A number of interesting new products have been launched over the last month. Barclays Global Investors launched the iPath Optimized Currency Carry Exchange Traded Note (ICI). With a .65% annual expense fee, it is ten basis points cheaper than the comparable PowerShares DB G10 Currency Harvest Exchange Traded Fund (DBV). Both of these products employ active currency trading strategies that are intended to generate returns that have low correlations with those on major asset classes. For example, over the 60 months ended in February, 2008, the returns on ICI had a theoretical correlation of (.04) versus the Dow Jones AIG Commodity Index, .07 versus the Lehman Brothers Aggregate Bond Market Index, .33 versus the S&P 500 and .29 versus the MSCI EAFE equity index. One major difference between them is that technically, an investor takes Barclays credit risk when investing in ICI, while DBV is an ETF without credit risk. Going forward, it will be interesting to see how the returns on ICI track those on DBV and whether they are essentially substitutes for each other.
Another new product of note comes from Rydex. The Alternative Strategies Allocation Fund (RYFOX) isn't cheap (1.76% annual expenses, and $25,000 minimum investment) - especially when you could get most of its components at a far lower cost. Twenty one percent of its assets are invested in none other than DBV. Another 14% track a commodities index. And about 17.5% were in commercial real estate. Frankly, the only interesting product to which the fund allocates its assets is the Rydex Managed Futures Strategy Fund (RYMFX). It isn't cheap either (1.77% annual expenses and a $25,000 minimum investment). It tracks the Standard and Poor's Diversified Trends Indicator Index, which is an active momentum based long/short product that gives commodity futures contracts a 50% weight (energy 18.75%, metals, 10.25%, and agriculturals 21.00%) and financial futures a 50% weight (35% to currencies and 15% to interest rate products). Like ICI and DBV. Frankly, we don't believe the extra benefits, if any, that this fund generates relative to other uncorrelated alpha strategies (e.g., like DBV, ICI, JAMNX, HSGFX, OGNAX, and ANGLX) are worth the much higher cost.
Elsewhere, State Street has launched a new ETF that tracks the performance of a portfolio of non-U.S. dollar inflation indexed government bonds. The DB International Government Inflation Protected Bond ETF (WIP) has annual expenses of .50%, and a portfolio allocated about 33% to Euro denominated issues, 18% to UK Pound Sterling issues, about 6% to Canadian Dollar issues and about 5% each to Swedish Krona and Japanese Yen issues. So where, you ask, is the remaining 33% or so? In interesting issues denominated in currencies issued by Korea, Brazil, Mexico, Israel and Turkey. So what is a good index investor to make of this new product? A good place to start is with the dynamics of real interest rates. As a recent research report from the IMF makes clear ("The Ties That Bind: Measuring International Bond Spillovers Using Inflation Indexed Bond Yields" by Bayoumi and Swiston), changes in U.S. real interest rates have a substantial impact on changes in real rates in other countries (with Australia and Japan being the least affected of the major markets). However, this is much less true in the case of inflation, where local factors dominate. Why is this important? Because in theory, changes in exchange rates (which will affect a U.S. dollar based investor's U.S. dollar return on WIP) are determined by differences between nominal exchange rates in two countries, which themselves are based on the real rate plus expected inflation plus a premium for bearing the risk of unexpected inflation over the life of the bond. That means that WIP is not a good substitute for an investor's allocation to U.S. Dollar denominated real return bonds. On the other hand, this product might well be a very good substitute for an investor’s allocation to BWX, RPIBX, PFBDX or other products that invest in nominal return foreign currency bonds. There is, however, a catch. These three products invest in bonds issued by developed country governments. With WIP you are building in a 33% allocation to emerging markets bonds. As we have noted in the past, we aren't big fans of emerging markets bonds, as we believe that they expose an investor to many of the same risks as emerging markets equities, while providing much less potential upside (this is the same argument that underlies our dislike for high yield bonds in the United States, compared to U.S. equity). So, to answer our question, does this new product belong in a U.S. dollar based investor's portfolio? At best, maybe. But it is clearly not for everyone.
Finally, three cheers for Barclays, for having launched a new ETF (ACWI) that tracks the MSCI All Countries World Index (ticker ACWI, .35% expenses). Why do we like this fund? We are often asked about how best to meet the challenge facing an investor with relatively little investable capital, but with a commitment to diversification across multiple asset classes. More so than any product thus far introduced, ACWI provides one stop exposure to the world's equity markets. Granted, a sophisticated investor may not like the underlying exposures (42% to the U.S., 43% to EAFE, 11% to Emerging Markets, and 4% to Canada, which isn't in the EAFE). However, that is less of a concern for an investor just starting out, and a product like this was long overdue. Congrats to BGI for finally launching it.
