Product and Strategy Notes: Bad News for Technical Trading Rules; Investing in Emissions Certificates: An Update; More Evidence on Why Active Managers' Success is So Often Self-Defeating; Interesting New Products - For a Variety of Reasons; and Pension Plan Design and Retirement Saving Adequacy

Bad News for Technical Trading Rules

There is almost no limit to the number of active investing strategies based on so-called technical trading rules, which buy and sell securities based on changes in their prices or trading volume. Examples of these include so-called "support and resistance", channel, and moving average rules. However, a new paper has called their profitability into question. In "Can Commodity Futures be Profitably Traded with Quantitative Market Timing Strategies?", Marshall, Cahan and Cahan test over 7,846 rules using historical data on the performance of 15 commodities between 1984 and 2005. They conclude that "while we cannot rule out the possibility that technical trading rules compliment some other trading strategy, we conclusively show that they are not profitable when used in isolation, despite their wide following."

Investing in Emissions Certificates: An Update

In Canada, a preliminary prospectus has been filed by GHG Emission Credit Participation Corporation (www.ghgemissioncredit.com). The new company is a vehicle for investing in this new asset class (see our previous article on this in our November 2006 issue). While it remains to be seen how whether a straightforward tax on carbon emissions or tradable emission certificates (which would create a new asset class) will end up as the dominant approach to managing the global warming problem (as the Wall Street Journal recently noted, economists favor the tax, while politicians favor tradable credits), we expect to see a growing number of retail oriented products launched in this area in the months ahead. At least in the short term (while the carbon market is in its infancy), there may be substantial opportunities for skilled managers to earn active management profits. Further confirmation of this comes from a recent research paper ("Are the European Carbon Markets Efficient?") by Daskalakis and Markellos, which concluded that restrictions on short selling and market fragmentation mean that, at least for the time being, this market is still far from efficient.

More Evidence on Why Active Managers' Success is So Often Self-Defeating

In their landmark 2004 paper ("Mutual Fund Flows and Performance in Rational Markets"), Berk and Green proposed an innovative theory of why active management success was not likely to persist. Skilled fund managers' success would attract such a large amount of new investment that diseconomies of scale would develop, forcing their returns back towards or below the market average. Berk and Green hypothesized that these diseconomies could include difficulty and expense in identifying attractive opportunities for deploying larger amounts of capital, and higher trading costs. However, since fund managers' compensation is in part tied to the size of their assets under management, Berk and Green concluded that the most skilled active managers would still end up with the highest compensation, even if this did not lead to superior returns for investors.

A recent paper provides evidence that one of Berk and Green's hypothesized scale diseconomies in fact exists. In "Scale Effects in Mutual Fund Performance: The Role of Trading Costs", Edelen, Evans and Kadlec study 1,706 U.S. equity mutual funds between 1995 and 2005. They find that "mutual funds trading costs are comparable to the expense ratio (144 basis points versus 123 basis points, respectively), but have higher cross sectional variability...Trading costs have an increasingly detrimental impact on performance as the fund's relative trade size increases." The authors define "excessive trading" as trading whose cost are larger than the additional value created by the trade. Some of this they attribute to funds reasonably accommodating investors' demand for immediate liquidity. However, this factor does not fully explain the apparently excessive trading. Hence the authors conclude that other factors, such as the need to generate so-called "soft dollars" (a portion of trading commissions that are used to obtain research, data and other services from brokers) are at work, and detract from the returns to investors in these funds.

Interesting New Products - For a Variety of Reasons

It seems that not a week goes by - even during the traditionally slow month of August - without another slew of new index investment products being launched. Needless to say, we don't write about most of them - let's just say that we are not big supporters of the continual creation of so-called "index" products based on increasingly narrow segmentations of broad asset classes. If you've read our publications for any length of time, you know that we believe that this "slice and dice" approach to product development essentially encourages active management that is likely to be detrimental to most investors' long-term economic health. As we have repeatedly noted, we believe that there are potentially three arguments to support taking these "tilts." First, one could believe that the higher or lower expected returns from these tilts rationally reflect higher or lower risks associated with them. Fair enough; however, we question the efficacy of adjusting a portfolio's risk/return parameters by taking tilts within an asset class rather than adjusting the weights given to different asset classes (since the correlations between tilts within an asset class are likely to be much higher than the correlations between broadly defined asset classes).

