide that they’re going to
take advantage of those differences. And
so they recognize that they ought to be
That view tends to favor investors with
a longer-term view on risk. Examples
include some individual investors, particularly
those with a lot of wealth that
they may be expecting to pass on to
subsequent generations. They may be
in a position to behave like longer-term
investors. Very often that means doing
the most uncomfortable things, like
buying assets that have been beaten up.
Meanwhile, there’s a whole set of investors
who don’t want the ugly looking assets
in their holdings list—mutual funds,
for instance. Or, maybe it’s a hedge fund
with a very short-horizon objective; or
an absolute return fund that’s trying to
hedge its downside risks and so it can’t
bear further declines.
The bottom line: There’s the potential
for trading between these two kinds of
investors that’s good for both.
Q: Is that because one is laying off risk
while the other is embracing it, and so
that ends up being a net gain for both?
A: From the perspective of their objectives,
the answer is yes. It’s not necessarily a
gain in the return space for both, but in
risk-adjusted return terms it very well
may be [a gain for both].
Q: Does thinking in risk-adjusted terms go
to the heart of why alpha isn’t necessarily
a zero sum game?
A: Yes, and that’s the way people ultimately
have to think about their objectives. One
simple example: If you’re an individual
without a lot of wealth, and dependent
on that wealth for surviving one or two
years out, you need to think about the
risk side of the equation because if you
hold more risk than you can financially
bear, your life could change dramatically.
You may not be able to pay the mortgage,
etc. So you may be able to improve the
risk-adjusted quality of your returns by
selling assets that have recently become
more risky.
Q: So alpha sums to zero for straight returns
relative to a benchmark, but the
principle doesn’t necessarily hold if you
add risk to the equation.
A: That’s right. It’s on that risk side that we
all distinguish ourselves. That’s why the
foundations and endowments are so different
from individuals of modest means.
What really distinguishes the institutions
is the ability to bear investment risk over
different types of horizons. And that’s
critical in the investment puzzle.
Here’s one way to think about it. You
always have a set of investment choices.
Let’s take two assets that you think have
similar return opportunities and similar
risks. You’re invested in one, which starts
going up. What should do you do? You
can switch over to the one that has the
risk/return profile that you can bear. It
doesn’t necessarily mean degrading your
return, but it does mean adjusting the
risk/return profile.
If you ignore the risk side of the equation,
this whole argument goes away. If
you’re living in a return-only world and
ignore the differences between investors,
which are risk differences, then return is a
zero sum game, if you will.
Q: Assuming that alpha sums to zero
seems to be the conventional wisdom.
A: From an academic perspective, a heroic
assumption is made that risk is the same
for every investor. We all value return in
exactly the same way and so the return
side of the issue is uninteresting when
you say there’s heterogeneity among
investors. But when you move to differences
in preferences, it’s all about those
differences in risk and objectives and constraints.
And so the academic literature—
and I think this is the big flaw in the zero
sum game argument—generally starts
with an explicit or implicit assumption
that all investors look at risk in the same
way. But they don’t. Your readers are remarkably
different from institutional investors,
for example.
Q: If someone accepts the idea that alpha’s
not a zero sum game, how does that inform
investment strategy?
A: One example is thinking about how your
risk profile and objectives differ from
other investors. In the past, pension
funds often had similar asset allocations.
But that was a mistake. How could they
make that mistake? They assumed that
there were no differences in their risk profiles
and so they assumed no advantage
in exploiting the differences.
Q: They assumed alpha was a zero
sum game?
A: That’s right, and so they behaved similarly
to the funds considered to be their
cohorts. A classic example was in the U.K.,
where there were dramatic differences in
the duration of the liabilities of the pension
funds. Yet they were all holding 70/30
mixes of stocks and bonds—or roughly so.
That shouldn’t have been the case. But
they assumed their differences away and
decided that there was no value in distinguishing
their objectives, which allowed
them to hold conventional allocations.
Q: If alpha doesn’t sum to zero, how does
that view square with the principle that
all investors can’t be above average?
A: If we limit that comment to idiosyncratic
risk, it’s absolutely true. But idiosyncratic
risk is so boxed in, if you will,
because we accept a benchmark and it’s
valued in the same way by everyone. In
that sense, generating return in excess of
the benchmark means taking that return
from someone else.
Meanwhile, compare that to a real world
case that’s topical. Fundamental
indices, for example. [Benchmarks that
weight securities by “fundamental” factors,
such as dividends and earnings,
and are considered alternatives to traditional
cap-weighted indices.] You can
say that investors with formalized liabilities
may place a higher value on more
fundamentally oriented-type stocks in
their portfolio. And while they may or
may not get a return advantage from
holding those stocks, they might get a
greater utility advantage because they’re
holding something that is a match for
their liabilities.
