Product and Strategy Notes: Private Equity Index Fund Registered; 3 Hedge Fund Studies; New Actively Managed ETFs; IMF - Future Commodity Prices;

Private Equity Index Fund Registered

We all knew it would eventually happen. And now it has. In early August, Powershares registered with the U.S. Securities and Exchange Commission a new "index fund" that will track the yet to be finalized "Red Rocks Listed Private Equity Index." Said "index" will include "stocks of securities and American depositary receipts ("ADRs") of approximately [_] publicly listed private equity companies, including business development companies ("BDC") and other financial institutions or vehicles whose principal business is to invest in and lend capital to privately-held companies (collectively "listed private equity companies")." Let's put it this way: we're not going to rush out to invest in this ETF when it is launched. Why not? Because on average, the returns from investing in private equity are no higher than those from investing in a broad public equity market index. But this average hides a more important fact: most positive private equity returns are earned by the top quartile of private equity managers - the rest earn far less.

Two recent research papers highlight why this is the case. In "Divisional Reverse Leveraged Buyouts: Finishing School or Financial Arbitrage?", Braun and Sharma compare a matched sample of divisions that were spun off by their parent companies via initial public offerings, to those which first go through an LBO before being IPO'd. They observe the latter outperform the former, and ask why this is so. They find that the LBO'd divisions start out with relatively superior operating performance, which remains unchanged while they are privately owned. The authors therefore conclude that the key driver of the superior IPO performance of the LBO'd divisions is superior deal selection and negotiation by private equity managers (in essence, their ability to buy the division from its owners for less than it is worth) rather than their ability to improve its operations before it is IPO'd. In another paper, "The Performance of Reverse Leveraged Buyouts", Cao and Lerner analyze 496 buyouts that were IPO'd between 1980 and 2002. They find much of the outperformance of these IPOs is concentrated in the larger deals. In the context of the soon-to-be-launched private equity "index" ETF, these studies raise a simple question: What are the chances that the relatively few private equity funds that will generate most of the returns from future buyout deals are going to be among those included in the index? In our view, the answer lies somewhere between slim and none.

Three Interesting New Hedge Fund Studies

We recently read three fascinating new studies of hedge fund performance. In "Hedge Funds: Performance, Risk and Capital Formation", Fung, Hsieh, Naik and Ramadorai study an extremely comprehensive database covering the performance 1,603 funds of funds between 1995 and 2004. They study funds of funds rather than individual hedge funds, because in today's environment more and more money is invested in hedge funds via this indirect route. Unsurprisingly, the authors find that there are significant differences across FOF's in terms of their ability to generate alpha for their investors. They also find differences among investors themselves, with some apparently skilled at identifying alpha generating FOFs, while others seem to simply chase returns, with no apparent skill at identifying alpha generators. Yet, like Berk and Green before them (in their famous paper, "Mutual Fund Flows and Performance in Rational Markets"), Fung, Hsieh, Naik and Ramadorai also find that in the hedge fund world, good times don't last. Funds that generate alpha receive larger inflows of new investment, which is associated with a decline in their future alphas. The authors conclude that their "findings suggest that there is an apparent mismatch between the supply and demand for alpha. On the one hand, capital appears to be seeking alpha. On the other hand, the supply of alpha appears to be drying up."

In "A Portrait of Hedge Fund Investors: Flows, Performance and Smart Money", Baquero and Verbeek shed more light on the behavior of hedge fund investors by separating their investment and divestment decisions. Specifically, outflows take place relatively quickly, based on quarterly performance, while inflows are more closely linked to annual performance. The authors speculate that the former phenomenon may lead underperforming hedge fund managers to take on excessive risk to avoid losing assets. They also speculate that the slow pace of inflows may lead to investor overconfidence about hedge fund manager skills, as it leads to apparent performance persistence at the quarter-to-quarter time horizon. The authors show that this confidence is not warranted, as on average hedge funds receiving substantial inflows tend to underperform their respective style indexes.

Finally, in "Can Hedge Fund Returns Be Replicated: The Linear Case", Hasanhodzic and Lo analyze the extent to which different hedge fund style returns can be replicated using linear combinations of six tradeable instruments: the U.S. dollar index futures, intermediate terms corporate AA rated bonds, the credit spread between BBB rated corporate bonds and U.S. treasury bonds, the S&P 500, GSCI, and VIX. Put differently, the authors attempt to replicate hedge fund returns using different combinations of stock, bond, credit, currency, commodity, and volatility risk. While full replication of hedge fund results proves impossible (due to the presence of alpha), the results the authors achieve will probably come as a surprise to many investors. Put another way, Hasanhodzic and Lo show that a surprisingly high proportion of hedge fund returns come not from alpha (i.e., exposure to unsystematic risk and manager skill), but rather from exposure to systematic risk (beta). This is not good news if you are paying 2% of the assets and 20% of the profits to a hedge fund manager, and perhaps another layer of fees to a fund-of-funds manager on top of that.

