Product and Strategy Notes: Interesting Research Papers and New Products (VEU and RYMFX)

Interesting Research Papers

Over the last month, we've read a number of papers we believe might be of interest to some or all of our subscribers. In "Long-Term Reversals: Overreaction or Taxes", George and Hwang pose a serious challenge to the behavioral finance community. Historically, behavioral finance has attributed the existence of short term stock momentum and its eventual reversal to some combination of investors' cognitive limitations and durable barriers to complete arbitrage (which enable less than fully rational investors to have an impact on market prices). The cognitive limitations in question are usually deemed to be underreaction to new information that disconfirms existing views, overreaction to new information which confirms them, and eventual (and sudden) reversals when sufficient disconfirming evidence accumulates to cause investors to change their views and others to herd behind them. In their new paper, George and Hwang show that a better explanation for momentum is the reluctance of investors to sell their winners and thereby trigger the payment of capital gains taxes.

On a more technical level, Professor Andrew Lo from MIT has proposed a new approach to the vexing (but critical) question of how to measure the amount of alpha (active return) that active investment managers actually generate. In "Where Do Alphas Come From?", he proposes the simple but straightforward approach of using the covariance between portfolio weights and returns to measure the results of active management.

One of the most insightful financial writers we know is Michael Mauboussin, who is currently based at Legg Mason. His two most recent publications (available at http://www.leggmason.com/funds/knowledge/mauboussin/mauboussin.asp) on "Turtles in Omaha" and "Explaining the Wisdom of Crowds" are not to be missed.

Finally, the Federal Reserve Bank of Cleveland recently published a fascinating article by Bryan and Molloy titled "Mirror, Mirror, Who's the Best Forecaster of Them All?" After examining 23 years of forecasts by leading economists, they "find little evidence that any forecaster consistently predicts better than the consensus (median) forecast and, further, that forecasters who gave better-than-average predictions in one year were unable to sustain their superior forecasting performance beyond the degree that random chance would suggest." However, the median forecast was within ½ percent of the actual year-ahead outcome (for GDP growth and inflation) only 30% of the time. Almost half the time, the median forecast was off by 1% or more. This paper's findings mirror those in the 2001 paper by Chan, Karceski and Lakonishok, on "The Level and Persistence of Growth Rates." The concluded that "there is scant persistence in earnings growth beyond chance, and limited ability to identify firms with high future long-term growth....Valuations that assume persistently high growth over prolonged periods rest on shaky foundations." Sobering reading for people who believe in allocating substantial portions of their portfolios to actively managed products.

Interesting New Products: VEU and RYMFX

Two recent product launches in the United States also caught some subscribers' and our attention. Vanguard has introduced a new ETF that tracks the FTSE All-World ex US Index (ticker VEU, expenses .25%). The FTSE index differs somewhat from the indexes tracked by Vanguard's Total International Stock Market mutual fund (VGTSX; .32% expenses). The latter is a combination of the MSCI EAFE and Emerging Markets Index, which excludes Canada. The former includes Canada at a 5% weight. In both indexes, emerging markets' weight is 15% to 16%. We have a mixed view of these very broadly based international index products. On the positive side, for investors with limited funds, they can be a very useful source of portfolio diversification. However, their relatively small allocations to emerging markets (e.g., a 30% allocation to one of these funds would result in a 5% effective allocation to emerging markets) may be suboptimal for many investors. For investors who have enough money to invest in a larger number of funds, larger allocations to emerging markets to produce higher returns may make sense, since other asset class products can be used to diversify and reduce some portion of the added risk.

The second product that caught our eye was the new Managed Futures Fund from Rydex (RYMFX; expenses 1.65%). This fund tracks the new "Diversified Trends Indicator Index" (DTI) launched by Standard and Poor's. This index is based on a large number of futures contracts, with a 50% weighting on commodities, 35% on major currencies, and 15% on U.S. interest rates. Most interestingly, the index attempts to simulate the trend following strategy used by many active futures investors. It does this by taking either long or short positions in the futures it tracks based on their recent performance compared to their long-term moving average. Standard and Poor's backtesting analysis shows that the correlation of the returns on the DTI with those on most major asset classes is quite low, with the highest being found versus "long-only" commodity products (especially the Goldman Sachs Commodities Index; correlation with the Dow Jones AIG Commodities Index is lower). This fund is an obvious candidate for inclusion in the portion of an investor's portfolio allocated to actively managed market neutral products that are expected to have low correlations of returns with those on passive asset class index funds. However, investors making this move should do so with their eyes wide open - trend following strategies only work when there are trends to follow. In periods (like today) when there are few discernible trends (i.e., when volatility in most asset classes and currencies is low, and the market is said to be "moving sideways"), these funds tend to lose money. In addition, with more and more hedge fund managers seeking to justify their "2 and 20" compensation arrangements (or, perhaps more accurately, continue to pay for what have become for some of them quite expensive lifestyles), the competition in the trend following space has increased, which should put downward pressure on returns even when market conditions are favorable.

| Currency Exposure: A Risk to Be Hedged, a Source of Uncorrelated Returns, or Both? | This Month's Letters to the Editor: Responses and Inquiries to "Why We Don't Sleep Well at Night?" | Global Asset Class Returns | Asset Class Valuation Update | Product and Strategy Notes: Interesting Research Papers and New Products (VEU and RYMFX) | This Month's Letters to the Editor: Responses and Inquiries to "Why We Don't Sleep Well at Night?" | 2006-2007 Benchmark Portfolios - All Currencies | This Month's Issue: Key Points | Whole Life Insurance As a Source of Uncorrelated Returns |