This Month's Letters to the Editor: Indexing vs Active Management; Stop-Loss Orders; Commodities Feb Issue vs March Issue; MLM Commodity Index and Gold Tilt in Commodities

I'm a new subscriber, and am somewhat confused by your views on indexing versus active management. You really don't seem to be in one camp or the other. Could you please explain?

As we like to say, experience has taught us not to be ideologues when it comes to this debate. As a practical matter, our base case view is that, for long-term investors, indexing makes the most sense. Successful active management ultimately comes down to successful forecasting. In turn, this depends on having access to superior private information about a security or asset class, and/or using a superior model to analyze publicly available information. Over a long-period of time, superior sources of private information are hard to sustain, and models lose their effectiveness due to either copying by competitors or changes in the economy that invalidate their assumptions. This is why, as the length of time is extended, a geometrically smaller proportion of active managers have been able to outperform the relevant index fund. There is a reason people like Warren Buffett are so well known: their skills are incredibly rare.

However, there are four important exceptions to our general rule that, for investors with a long time horizon, indexing makes the most sense.

The first exception is that, over the course of an investing lifetime, almost everyone will come into possession of superior private (which is different from illegal) information, that creates the opportunity for an active management success. For example, an investor may be aware of different developments in her industry that lead her to conclude that the market as a whole is underestimating its future growth rate, which should soon accelerate. In this case, she might allocate a portion of her portfolio to an exchange traded fund that tracks the industry, and watch its returns outperform the overall market index over the next year. Of course, this also raises the point that successful active management also requires knowing when to sell, realize one's profits, and reinvest them back into index funds. In essence, two forecasts are involved: one that says it is time to buy, and one that says it is time to sell. Active opportunities like the one just described don't happen very often for most people. In addition, if your superior information is limited to developments at your own company about which the public is unaware, you run the risk of committing the crime of insider trading if you trade your company's shares rather than a broader ETF.

The second exception is one we have frequently written about: bubbles, or, more technically, situations in which one or more asset classes appear extremely overvalued. When these situations occur, and when the asset class in question is well above its target weight in your portfolio, prudent risk management demands that you make an active management decision to reduce your allocation to well-below its target weight. The purpose of our Asset Class Valuation Update section is to help investors make these decisions.

The third exception to our preference for indexing is an asset class (e.g., timber, or, in some regions, foreign currency bonds) where no indexed investment vehicle is yet available.

The fourth exception is the most challenging. We know that in hindsight, it is possible to identify rare human beings like Warren Buffett who are truly skilled active managers. But hindsight is not foresight. We also know that it is next-to-impossible to identify tomorrow's Warren Buffett with any confidence (in the statistical sense of a significant T-Ratio test). Under these difficult circumstances, an investor might still rationally choose to allocate a portion of his portfolio to actively managed funds, based on his subjective evaluation of an active manager's skills. Such evaluations are inherently uncertain, since superior past performance, in most asset classes, has been shown to be of no use in predicting future superior performance (though private equity has, in the past, been an exception to this rule). In our experience, there are a number of questions one should ask when evaluating an active manager. The first is simply whether you trust him or her. Does he or she inspire confidence and a sense of integrity? If not, don’t even bother asking the other questions. Second, ask them to explain the theory that supports their belief that they can deliver positive active returns (i.e., returns above a comparable index fund, after costs and taxes) in the future. Third, ask the active manager to describe the obstacles that will prevent his or her approach from being copied by others in the future, and why these obstacles are durable. Fourth, have the manager describe how his or her theory is implemented in a disciplined investment process. Fifth, check to see that the manager's portfolio holdings reflect his or her active investment theory (any mismatch between the theory and the portfolio holdings is a red warning flag). Finally, check to see that the active manager's approach has actually delivered superior returns in the past.

In our view, any portfolio allocations made to active management strategies should logically be focused on funds that attempt to deliver returns that are uncorrelated with the returns that can be earned simply by investing in much cheaper asset class index funds. Technically, these are active funds whose objective is to produce "uncorrelated alpha." In contrast, traditional actively managed funds (which make up the majority offered to investors today) deliver a mix of overall asset class returns (technically known as "beta") and alpha. However, an investor can obtain the asset class returns more cheaply by buying an index fund. He or she therefore should only pay higher fees for returns that are not only above those on index funds, but also uncorrelated with them (because such returns add the most diversification benefit to a portfolio).

Our target return model portfolios with equity market neutral funds take this exception into account. They allow for an allocation of up to ten percent of the portfolio's assets to investments in equity market neutral funds whose objective is to deliver uncorrelated alpha through superior security selection. As we have discussed in our writing, another approach would be to use so-called "global macro" funds, which attempt to deliver alpha by shifting investment allocations to different asset classes over time.

