This Month's Issue: Key Points

This month's year-end issue covers a wide range of topics. Our lead article features three follow-ups from last month's asset allocation update. While we know that the distribution of some asset classes' returns are not normal (i.e., in the shape of the familiar bell curve), the extent to which use of other distributions will affect asset class weights is an unresolved issue among academic researchers. We analyze the impact of using non-normal distributions, and find that, except for our 7% target real return portfolios (where it leads to a higher allocation to domestic equity), it is not significant. On the other hand, we find that the constraints on asset allocation created by defined contribution pension plans' often limited range of asset classes can have a significant impact on an investor's asset allocation and probability of achieving his or her goals. Following up on an earlier article, we also analyze the impact of substituting a buy/write equity fund for a broad based domestic equity index fund. Once again, it only has a major impact in the case of our 7% target real return portfolios. We find that use of the buy/write fund leads to a significantly higher allocation to domestic equity when historical returns data are used to generate asset class risk and return assumptions. However, since the high risk adjusted historical returns on the buy/write strategy effectively amount to a free lunch, we are skeptical they will continue in the future.

Our next set of articles cover a range of product and strategy issues. While new sub-sector ETFs now being introduced have some potentially interesting uses, they may also tempt individual investors to pursue active trading strategies, which research shows lose money in the aggregate. We next review a recent IRS ruling that, in the short term at least, creates frustration for investors in commodity index funds. We strongly recommend that readers join us in writing to the U.S. Congress to urge changes in the relevant legislation by June 30, 2006. Commodity index funds are too important a source of diversification benefits to have them derailed by the IRS. We next move on to a discussion of new ETF products in Canada, and, in particular, one that tracks Canadian income trusts (which have been growing rapidly, and today account for ten percent of the market cap of the Toronto Stock Exchange). Converting a corporation into an income trust offers substantial tax advantages, provided the organization pays out virtually all of its earnings in excess of its annual depreciation charge. The high yields that result make these products popular with many investors. However, we identify two issues they raise. The first is the valuations companies receive upon their initial conversion from corporate to income trust status. In some cases, they appear to be higher than the tax advantages would warrant. The second issue is the fact that income trusts are not without risk. It may well be the case that the requirement that they pay out most of their earnings makes it harder for them to make the investments needed to maintain or improve their long-term competitive advantage.

Our next product and strategy note focuses on new funds from PowerShares and PIMCO that both aim to exploit Bob Arnott's finding that, historically, portfolios of companies weighted by revenue, cash flow, or book asset value have outperformed those weighted by the market capitalization of their equity. We explore the possible causes of this "fundamental indexation" anomaly, and whether it is likely to continue to exist in the future. In a market that is strongly attracted to efficiency, we suspect it won't, which makes us skeptical about the alleged benefits of these new funds.

Our last note summarizes a recent Financial Times analysis of the pros and cons of investing in private equity. Like us, The FT concludes that “fans of private equity argue it is a superior form of ownership. Skeptics, rightly, point out that it has no clear advantages.”

The last article in this month's issue is our regular quarterly economic warning indicators update. We conclude that while we successfully muddled through 2005 without a major crisis, the underlying imbalances in the world economy continued to worsen. Global economic growth remains dangerously dependent on the continued willingness of lenders to finance the U.S. housing and Chinese investment booms (or, perhaps, bubbles). When the day of reckoning comes, as we believe it must, we expect it will include a sharp drop in the U.S. dollar, a prolonged global economic slowdown, and, eventually, a substantial increase in inflation (with the U.S. leading the way). We also highlight three "unpredictable but potentially significant" developments that we could see in 2006. If nothing changes, the Iranian nuclear program may reach a critical point around March. Al Quaeda has apparently shifted its targeting to the world's oil industry. And H5N1 influenza appears to be slowly improving its human-to-human transmissibility.

| This Month's Letters to the Editor:MVO-Geometric Return, II's Rebalancing Method, Broad Hedge Fund to Equity Market Neutral, Funds for Foreign Commerical Property and Correction to Oct 05 Issue | The Financial Times Shares Our Skepticism About Private Equity | The Uses and Misuses of Subsector Index ETFs | December, 2005 Quarterly Warning Indicators Update | Global Asset Class Returns | Did the IRS Just Kill Commodity Index Funds? | This Month's Issue: Key Points | Asset Allocation: Uncertain Distributions, Additional Constraints, and BXM | New Products Based on Bob Arnott's Fundamental Indexing Theory | And What's Up with Canadian Income Trusts? | Equity Market Valuation Update |