Q: So investor utility helps explain why
alpha isn’t a zero sum game.
A: You just can’t get away from it [investor
utility]. If you say that not all managers
can beat the benchmark, that’s only true
in a return-only space. I accept that argument
all day long if we’re talking about
return only. In that case, alpha is a zero
sum game.
Q: The question is whether that’s how to
look at investing in the real world?
A: No, not even close.
Save for last November's 64,000 rise in nonfarm payrolls, 25 of the last 26 months have shed jobs. The red ink for nonfarm payrolls now stands at 8.4 million lost jobs, according to the Labor Department.
As for February, the losses were relatively light, compared with the carnage in the first half of 2009, but that's increasingly a thin reed for those trying to rationalize the numbers du jour as the moment of rebound slips ever forward.
At best, it was a mixed bag for last month's employment changes among the various subgroups that comprise the total nonfarm payroll number. Construction suffered the biggest hit, unsurprisingly, given the weather, losing 64,000 positions. The services sector almost but not quite picked up the slack, posting a 42,000 rise. But that masked the negative trend within the services sector last month, with one dubious exception. Indeed, the big winner among services firms in February came in temporary help services, which added nearly 48,000 jobs last month. Every bit of gain helps, of course, but that's not exactly the corner of the economy where expansion breeds bullish sentiment at this point.
Overall, there's a growing risk that the labor market will languish for an extended period. The big losses, perhaps any loss in nonfarm payrolls is behind us. But that's not good enough to begin the hard work of laying the foundation for even modest economic growth in the near term. More than two years after the Great Recession began, the labor market is still suffering, albeit suffering due to a lack of job creation. It's not obvious that this risk is factored into the crowd's sentiment, but another month or two of moving sideways in the labor market and there may be hell to pay.
Meantime, we'll be watching the weather forecasts. March has come in like a lamb and so the month may go out with a meteorological panthera leo.
]]>
What, then, are we to make of the fact that this real-time measure of anticipated infla¬tion was running in the 2.0%-to-2.8% range (based on 10-year Treasuries) for the five years through the end of August, as the chart above shows? That’s well below the reported 3.5% annual rise in the consumer price index (CPI) over the same time frame.
The government bond forecast for inflation looks even worse if you consider that the reported annual rate of inflation has been steadily rising in recent years, save for a year-long break through the summer of 2007. As of this past August, CPI rose 5.4% for the previous 12 months—or roughly twice as high as the average inflation forecast embedded in Treasuries for much of the past five years.
“That’s a pretty significant disconnect,” says Ben Thomp¬son, a principal at Samson Capital Advisors, a New York-based fixed-income boutique catering to high-net-worth and institutional clients.
Does that mean the market-based inflation forecast is irrelevant? Or, perhaps prospective inflation is a lot less threat¬ening than recent history suggests? The sharp drop in crude oil prices this past summer, along with a weakening economy, certainly suggests that pricing pressures are set to ebb.
No one can say for sure, of course. Only time can make definitive judgments about the accuracy of market predic¬tions, leaving investors to decide on a prediction. Meanwhile, this much is clear: The track record of inflation relative to the Treasury-based outlook for prices leaves plenty of questions, including: Is the TIPS market a defective asset class? If so, should investors rethink the use of inflation-indexed Treasur¬ies as a strategic holding in a diversified portfolio strategy?
No, at least not based on the seemingly erroneous infla¬tion forecast spawned by Treasuries in recent years. Even if the Treasury-TIPS spread is faulty, it’s not obvious that the problem is tied to inflation-indexed Treasuries. Yes, the market-based forecast of inflation arises from yields on two series of government bonds, but the burden of proof isn’t equally distributed.
Recall that TIPS offer investors an opportunity to lock in a real (i.e., inflation adjusted) yield for the life of the bond. If you bought a newly issued 10-year TIPS with a 2% coupon, you’re guaranteed to receive that real yield for the next de¬cade if you hold to maturity. Inflation may subsequently soar to hyperinflation or fade to deflation, but the 2% real yield remains intact. To the extent that government guarantees on bonds are reliable in this world, the TIPS real yield is as dependable as it gets.
TIPS, to restate the obvious, are immune from inflation (as defined by CPI). That’s the basis of their appeal. Not so for conventional Treasuries, which only guarantee a nominal pay¬out. TIPS, then, are a hedge on rising inflation; a security that allows investors to lock in a real current yield. But how does one square that utilitarian profile with the poor track record of inflation forecasting via Treasuries?
“It’s definitely the case that [the Treasury-TIPS spread] underpredicted the inflation we’ve seen over the last few years,” says James Hamilton, an economist at the University of California at San Diego.