As you can see, we are definitely not rigid ideologues in the indexing versus active management debate. Rather, our objective is to highlight how each approach can best be used by an investor.

Is this a good time to be using stop-loss orders to hedge downside portfolio risk?

We should start by clarify some terminology. A limit order is one that triggers an action (either a buy or a sell) when the market price reaches a certain threshold. Conceptually, there are two types of "limit sells." The first, a so-called "stop-loss" order, triggers a sale when the market price has reached some level below the price at which an asset was purchased. The second is a so-called "take-profit" order, which triggers a sale when the market price passes some level above the price at which an asset was purchased. Both types of limit sell are risk management tools. The stop-loss prevents the accumulation of unrealized losses on an asset, while the "take-profit" limits the risk of staying with an asset after its price rises above one's assessment of full (fair) valuation, and in so doing taking a loss (or at least a smaller gain) when this momentum is eventually reversed (i.e., when the "bubble pops.").

To put it in psychological terms, a stop-loss order protects an investor against the confirmation bias, which is the tendency to give more weight to information that confirms our views (e.g. about the fair value of an asset) than to discordant views. A take-profit protects an investor against excessive optimism. More crudely, one could describe these two psychological risks as insufficient fear and excessive greed.

However, I should also note that recent academic studies have found that, to some extent, limit-sell orders have an aspect of "self-fulfilling prophecy" about them. It turns out that take-profit orders tend to cluster around round price numbers, while stop-loss orders cluster just beyond them. When these limits are hit, the spike in selling they trigger can cause liquidity to disappear from the market (e.g., dealers widen their bid/ask spreads and reduce the maximum order size they will accept at their posted prices). The spike in sales and reduced liquidity then accentuate the fall in price, raising the probability that more limits will be hit, and a cascade (e.g., a run for the exits) will develop.

From an individual investor's point of view, stop-loss orders raise a number of issues. All investors should start with the fundamental assumptions that markets will naturally rise and fall, that a higher frequency of extreme (in percentage terms) price changes will be found a shorter time horizons (e.g, daily) than longer ones (e.g., quarterly), and that forecasting fair asset value, and the behavior of other investors (and hence asset price fluctuations) is very difficult to do consistently well. Given this, the challenge in using stop-loss orders as a risk management tool is twofold: (1) how to set stop prices sufficiently low to avoid excessive transaction costs due to their being triggered by intra-day price changes that balance out at longer (say, monthly) time horisons, and (2) how to accurately forecast when it is time to get back into an asset class once a stop-loss sale has been triggered.

Neither of these challenges has an easy answer. For that reason, many investors, particularly those with longer time horizons, avoid the use of stop-loss orders and depend on a well-diversified portfolio to limit their exposure to risk.

However, as we have written, there is a major exception to this rule: situations in which an asset class appears to be substantially overvalued. In our writing, we have stressed two important points in this regard. The first is that in financial markets that function as complex adaptive systems, such substantial overvaluations should be expected to occur from time to time. The second is that it is extremely difficult to forecast when they will reverse (e.g., think back to the development of the technology bubble at the end of the 1990s, and all the people who said in 1998 that "this can't last").

As we have noted in our writing, one way to deal with this type of situation is to rebalance one's portfolio so that the actual weight of the overvalued asset class is below its target weight. However, this does not address the options facing an investor who wants to capture as much of the upside bubble return as possible, while limiting his or her potential downside risk. This investor basically has two choices. He or she can buy put options on the asset in question, if they are available, or enter an out-of-the-money stop loss order. Again, the trade-off here isn't easy. Put options require the payment of an option premium, which can become expensive unless the strike price is well out of the money (i.e., unless it exposes the investor to substantial loss before it pays off). Moreover, as anyone who bought put options on the U.S. equity market in 1998 can tell you, premiums add up -- you can be right without necessarily being profitable!

While stop-loss orders involve no premiums, there remains the challenge of knowing where to set the price. As previously noted, at daily time horizons, there are (in percentage terms) more extreme price changes than there are at longer horizons. Hence, a stop-loss runs a significant chance of being triggered unless it is relatively far below the current price. On the other hand, a stop-loss set this low runs the risk of being caught up in a "disappearing liquidity" cascade, that can cause a substantial fall in the market price of an asset below the stop-loss price before the order in question is fully executed (just ask anybody who was on a trading desk in October, 1987). In other words, because of the risk of disappearing liquidity in a falling market, an investor may still realize substantial losses even in the presence of a stop-loss order, if that order's price is set significantly below the current market price. This argues for gradually adjusting a stop-loss order upwards towards the current market price as the perceived overvaluation of an asset grows larger.