More New Actively Managed ETF Products

Frequent readers know that we like to distinguish between active management, passive management and indexing. The return on a security reflects compensation for bearing two types of risk. Systematic risk is common to all securities in an asset class; unsystematic risk is unique to either a single security or group of securities. At the level of an asset class, the positive and negative returns from holding unsystematic risk (alphas) cancel out, leaving only the return from holding systematic risk (beta). Passive investors seek only the beta return from holding systematic risk. Active investors seek to earn returns from holding either a combination of systematic and unsystematic risk, or only unsystematic risk (e.g., via a market neutral fund). In both cases, earning positive alpha from active management depends on some combination of good luck and/or forecasting skill. Finally, indexing is nothing more or less than a rules based method for identifying a group of securities whose returns can be aggregated (using some weighting scheme) and tracked. You can index systematic risk at the broad asset class level, and you can index different combinations of systematic and unsystematic risk. The most commonly known examples of this latter type of indexing are based on size, style (e.g., value versus growth), industry and country tilts. However, more and more new combinations of indexed systematic and unsystematic risk (or, more specifically, indexed active management products) are now coming to market.

Among these are three new ETFs by Claymore Securities. The Claymore/Zacks Sector Rotation Fund (XRO; annual expenses .65%) will use a proprietary model (based on relative valuation, price momentum and earnings growth) to switch between 16 sectors of the U.S. equity market.  A similar product has been registered by PowerShares. According to its prospectus, the Claymore/Sabrient Stealth ETF (STH; .65%) will invest in stocks tracked by two or fewer analysts that have good fundamentals, and the Claymore/Sabrient Insider ETF (NFO; .65%) will buy stocks with good fundamentals and unusual insider buying activity. All of these new ETFs are expected to generate high turnover in their portfolios - up to 200% per year, according to some press reports. This implies a hefty tax bill each year if these products are not held in tax exempt accounts. So, should you invest in one of these products? Or all of them? Well, that depends. The first point to make is that these funds all deliver a mix of systematic returns and unsystematic returns. They are not "uncorrelated alpha" products like a market neutral fund. The second point is that there are a lot of quantitatively oriented active managers out there who use models that are similar to the ones employed by these new ETFs. Unfortunately, all of them suffer from the same limitations, which eventually cause them to become ineffective. Either their models become widely copied, or the structure of the real economy changes and undermines their key assumptions. Why should you expect these ETFs' models to be any better than those employed by lots of hedge funds? And, if you believe they are better today, how long will it be before they lose their edge? If you can answer these questions to your own satisfaction, maybe these new ETFs are for you. But we can't, and won't be investing in them.

Another newly launched ETF is quite different from the equity products mentioned above. The PowerShares DB G10 Currency Harvest Fund (DBV; .81% expenses) brings currency speculation to the masses. The question is whether this is a game the masses ought to be playing. A new research paper sounds a cautionary note. In "The Returns to Currency Speculation", Burnside, Eichenbaum, Kleshchelski, and Rebelo first describe in detail the strategies followed by funds like DBV, and note their theoretical attractions. However, they then show how market frictions - such as the tendency of prices to move against a trader as he or she adds to his or her position - make profits far smaller in practice than they appear in theory. Of course, the other aspect to currency trading is that it is a very high turnover game. Once again, the tax bills associated with DBV are likely to be high, unless it is held in a tax advantaged account. So, on balance, where do we come down on this one? To begin with, currency speculation is an active strategy that should have a relatively low correlation of returns with most asset classes. For example, between 1994 and 2005, the return on the index tracked by DBV had a (.14) annual correlation with the S&P 500, with about the same return and a somewhat lower standard deviation (volatility). On the other hand, this was also a period characterized by a relatively stable global macroeconomic environment and falling interest rates. It remains to be seen how this strategy will perform under less benign economic and financial market conditions. And the same cautions about the inevitable deterioration of all trading models' effectiveness apply here too. That being said, we are still attracted to DBV's potential for generating uncorrelated alpha. With that in mind, we believe that it could (assuming it is held in a tax advantaged account) play a role in an investor's portfolio, in the portion that is allocated to uncorrelated alpha products, such as equity market neutral funds and now, possibly, DBV.