Second, one could believe that the return premiums on different tilts are time varying, and that one has superior forecasting skill, and is therefore able to earn significant (read: positive after transaction costs and taxes) risk adjusted returns by switching between different tilts over time. Again, we understand the argument, but also note that when a room of 100 people is asked to rate their driving skill, well over 50% believe they are above (and often well above) average.

Third, an investor taking a tilt could believe that, rather than rational compensation for additional risk, the additional return he or she expects to earn reflects systematic mistakes being made by other investors. While we have the utmost respect for this type of behavioral finance argument, we also note that most investors who make it fail to acknowledge its second part - to generate alpha (positive risk adjusted returns), one must also believe that there are durable barriers that prevent other investors from taking advantage of the errors you recognize, and in so doing competing their excess returns down to zero. The bottom line: if you can recognize and exploit investment opportunities created by other investors' systematic mistakes, why can't everyone else?

For all these reasons, you haven't and won't see us gushing over many new product announcements. On the other hand, some new product announcements do interest us. In particular, and in keeping with the approach we have supported for many years, we are enthusiastic supporters of new products that give retail investors passive access to new broadly defined asset classes that have significantly different return generating processes from existing investment options. We are also supporters of new actively managed products whose returns are expected to have a low correlation with returns on broadly defined asset classes - these are also known as "uncorrelated alpha" products. Our model portfolios currently contain modest allocations to so called "equity market neutral" and one currency trading product that meet this test. Finally, in the past we have also noted that investors who want to shift their allocation to different asset classes in pursuit of higher returns (as opposed to risk reduction, which is better addressed through systematic and episodic rebalancing) might want to "outsource" this to so-called "global macro" fund managers who they believe to be skilled in this area. For example, ninety five percent of a portfolio might be divided between broad asset classes and a long-term allocation to uncorrelated alpha strategies; the remaining five percent might be allocated to a global macro or so-called tactical asset allocation fund (provided, of course, that said fund employed a wide range of asset classes, and not just domestic debt and equity).

It is with these considerations in mind that we call our readers' attention to a number of interesting recent product launches. As noted above, Canadian investors will soon have access to carbon emissions credits, which (as we noted in our November 2006 issue), have the potential to become an interesting new asset class. Another new product that caught our eye was the Bearlinx Alerian MLP Select Index Exchange Traded Note (ticker BSR) that was launched in July. We wrote about the Alerian MLP Index in our December, 2006 issue, and concluded that since natural/geologic processes (e.g., oil and gas field depletion) were a key component of many MLPs, it could provide attractive diversification benefits to a portfolio (we also noted the caveat that the overall amount of MLPs outstanding was quite small in comparison to the major asset classes, and the cost of access might therefore be prohibitive). The new ETN has an expense ratio of only .85%, which makes it attractive. On the negative side, the issuer is Bear Stearns, which, as evidenced by its recent bailout of two of its subprime mortgage focused hedge funds, presents an investor with a non-trivial amount of credit risk. Bottom line: nice product, questionable issuer.

Another product that caught our attention was a new family of ETNs called Elements Spectrum (www.elementsetn.com) launched by Nuveen Invesetments, Merrill Lynch, BNP Paribas, and Swedish Export Credit Corporation (which is the ETN issuer, and which has a strong credit rating). Thus far, they have launched three products. Two ETNs track the metals (ECX) and energy (ECT) subsegments of the Rogers International Commodities Index (RICI). We have often made the point that from our perspective, the best commodities index product is one that equally weights exposure to three groups whose returns usually have low correlations with each other - energy, metals, and agricultural products. In terms of broad indexes, the DowJones AIG Commodities Index comes closes to this ideal. However, the introduction of subsegment commodity index products (e.g., by ETF Securities in the U.K. and Europe, or PowerShares in the United States) enables an investor to achieve an even better balanced (though at the cost of more time spent rebalancing between them). In this regard, the new Elements ETNs are effectively more of the same. More interesting, though perhaps not for the right reason, is the Elements Momentum Index ETN (EEH). Its goal is to generate superior risk adjusted returns by using technical trading rules to shift investments between large cap stocks (to keep down trading costs) in different market sectors - to put it differently, this is a sector market timing active management strategy nicely tarted up as an index fund. As noted above, the efficacy of technical trading rules is highly questionable. Moreover, if it turns out that this fund has one that works, what is to stop others from, at some point in the future, using a bit of regression to infer what the rule is (from changes in the ETN's investment holdings) and then copying it? Bottom line: Swedish Export Credit is an attractive ETN issuer; too bad about the product design.