Yet a defective inflation forecast isn’t a death sentence for TIPS’ inflation-hedging capabilities. Anticipated or not, TIPSinvestors are compensated for any higher-than-expected infla¬tion. As CPI’s pace rise, so too do TIPS’ payouts—an adjust¬ment that’s business as usual for maintaining a real yield.
The future will offer no less an opportunity to hedge infla¬tion, regardless of the accuracy—or inaccuracy—of the overall Treasury market’s predictions. In fact, opportunistic investors should be hoping that the Treasury market continues to soft pedal the risk of future inflation.
“If you think inflation over the next 5 to 10 years is going to be higher than the breakeven yields seem to say, then you should be buying TIPS and dumping the nominals,” Hamilton advises. “If you think that TIPS are underestimating inflation, they’re a good buy because you think they’ll go up [in price] and experi¬ence a bigger [nominal] capital gain than the market expects.”
Recall that buying TIPS locks in a real yield, meaning that the nominal yield fluctuates with the CPI trend. That opens the door for bigger-than-expected nominal returns with inflation-indexed Treasuries if the market underprices infla¬tion’s potential.
Imagine it’s August 30, 2003, and you’re considering the breakeven spread for conventional and inflation-indexed gov¬ernment bonds. At the time, the Treasury spread anticipated inflation at just below 2.2% for the decade ahead. Halfway into that forecast (by the end of August 2008), reported inflation was running at about 3.7% a year for the previous five years—or more than two-thirds higher than forecast in August 2003.
The 2003 prediction turned out to be wrong, at least at the five-year mark. Yet it’s worth pointing out that the 2003 forecast looked like a reasonable guess at the time. Consumer prices rose just 2.2% for the year through August 2003, or virtually identical to the Treasury breakeven spread at that point.
Reasonable at the time, perhaps, but it still looked wrong in August 2008. But if you think that an erroneous inflation pre¬diction weighed on TIPS as an investment from 2003 through 2008, think again. Consider that the five-year trailing returns for the TIPS-focused Vanguard Inflation Protected Securities mutual fund (VPSIX) handily beat its investment-grade bond counterparts. Even substantially lengthening average maturity and duration in a portfolio of conventional Treasuries was ef¬fectively a wash against outdistancing TIPS.
The proof that TIPS can shine even when the Treasury spread forecast stumbles also comes from a more direct com¬parison of performance via inferring returns based on current yields on August 31, 2003. The 2.29% real yield for 10-year TIPS on that date proved superior compared to the 4.45% for the current yield on the nominal 10-year Treasury—if we fast forward five years and adjust for inflation. Indeed, a 4.45% nominal yield fades to 0.85% after CPI’s pace for the five years through August 31, 2008.
If TIPS have done relatively well in the wake of a flawed inflation forecast, who pays the price for the error? Owners of conventional Treasuries, of course, as the inferred real yield analysis above suggests.
“TIPS have proven to be a great inflation hedge because the market forecast for inflation, represented by the [yield] differ¬ential has been so consistently wrong,” says Timothy Wilhide, comanager of The Hartford Inflation Plus Fund. “It’s not the TIPS market that’s wrong; it’s the nominal market that’s overly optimistic on inflation,” at least as far as reported CPI goes.
There are a number of theories about why the conventional Treasury yield remained so low in the face of rising inflation. The so-called global savings glut that channels foreign export earnings into Treasuries is one idea; others are rising demand for the safe harbor of Treasuries and optimism that inflation will soon cool.
Whatever the reason, it doesn’t change the fact that TIPS function in two capacities. As a partner with conventional Treasuries, TIPS offer a real-time forecast of inflation. TIPS also provide the opportunity to secure a real yield. It’s debat¬able if a given real yield will suffice, but to the extent it does, there’s no reason to question its reliability.
Well, almost no reason. There’s debate about whether the underlying inflation benchmark adequately compensates for pricing pressures in the real world. But if you accept CPI (or tolerate it), TIPS are a tough act to beat. In fact, they’re the true investment benchmark for U.S. investors since they offer the only inflation-hedged yield guarantee that’s free of princi¬pal risk. Just remember: the guarantee ends there.
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Whatever U.S. investors think of the idea, listed hedge funds
are a growth industry. The rising level of assets under management
is one clue. Another indication of the trend is the rising
presence of listed hedge funds in stock market benchmarks.
As of this past May, eight of the London-listed funds of hedge
funds had sufficient size and trading liquidity to earn
a spot in the FTSE U.K. All-Share index.
The basic design of listed hedge-funds is
akin to a U.S. closed-end fund. As a result,
market prices can and do fluctuate around net asset value,
which creates an extra layer of opportunity, as well as risk in the
form of discounts and premiums.