More Criticisms of Private Equity
The editors at the Financial Times apparently share our skepticism about the benefits (at least for investors) of private equity. In March, they published two blistering OpEd critiques. The first was by Steve Rattner, a capital markets and public policy veteran who runs his own investment firm. He noted that, "amid last year's breathless coronation of the 'buyout kings', private equity acquired the luster of mythology. In fact, reduced to its essence, private equity is more prosaic - being simply leveraged equity." To a great extent, any higher returns that private equity delivers (and it often fails to achieve this goal), are due to leverage and the acceptance of more liquidity risk (as investments in private equity funds, unlike hedge funds, are typically "locked up" for long periods of time). Perhaps giving operating executives more upside and more closely supervising their performance (which, we note, is not to be confused with adding value to that performance) might add a bit more to return. But the real drivers are additional risk premiums for bearing higher leverage and liquidity risk.
This was the point made in a second OpEd by Michael Gordon, the head of Institutional Investment at Fidelity International. He rather acidly (yet accurately, in our view) observed that "as investors are increasingly bruised by the recognition that reality has once again triumphed over hope, the private equity barons are having to confess that the benefits of superior management, alignment of interest and, of course, the superior reward structure [touted by private equity advocates] counted for very little...Private equity as we have come to know it is all about debt - lock, stock and sinking barrel...That [private equity investors] were happy to pay high fees for simple leveraged equity structures that could have been assembled in a do-it-yourself fashion seems remarkable now."
Elsewhere in the Search for Alpha...
We've also read a number of very interesting research papers this month on the broad topic of (certain) investor's never ending search for alpha, and the traps and pitfalls that lie along the way. On the hedge fund front, in "Why Does Hedge Fund Alpha Decrease Over Time?", Ken Zhong finds that it is "not due to an increasing percentage of funds with unskilled managers and negative alphas as suggested by the hedge fund bubble hypothesis [i.e., that a greater percentage of unskilled managers are now running hedge funds]. Instead, it is due to a decrease in the proportion of funds capable of producing large, positive alphas. This evidence is consistent with the prediction of the capacity constraint hypothesis" [i.e., that successful hedge fund managers cannot maintain their performance as their assets under management grow because the supply of alpha that can be captured by their strategies is finite].
However, another paper raises questions about this conclusion. In "The Hedge Fund Game: Incentives, Excess Returns, and Piggy-Backing", Foster and Young show how derivative markets can be used to generate "fake alpha" by selling insurance against rare events. This is a point we have also often made in our writing. The authors make the point that it is very hard for hedge fund investors to structure incentive compensation plans that distinguish between real and fake alpha. The authors conclude that "it is extremely difficult for investors to tell whether a given series of excess returns [alpha] was generated by skill, by mere luck or by duplicity. Because it is easy to fake excess returns and earn a lot of money in the process, mediocre managers and con artists could be attracted to the market."
Another paper ("Does Risk Shifting Affect Mutual Fund Performance" by Huang, Sialm, and Zhang) sheds further (unflattering) light on active manager behavior. The authors note that "some mutual funds change their risk levels significantly over time" for two possible reasons. The first it to take advantage of time varying investment opportunities (i.e., risk/return relationships). The second is to "manipulate their expected distribution of returns in the hopes of gaining an advantage [over other managers] in the tournament among mutual funds." The authors then ask whether the observed risk shifting has an impact on performance. If the fund shifts occur for the first reason, one would expect to see higher risk adjusted returns by risk shifting fund managers. Instead, the authors find worse returns among risk shifting fund managers than among funds with more consistent risk profiles, leading them to conclude that the observed risk shifting is consistent with opportunistic manager behavior, rather than the presence of true alpha generating skill.
As we have repeatedly noted, for most investors, the pursuit of active management success is unlikely to succeed. After ten years of studying this question, we are more convinced than ever that the most prudent, "reasonable man" strategy for the average investor is to allocate his or her funds to a diversified portfolio of broad asset class index products. A new paper by Ken French ("The Cost of Active Investing") provides further support to this position. French concludes that, "averaging over 1980 to 2006, investors spend .67% of the aggregate value of the market each year searching for superior returns." As we have repeatedly shown, most of these investors are doomed to fail in their quest, particularly as the time horizon over which they play the active management game lengthens. French logically asks, "Why do active investors continue to play a negative sum game?" Answering this question, he suggests that "perhaps the dominant reason is a general misperception about investment opportunities. Many [investors] are unaware that the average active investor would increase is return if he switched to a passive strategy. Financial firms certainly contribute to this confusion. Although a few occasionally promote index funds as a better alternative, the general message from Wall Street is that active investing is easy and profitable. This message is reinforced by the financial press, which offers a steady flow of stories about undervalued stocks and successful fund managers...Overconfidence is probably the other major reason investors are willing to incur the extra fees, expenses and transaction costs of active strategies. Investors who are overconfident in their ability to produce superior return are unlikely to be discouraged by the knowledge that the average active investor must lose." Harsh, but no doubt accurate. I guess we'll keep waiting for our invitation to appear on CNN or MSNBC...
| Investing in the Anglosphere: Who is the Fairest of Them All? | This Month's Letters to the Editor: Legg Mason's Bill Miller and How Do We Treat Inflation in Our Portfolios? | Global Asset Class Returns | Asset Class Valuation Update | This Month's Issue: Key Points | Product and Strategy Notes: New Products ICI, DBV, RYFOX, WIP, and WCWI; More Criticism of Private Equity and Search for Alpha |