Product and Strategy Notes: New Commodity Index Product, Competition for DFA, New Rydex Hedge-Type Fund, Cost of Active Management, Latest S&P SPIVA's Report and New Bridgewater "All Weather Funds" in Australia

New Commodity Index Products

A new ETF tied to oil prices (“Oil Securities”) started trading in London at the end of July. Not sure how much difference there is between this and the GSCI, which is already heavily weighted towards energy commodities. Still, the more commodity index products, the better. In the United States, Barclays Global Investors has registered a new ETF that will, like the Oppenheimer Real Assets Fund, track the Goldman Sachs Commodity Index. A similar product is already trading in the Eurozone. With an expense ratio of only .75%, the new GSCI ETF will be considerably cheaper than the Real Assets Fund (which also carries a hefty front end load).

More Competition for DFA

We have noted in the past how Dimensional Fund Advisers have differentiated their index offerings by offering index value tilts in asset classes where they are not elsewhere available. Slowly, this is beginning to change. A good example of this is the recent launch by Barclays Global Investors of new ETFs that track the value and growth sub-indexes of the MSCI Europe, Asia and Far East (EAFE) Index. Of course, this still leaves investors with the question of whether or not to take a value tilt. As we have noted in the past, there are two competing points of view on this issue. One says that the additional return value tilts have earned in the past have been compensation for risk factors that aren't captured by the standard deviation statistic. The other argument says, in essence, that two factors make a “free lunch” (higher than market returns, but with less risk) possible. First, some investors consistently make valuation mistakes (e.g., overestimating future growth rates, and overpaying for growth stocks which drives down the return on a growth index, and drives up the relative return on a value index). Second, there are durable barriers that prevent arbitrageurs from competing away the higher returns from a value tilt. Our conclusion is that while the latter argument may apply over short periods of time, over a 20-year holding period the efficient markets argument seems the stronger of the two. In other words, in financial markets, as in most other areas of life, there is no free lunch.

New Rydex Hedge-Type Mutual Funds

Rydex has recently registered a very interesting new offering, which attempts go give small investors a relatively low cost opportunity to gain exposure to hedge-fund type investment strategies. The premise of the new “Structured Beta Funds” is that you can replicate hedge fund strategies by copying their exposures to different asset classes and tilts within them. The funds' draft prospectus expands on this point: “As the result of market observations and internal and external research, Rydex Investments (the “Advisor”) believes that aggregate hedge fund performance is largely driven by exposure to well recognized structural investment strategies or Beta. Beta is commonly referred to as market risk.

“To better understand this concept, the Advisor offers an expanded definition: Beta is exposure to any systematic risk for which the investor expects to be rewarded over time. In this context it is easier to see how the Advisor considers exposure to both directional positions (e.g., equities and fixed income) and non-directional positions (e.g., value and corporate default) as Beta. Although hedge fund exposure to these positions varies over time, their exposure to them, in aggregate, and the investment returns provided by the exposure are surprisingly stable. The conclusion of the Advisor's research is that aggregate hedge fund returns are replicable through exposure to these structural investment positions and, therefore, the benefits of hedge fund investing can be delivered in a mutual fund. The Rydex Structured Beta Series Funds all employ a proprietary quantitative model that uses a style analysis of appropriate hedge fund index returns. This style analysis compares the returns of the appropriate hedge fund index returns with the returns of various directional and non-directional positions. Based on the results of this analysis, historical research and market insights, the Advisor constructs a portfolio mix of directional and non-directional positions that best replicates the return, risk and correlation characteristics of the appropriate hedge fund universe. The Advisor anticipates adding and subtracting directional and non-directional positions over time based on continuing research of hedge fund returns.”

Here is a concrete example of how this would work in practice. We regressed the 1994-2004 quarterly real returns on the CSFB/Tremont Hedge Fund Index against those on eight asset classes (Rydex uses more): investment grade nominal return U.S. dollar bonds, investment grade non-U.S. dollar bonds, high yield U.S. dollar bonds, U.S. commercial property, commodities, domestic U.S. equity, international (developed and emerging markets) equity, and U.S. equity volatility. Together, these variables had a .42 correlation with the return on the hedge fund index over this eleven year period. The specific factor exposures were as follows:

Other studies have shown that by adding other factors to this regression (e.g., the returns on long and short index option positions, the returns to small cap and momentum tilts, etc.), its explanatory power can be increased still further. In short, there seems to be much merit to the approach being taken by Rydex. Their structured beta funds will initially attempt to replicated the returns on an overall hedge fund index, an equity long/short strategy, and an equity market neutral strategy.

The True Cost of Active Management

We have long noted that, because of their net-long positions, actively managed mutual funds are effectively in the business of charging active fees (e.g., expenses as a percent of fund value) for what are, in large part, passive returns (i.e., the percentage of fund returns that are due to movements in the overall market, which could have been obtained via a low-cost index fund). This is the underlying problem that has given rise to the movement among institutional and sophisticated individual investors to “separate alpha from beta”, for example, by investing in a mix of asset class index funds, along with equity market neutral and global macro hedge funds.

A great new research paper has finally quantified the cost to investors that comes from mistaking beta for alpha. In “Measuring the True Cost of Active Management by Mutual Funds”, Ross Miller finds that over 90% of the variance in the average active fund's returns can be explained by market movements, not active management decisions. He then relates the active management expenses they charge to the active returns (alpha) they actually deliver. He estimates that (conservatively) actively managed funds in the Morningstar universe have an average active expense ratio of 5%. Ouch!

Latest Standard and Poor's Index Versus Active Report

S&P has published its latest SPIVA Report. The following table shows the percent of actvely managed mutual funds that underperformed the relevant index over the last five years.

Given the aforementioned finding that the average active expense ratio is actually 5% per year, doesn't their stunning long-term underperformance versus index funds make you feel good?

New Bridgewater “All Weather” Fund Launched in Australia

Bridgewater Associates and Bell Potter funds have recently launched a retail version of their institutional “All Weather Fund” in Australia. The fund's goal is to deliver a return similar to domestic equities, with a risk similar to domestic bonds. Its strategy for achieving this goal is to invest in a mix of asset class index funds, using some leverage in addition to investors' funds. Based on the average annual real return on Australian equities between 1989 and 2004, the fund's target average arithmetic real return should be about 8% per year.

| Equity Market Valuation Update | Should You Be in Hedge Funds and Private Equity? | This Month's Issue: Key Points | Global Asset Class Returns | Product and Strategy Notes: New Commodity Index Product, Competition for DFA, New Rydex Hedge-Type Fund, Cost of Active Management, Latest S&P SPIVA's Report and New Bridgewater "All Weather Funds" in Australia | This Month's Letter to the Editor: T.Rowe Price and Oppenheimer International Bond Funds (Alternatives) and Schwab One Source for II's Model Portfolios |