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What are your thoughts on the new Fed Chairman? -- Subscriber, USA
Frankly, given our view of the possible future scenarios we are facing, we couldn't be happier with the appointment of Ben Bernanke to replace Alan Greenspan. If you look at the research papers Bernanke has co-authored in recent years, you see a growing focus on the dangers of deflation and the prolonged slump in real economic growth it can cause. More than any other member of the Fed's Board of Governors, Bernanke seems to have focused on how the United States, and indeed, the OECD as a whole, can avoid a repeat of the Japanese experience when the current imbalances in the world economy are inevitably reversed. Some of the recent papers he has written (which we'd recommend reading if you don't mind some heavy economics at times), include “Financial Fragility and Economic Performance”, "The Macroeconomics of the Great Depression", "Monetary Policy and Asset Price Volatility", and “Monetary Policy Alternatives at the Zero [interest rate] Bound”. In sum, if we're going to be sailing into a storm, he seems like the right captain to have on the bridge.
How can I tell if my financial adviser is generating alpha? -- Subscriber, UK
With the increasing focus on separating alpha and beta investing, this is a question that seems likely to come up more often in the years ahead. To quickly review the terminology, the return on traditional actively managed mutual funds is composed of two parts: the beta return on a given asset class (which could have been replicated with an index fund), and the "alpha" return, which is the difference between the active fund's return and the return on a comparable index fund. In theory, you pay higher fees to an active manager because of his or her ability to consistently generate alpha.
You can analyze alpha in many different ways, including at the level of an individual fund, at the level of an asset class, or for your portfolio as a whole. Let's start with the first situation. The first question you should ask your adviser is, "what was the beta return that was used to estimate the active manager's alpha?" Answering this question is not as easy as many advisers would like you to believe. For example, suppose your adviser tells you that the manager of a value fund is generating alpha. Your first question should be, “what benchmark did you use to estimate alpha?” The issue here is that too many advisers, either on purpose or by accident, use the wrong benchmark. In our example, if the adviser says, “the S&P 500”, that's the wrong answer. The right answer would have been “a value index”, like the Russell 3000 Value (if the manager takes no consistent size tilts), or something like the Russell 2000 Value or S&P 600 Value if the tilts toward small cap value stocks. The key point is this: it is only after you have properly measured beta that you can accurately estimate alpha.
Now let's move on to the second question to ask your adviser: “And what is the manager's tracking error?” Alpha is the average of the monthly differences between the manager's return and the return on the relevant index. The standard deviation of these alphas is a measure of the amount of active risk being taken to generate the active return. Another name for this standard deviation is “tracking error.” This leads to the third question to ask your adviser: “And the manager's information ratio is?” The information ratio is the average alpha divided by the standard deviation of the monthly alphas, or tracking error. It basically relates the active return you are receiving to the active risk being taken to generate it. IRs above .5 are rare. And this brings us to the last question to ask your adviser: “Is that IR statistically significant?” This is a fancy way of asking, “is there any statistically significant difference between that IR and pure luck?” There are two ways to achieve this level of significance (technically, a T-Ratio of greater than 2.00). The first is to generate a low positive IR over a long period of time. The second is to generate a much higher IR over a shorter period of time. Low IRs over short periods are indistinguishable from luck (of course, this result leads to a fifth question: "So why did you put me in this fund?")
You can also estimate the overall alpha for your whole portfolio. The calculation approach is the same as before; the key challenge is to identify the right weights to give to different index funds when estimating the portfolio's beta return. These should reflect your long-term asset allocation strategy. You should also use the lowest cost index funds you can find in this analysis, and make sure you subtract the investment management fees charged by both active funds and your adviser from the total return earned by your portfolio. While the calculations are a bit more complicated, the questions are the same as in the single fund case.
What do you think of the new iShares in the UK? -- Subscriber, UK
The short answer is that we're excited for UK investors, which includes us (some of us here still have funds invested there). Along with Fidelity's recent dramatic expense reduction on its FTSE All Share tracker, Barclays' move represents a step function change in the UK tracker market. Regarding the new iShares, the Index Linked Gilt and Emerging Markets trackers fit nicely into the asset class categories we use in our model portfolios. So too does the MSCI World, assuming you offset its use with a reduction in other exposures to UK equity (the UK represents about 10 to 11% of the MSCI World). The UK Dividend Plus is a value-type tilt within UK equity. Other funds offer a wider range of value and size based tilts within your Eurozone equity exposure, if you prefer them to a broad market index.
The Europe/EPRA Property iShare is more problematic, as it includes the UK; give the changes underway in the UK Property Sector (with Property Investment Funds), a product that tracked Eurozone property, or better yet, property outside the UK would have been a more useful. Finally, the All Country Far East ex-Japan fund is interesting, but potentially confusing. It is not the same as the Pacific ex-Japan iShare that trades in the United States (EPP), and includes Australia, New Zealand, Hong Kong and Singapore. Rather this new one includes nine countries: China, Hong Kong, Indonesia, South Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand. It does not include Australia and New Zealand. So if you are trying to combine this iShare with a Japan fund to replicate the MSCI Pacific Index, you are going to miss the mark. Also, if you are invested in both the Emerging Markets iShare and this one, you are going to be overweight in many Asian emerging markets.