Product and Strategy Notes: State Street's Filed -US ETF "IBND", Claymore's "WFVK"; Investing in Bond Indexes; New Paper - Sharing Longevity Risk - A Must Read

• On the new product front, State Street has filed for a new US ETF that will track an index of non-USD investment grade corporate bonds. Given the investors' growing worries about sovereign debt (the subject of an article in next month's issue), this new product (planned ticker is IBND) could prove quite useful in the years ahead. Elsewhere, Claymore has launched an ETF that tracks the Wilshire 5000 US Equity Index, which is the broadest measure of US equity market performance. Its ticker is WFVK, and, with expenses of just 12 basis points per year, it is very aggressively priced.
  
  
• On the fixed income indexing front, we were interested to read two recent articles: "In Bond Indexing, the Worst is First" by Randall Forsyth in the March 16, 2010 issue of Barrons, and "Region of Reverse Command", by Ramin Toloui from PIMCO. Both of them raised the same criticism of bond indexes that we did in our December 2004 article on "Investing in Debt Markets" -- because (unlike equities) bonds don't represent a residual claim on the issuer's cash flow, market capitalization based indexing methodologies run the risk of perversely giving more weight in an index to profligate issuers whose credit quality may be on the decline. Unsurprisingly, PIMCO found that a GDP weighted index of sovereign bonds outperformed a market cap based index. As we first noted six years ago, we continue to believe that fixed income indexing methodologies are relatively underdeveloped, and that sampling approaches (e.g., an equally weighted matrix defined by duration and credit exposure) are preferable to market cap weighting. The PIMCO article also made another point that we have previously raised: that in today's brave new world, there is room for debate over what constitutes the "risk free asset" upon which so much asset pricing theory depends. As a practical matter, we believe that U.S. Treasury securities will continue to play that role; however, but for the limited liquidity of their markets, we continue to believe that Australian and Canadian government bonds could also be candidates for that role, given these nations' resource endowments, good fiscal management, well functioning political systems, and the way they have dealt with their pension and health care liabilities.
  
  
• Speaking of fixed income, with many sovereigns needing to issue large amounts of debt over the next few years, public debt management offices are undoubtedly searching for new products to entice investors. With that in mind, we found a new discussion paper from the UK based Pensions Institute a very interesting read. In "Sharing Longevity Risk: Why Governments Should Issue Longevity Bonds", Blake, Boardman and Cairns make a compelling case for governments taking this step. If you want to quickly develop a good understanding of what may soon emerge as an investable asset class, read this excellent paper.
  
  
• We also recommend two recent papers on investing in commercial property/real estate. Institutions such as insurance companies and pension funds that are trying to match long term assets with long-term liabilities need to develop estimates of their respective durations (i.e., weighted average maturity and sensitivity to interest rate changes, which are often used to discount pension liabilities to their present value). In this context, the duration of commercial property, and therefore its role in a portfolio that seeks to match the duration of assets and liabilities has long been a subject for debate, because many of the cash flows associated with real property (e.g., rents and maintenance) can change over time, in line with economic growth and inflation, as well as factors specific to a given property market (e.g., the degree to which new supply is constrained). In a new paper ("The Interest Rate Sensitivity of Real Estate"), Chaney and Hoesli present a new study of the real estate duration issue, using a very detailed database covering the Swiss investment real estate market. We were very interested to read their conclusion that the average Swiss property in their database had a long-term free cash flow based return of 4.4% per year -- exactly in line with the 4.5% assumption we have used in our valuation model for Swiss commercial property. On the duration issue, the authors conclude that a 1% change in interest rates should, on average, produce a 13.1% change in the value of a commercial office property.
  
  
• The second interesting paper on real estate investing is "Real Estate Allocaiton Puzzle in the Mixed Asset Portfolio: Fact or Fiction?" by Cheng, Lin, Liu and Zhang. The authors' starting point is the observation that actual allocations to real property are lower than modern portfolio theory suggests they should be. In response, they note that MPT is a single period model that, critically, assumes that asset class returns are independent and identically distributed over time (i.i.d.) They show that for non-securitized property (i.e., non-REITS), this assumption is rejected by the data. As a result, actual real property returns and risk are holding period dependent. They conclude, "once real estate performance is measured over more realistic holding periods -- which are longer due to illiquidity and high transaction costs -- the real estate allocation puzzle appears to be fiction rather than fact."

| Product and Strategy Notes: State Street's Filed -US ETF "IBND", Claymore's "WFVK"; Investing in Bond Indexes; New Paper - Sharing Longevity Risk - A Must Read | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Global Asset Class Valuation Updates Detail through March 31, 2010 | Table: Market Implied Regime Expectations and Three Year Return Forecast | This Month's Letters to the Editor: How Can a Retail Investor Access Volatility? Clarification of "Return Momentum" | Table: Fundamental Asset Class Valuation and Recent Return Momentum | April 2010 Issue: Key Points | Investor Herding Risk Analysis | Feature Article: What Lies Ahead for China? |