There are a number of investor-friendly features with listed
hedge funds, but what’s in it for the issuers? First is the ability
to transfer the redemption burden to the secondary market
for trading shares. That’s a potentially large benefit for funds
holding illiquid investments, since it allows management to
minimize, if not eliminate, the potentially destabilizing task of
meeting large redemption requests at awkward moments.
Marketing is another plus. Some institutional investors,
including some pension funds, are prohibited from buying
unlisted securities. By listing hedge funds on exchanges, managers
can broaden their investor base.
Yet hedge fund managers that go the exchange route don’t
go all the way. According to ABN AMRO, all managers with
listed funds raise the bulk of assets by means other than
floating shares.
Despite the plusses, U.S.-based investors should not dive
into the pool of listed hedge funds blindly—if at all. Taxes and
foreign currencies are complicating factors. Another potential
problem: Some listed hedge funds shun U.S. investors.
“There are a number of companies that formally state that
there must not be any U.S. investors on the shareholder register,”
says Mark James, who follows listed hedge funds for ABN
AMRO in London.
That’s not an obvious obstacle, since U.S. investors can
generally find a way to buy whatever they want on foreign
stock exchanges. In fact, the Greenwich, Conn.-based Interactive
Brokers recently confirmed for Wealth Manager that
trading London-listed hedge funds was just a keystroke away
for U.S. clients.
Taxes and forex, however, are not so easily resolved. “My
current understanding is that U.S. investors should not
invest in listed funds in taxable accounts,” advises Mebane
Faber, portfolio manager at Cambria Investment Management
in Los Angeles. The trouble stems from what’s known
as passive foreign investment companies (PFICs). Given the
rather harsh treatment for U.S. investors regarding PFICs, it’s
best to own listed hedge funds in tax-deferred accounts, such
as an IRA, he says.
None of this discourages Faber, who reports that he’s
looking at LSE-listed hedge funds as possible investments
for Cambria’s high-net-worth clients. He cites the usual
hedge fund charms, such as bringing diversification to a
portfolio of conventional assets. Meanwhile, with listed
funds “You get around a lot of the problems you otherwise
have with [non-listed] hedge funds,” he explains. “There are
no liquidity issues, there are no lockups, and there’s a lot
more transparency.”
That leaves the foreign exchange issue. Purchases of London-
listed hedge funds necessarily clear in sterling. Unless
you’re interested in making a bet on the pound, buying an
LSE-listed fund requires an offsetting forex hedge. Fortunately,
forex hedging is easy and inexpensive with options,
foreign currency ETFs and other products.
But let’s not kid ourselves: Even the most rabid U.S.-
based hedge fund advocates will probably never look at a
foreign-listed hedge fund—much less buy one. Given the
complications and risks of offshore investing even in the
21st century, perhaps it’s all for the best.
That leads to the question of why there are no exchangelisted
hedge funds in America. In search of answers, Wealth
Manager spoke with a number of sources, ranging from a
spokesman at the SEC to analysts and lawyers specializing
in hedge funds. A typical response: The hedge fund industry
isn’t interested in publicly floating shares of its investment
funds for U.S. investors.
“We as an association, and our members, don’t have any
interest in turning hedge funds into a retail product,” says Ben
Allensworth, senior legal counsel at the Managed Futures Association,
a Washington, D.C. trade group representing hedge
funds. “We think hedge funds work well when they’re sold to
sophisticated investors through private placements. That’s the
way the industry has developed over here, and we think that’s
the appropriate marketplace for it.”
Presumably, the preference is partly to protect John
and Jane Doe from undue risks in the marketplace. Well
intentioned, perhaps, but not entirely logical. Sure, there
are some aggressive hedge funds that court high risk; some
even blow up. But there is no shortage of ways for retail investors
to lose money in, say, levered and short ETFs, penny
stocks, forex trading accounts, and even blue chip stocks
that suddenly look a bit less blue.
If hedge funds are too risky for the average investor, then
so too are a fair number of mutual funds and ETFs. Indeed,
you don’t have to look far to find some mutual funds registered
under the Investment Company Act of 1940 that assume
comparable, and even higher levels of risk than some
of the hedge funds of funds listed in London.
No doubt some intrepid firm will one day breach industry
protocol and list a hedge fund on an American exchange.
Meanwhile, the lines between hedge funds and so-called conventional
investment strategies have blurred to the point that
real-world distinctions are often non-existent.
As for listing hedge funds in the U.S., the main criticism
from the industry seems less about protecting Joe Sixpack
than keeping the SEC at arm’s length in regulatory matters.
Restricting hedge funds to the privately offered niche helps
keep regulators at bay, but how this helps the average investor
is certainly not obvious.
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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.
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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.
]]>
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.
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