Interesting New Research
Deciding whether to invest actively (either by directly picking securities, or by picking a manager whom you believe is skilled at this art) is, at one level, a decision on how confident you are in your own sense of expertise. While we can and do argue that there is a higher wisdom involved - that involves recognizing the limits of one's knowledge and the power of one's emotions - we also recognize how the investment management industry very effectively plays on our natural desire to feel confident in our own judgment. Passive investing is for wimps, "who wants to be just average?" and all that. Regular readers know this game well. Two papers we read recently provide interesting food for thought on this issue. In "To Hold Familiar Assets or To Diversify? Keynes Meets Markowitz", Boyle, Garlappi, Uppal, and Wang develop a theory of why, when the level of ambiguity about the economy is high, investors might prefer the apparent security of investing in assets they know well (e.g., stock in the company where they work). However, a more recent paper ("Expertise Bias" by Doskeland and Hvide) provides a well-documented cautionary note about the risks of this strategy. Using a very detailed Norwegian data set, they ask whether concentrated holdings are driven by investors' possession of truly superior insight (which would tend to generate superior returns) or by behavioral factors (like ambiguity aversion) which would not. They conclude the latter is the most likely case, since, in their data set, these investments were far more likely to underperform. We should all keep in mind the famous Will Rogers quote: "It isn't what we don't know that gives us trouble, it's what we know that ain't so."
Further testifying to Rogers' insight is another paper, "Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds" by Choi, Laibson and Madrian. Subjects in their experiment were asked to allocate $10,000 across four index funds that track the S&P 500. The 730 subjects' rewards were tied to the future performance of their portfolio. They were given fund prospectuses that differed in an important way: annualized historical returns for the four index funds were covered different periods of time (e.g., Fund A had an annualized return of 18% between x and y; Fund B had a 15% return between a and b). Assuming all funds had similar tracking errors versus the S&P 500 Index (which wasn't reported, though these are typically small), the optimal decision in this experiment was to invest all the money in the fund that had the lowest expense ratio, as that would maximize realized returns. Yet almost none of the subjects made this choice, and most of them identified the differing reported historical returns for the funds as one of the top three factors that affected their allocation decision (apparently, few people realized the implications of the differing time periods). Amazing - and depressing.
On the other hand, we were heartened by a study by Bernheim and Meer provocatively titled, "How Much Value Do Real Estate Brokers Add?" Based on a high quality data set involving repeat sales over a 26 year period of houses located on the campus of Stanford University, the authors systematically examine the various potential sources of a real estate agent's value added and "find no evidence that the use of a broker leads to higher average selling prices or that it significantly alters average initial asking price. However, clients who use brokers sell their houses more quickly." And we won't even get into the differences in the legal requirements for truthful disclosure between the real estate and the securities industries. Let's just say we remain amazed that real estate agents have been able to keep charging their 6% commissions long after they went the way of the dodo in the securities industry. Perhaps agents' stellar contribution to the ongoing housing price collapse, and buyers' collective anger at having been hoodwinked will finally bring about long overdue change in this area.
New Product Launches
Downturn? What downturn? This month has seen not one, but two new "one stop shopping" ETFs launched that cover the global listed commercial property securities market. The first is from State Street - the SPDR Dow Jones Wilshire Global Real Estate ETF. It contains about 240 different property company securities (a definition that is broader than simply REITs) and an annual expense charge of .50%. Its ticker is RWO. The second product is the Cohen and Steers Global Realty Majors ETF. Its expense load is .55%, and its ticker GRI. It includes a smaller number (about 75) of the largest commercial real estate companies around the world. These two new products join the previously launched First Trust EPRA/NAREIT Global Real Estate Index Fund (.60% expenses, ticker FFR, about 300 companies in the index). As we have noted before, we generally believe these "global asset class" products are most attractive to people with few funds to invest who also want to maximize the diversification benefits in their respective portfolios. In this case, we prefer RWO, because of the greater number of securities and the lower expense charge. Investors with more to invest generally benefit from being able to assign different domestic/foreign weights than those built into these "all in one" products. While many researchers have found a significant common "global" component in commercial property returns across different countries, they have also found significant region and country specific factors that generate varying diversification benefits (depending on domestic versus foreign property weighting) at both the asset class and more importantly at the portfolio level (see, for example, "Global Real Estate Markets: Cycles and Fundamentals" by Case, Goetzmann and Rouwenhorst; "International Real Estate Returns: A Multifactor, Multicountry Approach" by Bond, Karolyi and Sanders; "What Factors Determine International Real Estate Security Returns?" by Hamelink and Hoesli; "Global Commercial Property Market Cycles" by Goetzmann, Wachter and Case; "Commercial Retal Estate Return Performance: A Cross Country Analysis" by Ling and Naranjo, and the Global Real Estate Study done by Ibbotson Associates for that National Association of Real Estate Investment Trusts).
