Product and Strategy Notes: BIS Endorses Euro as Reserve Currency, Canadian Income Trusts, "Infrastructure", and US Investors - International Commercial Property Exposure Option

BIS Endorses Euro as Reserve Currency

As if the U.S. dollar didn't have enough problems, in a new working paper "The Euro as a Reserve Currency", the Bank for International Settlements concludes that the greenback finally has a serious competitor. The BIS "finds that the liquidity and breadth of euro financial markets are fast approaching those of dollar markets, and as a result the euro is eroding some of the advantages that have historically supported the pre-eminence of the US dollar as a reserve currency. This strengthens the incentive for monetary authorities to reconsider the currency composition of their reserves. Nevertheless, the introduction of the euro has not yet resulted in a significant change in the currency composition of official reserve holdings. The US dollar has maintained its place as the dominant reserve currency, supported perhaps by the edge that dollar financial markets still have over euro markets in terms of size, credit quality and liquidity, as well as inertia in the use of international currencies." We're not betting those advantages are going to last much longer.

So Much for Canadian Income Trusts

Among other truisms in life, it is almost always the case that, if a clever way to reduce taxes becomes sufficiently popular, it will trigger a regulatory response usually not to investors' liking. Take the recent case of Canadian income trusts. Over the past few years, an increasing number of publicly traded Canadian corporations had reorganized as income trusts. These conversions almost always generated a significant increase in the market value of the organization. There were believed to be two reasons for this. The most obvious was a sharp reduction in tax payments. The income of corporations was effectively taxed twice - once at the corporate level and once if it paid dividends to investors who held their shares in a taxable account. Income trusts avoided the corporate level tax, provided most of their free cash flow was paid out to investors. If trust shares (technically called "units") were held in tax advantaged accounts, the cash received could completely avoid taxation. Because of this, Canadian income trusts became quite popular with retired investors seeking high yields - and equally unpopular with governments facing serious revenue losses.

The second reason for the increase in trust values was more subtle, but no less important. Because most of their free cash flow had to be paid out to investors, income trusts had to return to the market (i.e., issue new units) every time they wanted to fund a significant investment. Among some investors, there was a belief that this resulted in more management discipline, and fewer value destroying investments. Others, however, thought that over the long term, the heavy payout requirement would discourage investment by Canadian income trusts, and lead to a gradual loss of global competitiveness (and, therefore, lower and lower income distributions over time). For better or worse, we will never learn which of these arguments was true. At the end of October, Canada announced that all new trust would effectively be taxed as corporations, while existing trusts would be taxed that way from 2011 forward, proving once again that it is not wise to tease the tax man.

Has Your Broker Called You About "Infrastructure" Yet?

If not, he or she soon will. You see, infrastructure is the new new thing. So, just what is "infrastructure?" Is it a new asset class? A new sure fire way to make money? No. It is what, in a bygone age, many of us called "utilities." Today, infrastructure is one of those maddening faddish investment terms whose meanings too often stretch like rubber to cover a multitude of sins. Toll roads and bridges are infrastructure. So are airports. And power plants. And water works. And pipelines. Basically, if George Banks sang about it in Mary Poppins, it's infrastructure (he was just a little ahead of his time, I guess. Who knew?). So what's the appeal? In theory, steady cash flows, with perhaps a little more upside than a bond, assuming you can either grow your franchise, or negotiate a higher return with the regulators. That's the theory, at least. However, based on twenty plus years experience with what, in the old days, used to be called "project finance" (before it became "infrastructure") we have a somewhat more jaded view. First, infrastructure is not a separate asset class. In some cases (e.g., airports, seaports) cash flow has a relatively strong correlation with GDP growth, and therefore with equity markets. In other cases (say, a water utility), share values should move up and down with local interest rates, just like a domestic bond. But unlike a bond, there is more risk involved with infrastructure projects. Just ask anybody who financed an infrastructure project with foreign currency debt and then discovered that it was politically impossible to raise prices (take your pick: tolls, power rates, water and sewer rates etc.) by an amount sufficient to meet rising debt costs. Or anybody who thought that nobody would be crazy enough to put in a competing pipeline. So much for that steady income you expected. Believe us, we've seen all of these and more. So excuse us for not jumping on the "infrastructure" bandwagon. We've seen this movie before.

Another Way for U.S. Investors to Gain International Commercial Property Exposure

As always, following hard on the heels of impressive returns in an asset class, more investable products appear. Foreign commercial property is no exception to this rule. We've mentioned four of these in the past: the Cohen and Steers International Realty Fund (IRFAX) and Worldwide Realty Income Fund (RWF); the Fidelity International Real Estate Fund (FIREX), and the Northern Trust Global Real Estate Index Fund (NGREX). Last month saw another potentially very interesting addition to this list, as State Street registered a new ETF with the SEC, which will track the DowJonesWilshire exUS Real Estate Index. Initially, the heaviest exposure will be to those countries with the most developed commercial property securities markets, including Australia, Japan, the U.K, and Canada. However, with more countries around the world changing regulations to encourage the securitization of commercial property, expect this to change over time. No word yet on when the new ETF will start trading.

Two Good Reads

Leave it to two professors from Trinity College in Dublin to make learning some important investment lessons memorable and fun. Go to www.ssrn.com and download "The Seven Deadly Sins of Investing" by Dowling and Lucy. You’ll be glad you did. Also, frequent readers of our publications know that one of the key assumptions underlying our view of the world is that financial markets (and indeed the global economy) function as a complex adaptive system. If you have ever wanted to read a clear treatment of this subject, your prayers have been answered in an outstanding new book by Eric Beinhocker from the McKinsey Global Institute. We strongly recommend adding The Origin of Wealth your Christmas list. It's a great read.

| This Month's Letters to the Editor: "What is a Market Index? - GCMI?" | Climate Change and Asset Allocation | Asset Class Valuation Update | Global Asset Class Returns | Market Microstructure: A Key to Volatility, Liquidity and Correlation Risk | Product and Strategy Notes: BIS Endorses Euro as Reserve Currency, Canadian Income Trusts, "Infrastructure", and US Investors - International Commercial Property Exposure Option | 2006-2007 Benchmark Portfolios - All Currencies | Recent Research on Investor Decision Making | Other Sources of Deep Systemic Risk | This Month's Issue: Key Points |