This Month's Issue: Key Points

This month’s letter to the editor reviews the source of returns on commodity index investments. Since these indices are based on investments in commodity futures contracts, their returns principally reflect compensation for bearing the risk of short-term price fluctuations. Hence, it is possible to earn a positive return on a commodity index even when the price of the underlying commodity is falling. We note another study by the IMF that finds that commodity price volatility steadily increased between 1862 and 1999, even as real prices declined by an average of one percent per year. The IMF finds that this slight real price decline was completely overwhelmed by the rise in price volatility. Hence the need for futures contracts that insure against this volatility, and the profitability of investing in them. In our product and strategy notes, we relate these points to a discussion about the new gold exchange traded fund (ticker GLD) that was recently launched in the United States (similar products already exist in Australia, South Africa and the U.K.). The price of this ETF is equal to one-tenth the price of a troy ounce of gold. It is also backed by an amount of physical gold equal to ten percent of the notional ounces of gold represented by the market value of the ETF. We do not find the structure of this ETF as attractive as investing in either gold futures or physical gold coins. The former have a more reliable source of returns, while the latter are more useful as a store of value and medium of exchange in case of the "worst case scenario" which is on many people’s minds when they invest in gold.

Nevertheless, the new gold ETF has quickly attracted over $1 billion in investment since it was launched in mid-November. The reason for this may have something to do with our last product and strategy note, which reviews the current status of the economic scenario indicators we described in our September economic update. We conclude that the probability of our recession/deflation scenario developing has increased. Consequently, if we were currently in the process of changing to a new portfolio asset allocation, we would emphasize getting our investments in real return bonds and foreign currency bonds in place before focusing on other asset classes. We would also review our domestic bond investments to ensure that they were in high quality issues.

Our feature article addresses a problem faced by many investors: whether to invest in index mutual funds from Dimensional Fund Advisers (DFA), even though this can only be done through financial advisers who usually charge a fee equal to one percent of the assets they manage. We compare the historical returns and risks of DFA and comparable Vanguard index mutual funds in different asset classes. In close cases, we perform simulation analysis to assess the impact of higher DFA fees on the probability of achieving a target portfolio withdrawal rate. We conclude that, as is so often the case when all-stars are compared, there is no clear winner when it comes to DFA versus Vanguard. Based on the performance data we have used in our analysis, we prefer the DFA offerings in Domestic Large Cap Value, Commercial Property, Large Cap International Value, International Small Cap, International Small Value, Emerging Markets Value and Emerging Markets Small Cap. We also prefer DFA for Microcap equity, where Vanguard lacks a comparable offering. On the other hand, we prefer Vanguard's products for Domestic Large Cap Equity, Domestic Small Cap and Small Cap Value, Large International, Broad Emerging Markets Equity and Fixed Income. We also prefer Vanguard for real return bonds, where DFA lacks a comparable offering. And we wish one or both of these firms would introduce products in the commodities and unhedged foreign currency bonds asset classes.

Another product and strategy notes look at the continuing tracking error problem at some exchange traded funds. In this case, TIP and AGG have significantly underperformed comparable Vanguard index mutual funds so far this year. At a reader’s suggestion, our last note examines the Hussman Strategic Growth Fund (HSGFX). We find that its strategy resembles that of an equity market neutral hedge fund, and that it is very reasonably priced. We conclude that, like the PIMCO All Asset Fund (PASDX), whose strategy is similar to that used by global macro hedge funds, HSGFX is a reasonable option for an investor who wishes to mimic the institutional strategy of combining index funds with hedge funds.

| This Month's Issue: Key Points | This Month's Letter to the Editor: Weighting of Commodities in Model Portfolios | Global Asset Class Returns | Equity Market Valuation Update | DFA versus Vanguard: The All-Stars Compared | Model Portfolio Update | Product and Strategy Notes: Gold ETF, ETF Tracking Error, Hussman Funds and Economic Indicators Update |