Another interesting new product was a series of foreign currency (actually, short term money market) ETFs launched by WisdomTree. Of particular note is CYB, the WisdomTree Dreyfus Chinese Yuan Fund (.45% annual expense charge). For the first time, this makes it easier for investors to add this increasingly important currency to their portfolios, either in their passive allocation to foreign currency bonds, or, for the more actively inclined, as a dedicated bet on the appreciation of the yuan/renminbi. Another interesting product in this line up (ICN) will track the Indian Rupee (.45% expenses). This will make it much easier for an investor domiciled outside of India whose functional currency is still the Rupee (e.g., because of an intention of retiring there) to make an allocation to domestic Rupee fixed income.
With oil prices so high today, the launch of an ETF that tracks the percentage change in home heating oil prices could not be better timed. The United States Heating Oil Fund (ticker UHN). Like other commodity index products based on a continuously rolled portfolio of commodity futures contracts, UHN will earn interest income (since futures are purchased on margin, the balance of the fund's cash can be invested in U.S. Treasury Bills), which is estimated at about 1.25% per year in its prospectus. This more than offsets the .60% annual expense charge. However, what we find particularly interesting about the fund is that it will, for the first time, put a hedging vehicle within the reach of the average retail investor who heats his or her home with oil. For example, assume an investor spent $2,000 on home heating oil this year, wants to protect him or herself against spending any more than that next year. Investing this amount in UHN could, assuming the product performs as intended, provide this type of hedge. If the price of physical heating oil increased by 25% (so that the year's heating bill was now $2,500), the price of the ETF would also increase by this amount, and selling the EFT would enable the investor to pay his or her heating bill at the targeted $2,000 cash cost. Of course, there are transaction costs involved in buying and selling the EFT, particularly if the ETF is sold in small lots. Needless to say, we don't expect home heating oil companies to be trumpeting this product's virtues, as they appear to charge quite healthy fees for the underlying options they offer in the form of "price locks" and similar types of contracts.
Moving on to products that are notable for other reasons, we shook our head when we read about Deutsche Bank's launch of a series of leveraged reverse commodity Exchange Traded Note Products. Think about it: thanks to the miracle of leverage, you too can now easily take large speculative positions in commodities. Think DB's commodity index is going to rise still further? They make it easy to double up your long side bet with DYY. Think the index value is going to fall? Then double up on the downside with DEE. Too bad they didn't call these products "DUHs". We're not fans, as you may have guessed by now. The last thing the investment management industry should be doing now is encouraging speculation in commodities. Whatever happened to fiduciary duty and capital preservation? Dying virtues, it seems.
Imitation is the Sincerest Form of Flattery Department
Canadian company Jovian Capital has launched three new ETFs that are funds of ETFs (with another layer of brokerage commissions and fees added). They note that they "have developed a series of tactical asset allocation portfolios which provide the benefits of ETFs with an asset allocation platform managed by one of Canada’s largest independent money managers." These new ETFs are "designed to provide exposure to a combination of global equity, commodities and fixed income markets." The new ETFs come in three flavors: "Conservative Tactical Asset Allocation", "Balanced Tactical Asset Allocation" and "Growth Tactical Asset Allocation", "which all have been constructed following a disciplined, diversified approach that takes into account an investor's risk profile and investment time horizon." Wow. Breakthrough stuff. Well worth the high fees, we're sure. But at least "asset allocation" seems to finally be getting some attention. Who knows, maybe it's even becoming sexy. Try talking about it at the next party you attend, and let us know...
On a more serious note, both Vanguard and Russell have recently introduced specialized products aimed at retired investors who are trying to manage their decumulation strategy. Russell calls their offering the LifePoints Target Distribution Strategies. They note that it is designed to "provide a steady, but not guaranteed annual distribution." Their pitch is that "the funds leverage a unique, dynamic asset allocation strategy designed to provide retirees with an ongoing, reliable way to replace pre-retirement income; for certain funds, the potential to preserve some savings, and the flexibility to make changes throughout retirement" [take that, those of you pitching annuities!]. The funds come in two classes (the "S" Class charges 1% per year for "advice"), two target dates (2017 and 2027 - i.e., 10 and 20 year horizons), and high and low annual income targets.
Vanguard calls its offering "Managed Payout Funds." They come in three flavors: "Growth Focus", "Growth and Distribution Fund" and "Distribution Focus." Annual real payouts (which are not guaranteed), as a percentage of capital, are targeted at 3%, 5% and 7% (sounds familiar), and annual expenses are .57%. We find it interesting, and heartening, that these funds not only focus on a constant real payout, but also that they can invest in a wide range of asset classes, including domestic, foreign and real return bonds, domestic, international and emerging market equities, commercial property, and commodities. Frankly, this sounds like a big step in the right direction for the decumulation market. It is about time they caught up with us!