Finally, we have encouraging developments to report on the timber front. At least in Europe (we're not sure about their availability elsewhere), UBS has started to sell "certificates of participation" linked to the returns on their "Global Timber Index." This index tracks the returns on fifteen publicly traded timber-oriented companies. It includes Plum Creek and Rayonier, the two timber REITS we use to implement our allocation to this asset class. The advantage of the GTI is that it offers exposure to an internationally diversified mix of timber-oriented companies. Regional weights are the USA, 44%, Canada, 28%, Eurozone, 21% and Australia, 7%. The disadvantage is that some of these companies (e.g., Weyerhaeuser and Louisiana Pacific) are exposed to a wide range of return generating factors besides timber. Still, any progress toward making it easy for retail investors to gain broad exposure to this asset class is good news.

The IMF on Future Commodity Prices

The most recent World Economic Outlook, issued in September by the IMF, contains a special chapter on the future of commodity prices. As always, it is well written and insightful. The IMF begins by noting that "some observers have suggested that the rise of China and other large emerging markets may have led to a fundamental change in long-term price trends, and that the world has now entered a period of sustained high prices, particularly of metals. In contrast, others believe that speculative forces have largely decoupled metals prices from market fundamentals, and that prices will inevitably fall back and continue to decline gradually in real terms, as during most of the past century." It then sets out to determine which view is best supported by the available evidence.

The IMF analysts begin by noting that "despite recent increases, the prices of most nonfuel commodities remain below their historical peaks in real terms. Over the past five decades, commodity prices have fallen relative to consumer prices at the rate of about 1.6 percent a year. This downward trend is usually attributed to large productivity gains in the agricultural and metals sectors relative to other parts of the economy. Compared with the prices of manufactures, however, commodity prices stopped falling in the 1990s as the growing globalization of the manufacturing sector slowed producer price inflation. On a year-to-year basis, commodity prices can significantly deviate from the long-term downward trend, as price volatility is much higher than the average real price decline (one standard deviation of annual price changes is about 11.5 percent, compared with the long-term price decline of 1.6 percent a year)." The authors stress that "the current volatility in nonfuel commodity markets is not unusual by historical standards. In fact, the volatility of food and raw agricultural material prices seems to have fallen on average over the past couple of decades, as growing geographical diversification of production and technological advances have reduced the sensitivity of prices to supply shocks, such as bad weather or natural disasters."

Another important point is that "nonfuel commodity prices - especially metals - have a strong business-cycle component. The correlation between world growth and annual changes in real metals prices is about 50 percent. Moreover, almost all periods of large upward movements in metals prices have been associated with strong world growth. Prices of agricultural commodities also tend to rise during cyclical upturns, but their response is much more muted than in the case of metals because of more flexible supply and the low income elasticity of demand."

This is the reason why, "over the past four years, commodity prices have evolved very differently across various subgroups of the nonfuel index. Metals prices have risen sharply since 2002 to the present (by 180 percent in real terms), while food and agricultural raw materials prices have increased much less (by 20 and 4 percent, respectively). As a result, metals contributed almost 90 percent to the cumulative 60 percent real increase in the IMF nonfuel commodity index since 2002. The current price dynamics of food and agricultural raw material prices are similar to earlier cyclical episodes.... Until recently, metals prices have also tracked historical patterns - but the continued run-up in metals prices this year has made the cumulative price increase significantly larger than usual. A part of the unusually strong run-up in metals prices can be attributed to low investment in the metals sector in the late 1990s and the early 2000s that followed a period of earlier price declines. Some analysts have also suggested that the intensity of the price upswing in this cycle has been amplified by new factors - the increasing weight of rapidly growing emerging markets (especially China) in the world economy and investment activity of financial investors in commodity markets."

