Product and Strategy Notes: Recent Research Reports and STILL more ETF Products

Interesting Recent Research Papers

As regular readers know, we read a lot of research papers. While we try to incorporate as many of them as possible into longer articles on subjects of interest, some of them don't immediately lend themselves to this purpose. Yet their findings are still interesting. Here are some examples. The OECD recently published two new research papers on a topic we have written about in the past: longevity risk. "Longevity Risk and Private Pensions" Pablo Antolin highlights the fact that many defined benefits pension plans have inadequately taken this risk into account, and attempts to quantify the potential impact. The key finding is that the size of the risk grows as the average age of people in a plan declines, and can reach very substantial levels. Of course, this raises  the obvious question as to how plans might hedge this risk. In "Governments and the Market for Longevity-Indexed Bonds", Antolin and Blommestein show how governments already have significant exposure to this risk themselves (e.g., via their commitments to provide old age related benefits), and might logically be reluctant to add to it by issuing longevity indexed bonds. On the other hand, the authors also note that governments are ideally positioned to establish and maintain the longevity indexes which are a necessary precondition to further private sector innovations in this critical area.

Moving on to other topics, in "A Two-Factor Asset Pricing Model and the Fat-Tailed Distribution of Firm Sizes", Malevergne and Sornette note that, while in theory diversification causes the capitalization weighted market portfolio to contain no firm-specific risk, in practice this assumption is violated when the distribution of firm market capitalizations follows a power law. In other words, an investor holding the broad market index may still end up exposed to some firm specific risk in the companies with the largest weights in the index. The authors then show how a combination of the equally weighted portfolio (which proxies for this under-diversification risk) and the market capitalization weighted portfolio is a superior asset pricing model than the market capitalization weighted portfolio alone - that is, a model which forecasts future stock returns based on exposures ("betas") to both factors is more accurate than one that only uses the market cap weighted factor. This approach is compared with the more widely known four factor model of Fama, French and Carhart (which forecasts returns based on exposure to the market cap weighted factor, plus size, value and momentum factors), and shown to be equivalent to it.

In reading the popular press, one frequently sees assertions that the benefits of international diversification have declined in recent years, as equity markets have become more integrated. However, in a recent paper ("Is the International Diversification Potential Diminishing?"), Karen Lewis of the University of Pennsylvania finds that the covariance between the U.S. and foreign markets has increased only slightly over the past twenty years. Moreover, "when [an investor] is restricted to holding foreign assets in the form of market indexes, the optimal allocation in foreign markets has actually increased over time."

On another front, in "Forestry and The Carbon Market Response to Stabilize Climate", Tavoni, Sohngen, and Bosetti explicitly link forestry management to the achievement of the Kyoto Protocol's objectives to reduce greenhouse gas emissions. They find that biological sequestration of CO2 (i.e., forestry management) could reduce the price of carbon emissions by 40% by 2050. This suggests that in the future, we may see an inverse correlation between returns on timberland  and carbon allowances, when and if trading in the latter grows.

In the past, we have written about the complicated trade-off retired investors face between achieving their bequest goals and hedging their longevity risk via the purchase of annuities. A new paper by Horneff, Maurer, Mitchell and Stamos ("Money in Motion: Dynamic Portfolio Choice in Retirement") covers the same issues and reaches the same conclusion that we did: the option to annuitize a part of one's savings should not be exercised all at once, and should never be completely taken up.

Rebalancing strategy is another favorite topic of ours. Vanguard has just published a paper ("Do Trader's Win? Trading Behavior and 401(k) Portfolio Performance") that reinforces many of the points we have made over the years. Specifically, the most frequent traders tend to underperform, while a disciplined approach to rebalancing strategy generates superior returns. Unfortunately, Vanguard finds that only nine percent (!) of plan participants rebalance their 401(k) accounts.

Still More New ETF Products

You have to give ETF marketers credit for one thing: they are an industrious bunch, even as we increasingly observe that most of the new products they produce are of little benefit to most investors' portfolios. Recent months have generally not been an exception to this rule. For example, Barclays Global Investors has launched a number of new ETFs that disaggregate the broad fixed income market and allow investors to take on finely targeted exposures to duration (maturity), credit risk, and mortgage prepayment risk. The only question we have is, "why would any non-professional investor want to do this?" As we have noted many times in the past, a most of the return on any domestic fixed income investment comes from changes in the yield of the five year government bond. Returns from other sources are more often than not marginal in comparison, and can be bought en masse by buying a broad based fixed income fund. Up to now, iShares AGG has been the only way for investors to do this via ETFs. However, Vanguard has now made its Total Bond Market Fund available in ETF form (BND) at an expense ratio of only 11 basis points. On the other hand, to give Barclays credit, we are big fans of the new Index Linked Gilt (real return bond) ETF it launched in the UK. Unfortunately, despite all the innovation in fixed income ETFs, we have yet to see a product that makes it easy for investors to gain exposure to foreign currency bonds.

Recent months have also seen an extension of other trends. As advisers and retirees continue to seek ways to earn high income returns, ETF product providers have responded, initially with high dividend oriented products, and now with products that track the high yield bond market (HYG) and U.S. Preferred Stocks (PFF). As we have repeatedly noted in the past, we believe that this focus on income is rooted in an irrational aversion to "eating into one's capital" and can too easily lead to uncomfortably high risk exposures (e.g., who out there things that this is just a great time to be adding to your exposure at the more exciting end of the credit risk spectrum, via a product like HYG?). Instead of this approach, we focus on total returns for an asset class (income plus capital gains), and even more important, the total returns to an overall portfolio.

Slicing and dicing a broad asset class into ever smaller pieces is a trend that is now moving beyond equity and fixed income. SSGA has introduced a range of new products that divide emerging markets equities into regional slices. New commodity products are also being introduced (e.g., iShares new natural gas ETF, which joins oil and precious metals ETFs and soon sub-segments of broader indexes, which will track agricultural, metals, and energy), as are new commercial property products (e.g., products in Europe and the United States that track regional commercial property indexes, and soon products that will track subsegments of the commercial property market like the apartment, industrial, retail and office sectors). While we like the sub-sector commodity products (because they will enable construction of equally weighted exposures to this asset class, which should maximize diversification benefits and returns), and many of the commercial property products (that make it easier for investors to gain exposure to domestic and foreign commercial property markets), too many of the sub-asset class ETF products leave us cold. We fear that they will tempt retail investors to believe they can successfully play the sector rotation game (against the professionals), and/or provide unscrupulous advisers with another opportunity to generate commissions by pitching spurious benefits to unsuspecting and trusting clients (e.g., "diversifying" exposure across products whose returns have correlations of .9 or higher).

| This Month's Issue: Key Points | This Month's Letters to the Editor: FT Articles: Commodity Index Funds' Future Contract Rollovers and VIX and Barclays' Water iShare | Global Asset Class Returns | Asset Class Valuation Update | Implementing Withdrawal and Savings Strategies | The Potential Benefits from MacroShares | Style Rotation With REITS | Product and Strategy Notes: Recent Research Reports and STILL more ETF Products | 2006-2007 Benchmark Portfolios - All Currencies |