In sum, there are no easy answers to the question you pose. On the other hand, we hope this reply will help you to think through the decision you face.

Is there a contradiction between your February issue, which concludes that commodities may be overvalued, and your March issue, which contemplates overweighting them (among other asset classes) to hedge against the potential impact of a severe downturn in the global economy?

We agree that they appear to be in conflict, for which we apologize. To make a long story short, the two articles were written with different time frames and different indexes in mind when it comes to commodities. So, to clarify, in the short term, we believe that at a chaotic unwinding of today's global economic imbalances would most likely (absent a major supply disruption) trigger a fall in expected global economic growth and hence a fall in the price of those commodities (like energy and industrial metals) that are most overvalued today. Hence, commodity index funds that are heavily weighted towards energy (e.g., those that track the Goldman Sachs Commodities Index) would be most exposed to this correction. That was the basis for our February conclusion.

That being said, we have also noted that we believe that this downward price move will be less severe for commodity funds that track more broadly diversified commodities indexes with less energy exposure, like the Dow Jones AIG Commodities Index (which is the one we prefer to use when implementing our model portfolios' asset allocations). Moreover, in the medium term, if the global downturn triggers widespread deflation, then we also expect to see a coordinated attempt by more than one central bank to sharply expand the money supply and reflate the world economy (repeating the Japanese experience). Under these conditions, the price of real assets, including commodities, should rise. This was the basis for our March conclusion. Again, we apologize for any confusion this caused, and will redouble our efforts in the future to clearly describe the assumptions and logic underlying our conclusions.

What is the MLM Commodity Index?

The MLM Index was launched in 1988 by Mount Lucas Management of Princeton, New Jersey. It is based on a quantitative trend following (momentum) strategy, applied to an equally weighted mix of energy, metals, agricultural, interest rate and currency futures contracts. Mount Lucas Management revises the number of contracts traded each year; the companies last 10-K report (filed with the U.S. Securities and Exchange Commission) showed that it was using 22 different contracts. The trend following strategy causes the index to take both long and short positions in these futures contracts. In this sense, the MLM Index is not a true "passive strategy"; it very clearly has an underlying active component. Rather, we prefer to view it as one of a number of benchmarks against which the performance of other "Commodity Trading Advisors" (essentially, firms that actively trade futures contracts) can be measured. From a different perspective, the dynamics of the MLM Index are very different from those of long-only passive commodities indices like the Goldman Sachs Commodities Index or the Dow Jones AIG Commodities Index. For example, in 2005, both of the latter delivered higher returns than the 3.75% (in US Dollars) on the MLM Index. Like many commodity trading advisors, the MLM Index suffered from the lack of strong trends in many commodities futures market. However, that being said, over a longer period the MLM's performance looks better, in particular because of its lower volatility compared to the GSCI and DJAIG. However, its low correlation versus both of these indices also shows it is a very different product -- a active trading strategy (like a hedge fund) rather than an asset class.

In Canada, SEI Investments offers a product (the SEI Futures Index Fund) that tracks the MLM Index. Unfortunately, there are, as yet, no products available in Canada that track the GSCI or DJAIG.

Does the rise in the price of gold suggest the need to tilt one's commodity exposure in that direction?

First, well-diversified commodity indexes like the DJ AIG already include an allocation to gold futures. The question, therefore, is whether to increase this relative weight by investing in a gold ETF. We continue to believe that the medium term case for making an additional allocation to gold is fundamentally based on one's perception of the future relative importance of its role as a store of value during periods of great monetary instability, including both deflation and inflation. Since current global economic conditions have increased the probability that one, and perhaps both of these conditions will occur in the future (e.g., a sharp economic slowdown that triggers deflation, followed by a concerted attempt to reflate the global economy), the case for holding gold has strengthened (though we have found no way to relate the strength of that case to the fairness of the current gold price, which appears to have a strong momentum element to it). However, if one assumes that periods of great moneteary instability may also put the functioning of financial markets at risk, then we continue to argue that holding physical gold (e.g., coins in a safe deposit box) makes more sense than an ETF backed by gold bullion.

| A Note from our Publisher | This Month's Letters to the Editor: Indexing vs Active Management; Stop-Loss Orders; Commodities Feb Issue vs March Issue; MLM Commodity Index and Gold Tilt in Commodities | This Month's Issue: Key Points | Global Asset Class Returns | Asset Class Valuation Update | Is Timber Overvalued? | Do Sector Index Funds Make Sense? | New Lyxor ETF (Jeffries CRB Commodities Index); KKR's Private Equity LLP; Asset Risk Premiums; Windham Capital's Asset Allocation Software and Paper from Bank of International Settlements | 2006-2007 Benchmark Portfolios |