"China has become a key driver of price dynamics in the metals markets. During 2002 - 05, China contributed almost all of the increase in the world's consumption of nickel and tin (Table 5.3). In the cases of lead and zinc, China's contribution even exceeded net world consumption growth. For the two most widely traded base metals (aluminum and copper) and for steel, the contribution of China to world consumption growth was about 50 percent. Compared with the last decade, the relative contribution of China to global demand for commodities has increased considerably, as a result of both its rising weight in the world economy and its particularly rapid industrial production growth - including industrial exports - which is closely linked to the demand for metals. Other emerging market countries have also contributed significantly to demand in specific metals markets but, overall, their contribution was not as broad-based as China's. Is the strength of Chinese demand for metals temporary or permanent? Historical patterns suggest that consumption of metals typically grows together with income until about $15,000 - $20,000 per capita (in purchasing power parity, or PPP, adjusted dollars) as countries go through a period of industrialization and infrastructure building. At higher incomes, growth typically becomes more services-driven and, therefore, the use of metals per capita starts to stagnate. So far, China (with its current PPP-adjusted real income of about $6,400 per capita) has generally tracked the patterns of Japan and Korea during their initial development phase. For some metals, China's per capita consumption at a given income level is higher than in the other emerging markets, partly because it has a much greater share of industry in its gross domestic product than is typical for other countries at a similar stage of development. This outcome reflects historical antecedents as well as the strong competitiveness of the Chinese economy and relocation of manufacturing production from advanced economies and other emerging markets to China. Looking ahead, rapid industrial output growth, construction activity, and infrastructure needs could sustain the growth of demand of emerging markets for metals at high rates in the medium term. That said, some of the current demand strength could be temporary - especially as the Chinese government is aiming at a rebalancing of growth from investment to consumption over the medium term."

Just as important to future metals prices is the supply side response they trigger. "The market price of base metals is typically close to the production costs of marginal (i.e., relatively less-efficient) producers - especially at the bottom of the cycle. During booms, the market price can rise to a multiple of the production cost, although over the past couple of decades, the market price has tended to return to a little above costs within a few years. For aluminum, copper, and nickel, the current ratios of market price-to-cost in the range of 1.50 - 2.75 are similar to, or somewhat higher than, those experienced during the cyclical peak in the late 1980s. Back then, it took approximately two years for the market price to come down from the peak to near the cost level.... Production costs vary considerably over time, mainly reflecting energy prices, exchange rate changes, and cyclical factors, such as availability of skilled personnel and hardware. During 2002 - 05, production costs escalated for all metals -- by about 20 to 50 percent for the marginal producers -- with rising energy costs playing a significant part. It is clear, however, that the doubling to tripling of market prices over the past four years cannot be fully explained by the cost structure of the industry. Since demand for metals seems to be rising due to higher global growth and rapidly increasing income and industrial production in large countries such as China, the speed and costs of supply additions will determine whether metals prices retreat from the current high levels in the medium term."

The IMF's modeling results lead them to conclude that "rising commodities supply will be able to meet robust demand growth [and lead to] falling prices. The price decline is generated by a combination of factors: (1) recent accumulated price increases will have some dampening impact on demand; (2) considerable supply expansion is projected in the next five years; and (3) some additional supply is expected to come on stream in the short term." The IMF also notes that "the speed of supply response is significantly faster in the agricultural sector than in metals -- for example, crops can be switched from harvest to harvest relatively quickly in response to price signals. Moreover, the demand for agricultural commodities is less cyclical and therefore more predictable. Given these factors, long-term agricultural prices will mostly be determined by productivity gains, which are expected to continue in the future due to technological progress."

Finally, the IMF examines the contribution of financial speculation in futures markets to the recent increase in commodity prices. They conclude that "the short-run causality generally runs from spot and futures prices to speculation, and not vice versa... These findings are consistent with the hypothesis that speculators play a role in providing liquidity to the markets and may benefit from price movements, but do not have a systematic causal influence on prices." For the IMF, the conclusion is clear. "Most of the recent increase in nonfuel commodity indices is due to metals. The current upturn in their prices has been amplified by rapid growth in emerging market economies, particularly in China. Over the medium term, however, metals prices are expected to retreat from recent highs as new capacity comes on stream, although probably not falling back to earlier levels -- in part because higher energy prices have increased production costs. That said, the timing and the speed of the price reversal is uncertain, because with current high capacity utilization rates and low inventories, markets are very sensitive to even small changes in supply and demand.

| Key Conclusions from the IMF World Economic Outlook | This Month's Letters to the Editor: Comparison of Equity Market Neutral Funds: HSGFX, JAMNX, ANGLX, OGNAX and RYMQX | Global Asset Class Returns | Asset Class Valuation Update | Product and Strategy Notes: Private Equity Index Fund Registered; 3 Hedge Fund Studies; New Actively Managed ETFs; IMF - Future Commodity Prices; | This Month's Issue: Key Points | Volatility: A Primer |