New Research on Investing After Retirement
While the new products from Russell and Vanguard are clearly improvements over what preceded them, they do not yet incorporate the full range of findings from the explosion of recent academic research into decumulation problems (i.e., investing after retirement). The starting point for much of this research has been the observed facts that take up of annuities has been low, and that (as Love, Palumbo and Smith note in "The Trajectory of Wealth in Retirement") "in real terms, the median household's wealth declines more slowly than its remaining life expectancy, so that real annualized wealth actually tends to rise with age during retirement." The key hypotheses that have been explored involve uncertain longevity, uncertain investment returns, uncertain exposure to future uninsured medical expenses, and intended bequests, either individually or interacting with each other.
Three early papers (which in this context means before 2006) in this area are "Annuities and Individual Welfare" by Davidoff, Brown; Diamond and "Health Shocks and the Demand for Annuities" by Sinclari and Smetters; and "Differential Mortality, Uncertain Medical Expenses and the Savings of Elderly Singles" by De Nardi, French and Jones. Both found that precaustionary saving for uncertain future health expenses (also known, in the U.S. papers, as "aversion to Medicaid", which is the federal health assistance program for the poor) provided a good explanation for the low take up of annuities (which insure against outliving one's assets, though at the cost, in many cases, of foregoing a bequest).
In "Elderly Asset Management", Feinstein and Lin focus on how the utility of a retiree's bequest motive changes over time, with attendant implications for asset allocation. For example, an investor's willingness to take risk in order to provide a bequest is likely to be higher than willingness to take risk with respect to his or her annual income. This will also be affected by the amount of relatively illiquid housing equity that the investor plans to include in the bequest. In short, like health, the bequest motive is a moving target that is likely to evolve over a retiree's lifetime.
In "Optimizing the Retirement Portfolio: Asset Allocation, Annuitization and Risk Aversion", Horneff, Maruer, Mitchell an Dus find that while fixed percentage of capital withdrawal strategies work quite well, investor’s welfare can be enhanced if the decision to annuitize part of their savings can be made at multiple points in the future when more information is available about his or her health condition and likely longevity (a point we have made in our writing too). Finally, two papers published this year attempt to take an even more comprehensive approach, by incorporating uncertain future health as well as annuitization in their respective models. In "Optimizing the Equity-Bond-Annuity Portfolio in Retirement", Pang and Warshawsky find that "the presence of health spending risk drives households to shift their portfolios from risky equities to safer assets and works to enhance the demand for annuities due to their increasing-with-age superiority over bonds as a hedge over health spending and longevity risks. The safe and higher return annuities inturn provide greater leverage for equity investments in the remaining asset portfolios" to help satisfy bequest motives. In "Portfolio Choice in Retirement: Health Risk and the Demand for Annuities, Housing and Risky Assets", Motohiro Yogo of the University of Pennsylvania finds that these decisions evolve over time, and that the welfare gain from annuitization is highest for retirees in the best health. Finally, in the previously mentioned paper by Love, Palumbo and Smith ("The Trajectory of Wealth in Retirement") the authors calibrate a model that incorporates actual portfolio data as well as uncertainty about longevity, asset returns, and health as well as annuitization, household equity and a bequest motive. They find that their model appears to explain most of the observed portfolio data.
All of this research points to the conclusion that there is still much work to be done on the product development side, not only in the development of better decision support tools for retired investors (a subject near and dear to our hearts), but also in the development of new offerings that integrate the management of longevity and health risks. In "The Life Care Annuity", Mark Warshawsky from Watson Wyatt proposes a product that combines long-term care and longevity risk protection. In "Annuity Valuation, Long-Term Care, and Bequest Motives", Ameriks, Laufer and Van Nieuwerburgh make a similar recommendation, as well as the creation of more contingent payout annuities that would be linked to various life changes during retirement. All of this research is very promising; we expect that Vanguard and Russell's new offerings are just the beginning of a wave of interesting new product offerings targeted at the needs of retired investors.
| 2007-2008 Benchmark Portfolios - All Currencies | This Month's Issue: Key Points | Product and Strategy Notes: Interesting New Research; New ETF Products - RWO, GRI, FFR, CYB, ICN, UHN and DYY/DEE; Canadian Asset Allocation ETFs; Vanguard & Russell Retirement Products; and New Research Investing After Retirement | May 2008 Economic Update | This Month's Letters to the Editor: Nominal vs Real Calculations, Canadian Oil Trusts - Claymore's ENY and Omega Function in Optimization | Global Asset Class Returns | Asset Class Valuation Update |