On another front, investors in the U.S. now have a wider variety of funds to choose from to gain exposure to non-U.S. commercial property (real estate). In the beginning, there were actively managed funds from Cohen and Steers (IRFAX) and Fidelity (FIREX). Then came the first index product, State Street's SPDR Dow Jones International Real Estate ETF (RWX), which rapidly accumulated over $1 billion in assets. Now there are two more index offerings, one from Barclays Global Investors (iShares S&P World ex U.S. Property Fund, ticker WPS), and an expense ratio of .48% compared to the SPDR's .60%, and the Wisdom Tree International Real Estate Fund (DRW) with an expense ratio of .58%. While the State Street and BGI products use market capitalization weighting, the Wisdom Tree fund, in keeping with the firm’s fundamental indexing approach, weights its holdings by their respective dividend yields.

Speaking of real estate, earlier this year, BGI (iShares) launched three new ETF products in the United States based on the industrial/office (FIO), residential (REZ), and retail (RTL) subsegments of the broad FTSE NAREIT index. Presumably, part of the logic for these new products was to make it easier for investors to implement sector rotation strategies within the domestic property asset class, on the assumption that the returns on different sectors would have low correlation with each other, and would vary differently over the economic cycle. So far, a quick look at these three products' price history will show you that this theory hasn't quite panned out, with macro factors that affect the broad real estate asset class seeming to overwhelm any segment factors that are at work.

Another fund that has caught our interest is Affiliated Managers' Group First Quadrant Global Alternatives Fund (MGAAX; 5.75% load, 2.50% annual expenses). This fund was launched last year and is managed by First Quadrant, a Pasadena based boutique investment manager that specializes in global macro strategies. After more than a year of performance history, we were curious about how it compared with the Pimco All Asset Fund (PASAX, 3.75% load - though the C shares can often be obtained without a load through some fund supermarket programs - and .84% annual expenses), which also employs a global macro like approach and is managed by Rob Arnott, another well know Pasadena based investment manager. So who owns the bragging rights at the local money manager watering hole? The following table shows the two funds' performance, measured on multiple dimensions, between the end of April 2006 and August 2007:

On a return per unit of risk as measured by standard deviation, PASAX is the winner. However, standard deviation is a problematic measure of risk, as it gives equal weight to returns above and below the average and also (to the extent it is assumed to be a valid risk measure) assumes that returns are normally distributed, with zero skewness (a measure of a distribution's symmetry around its mean) and kurtosis (a measure of a distribution's peakedness relative to the normal distribution, and the likelihood of experiencing extreme returns). In this case, both MGAAX and PASAX show evidence of being managed by very skilled investment managers, with positive returns more likely than negative ones, and a relatively low likelihood of extreme returns. However, given the difference in costs, on balance we still prefer PASAX as a global macro product for retail investors.

Pension Plan Design and Retirement Saving Adequacy

Two recent research papers make important points about the effects of pension plan design. The first is from the Reserve Bank of Australia. As frequent readers know, we are big fans of the way Australia - unlike other developed countries - has found solutions to two of the biggest problems confronting governments today: how to fund health care and retirement income security. In the latter area, individual investment in defined contribution pension plans (known as Superannuation Funds) is mandatory. Up to now, a critical question has been whether these mandatory contributions would reduce voluntary savings by individuals. In "The effect of the Australian Superannuation Guarantee on Household Saving Behavior", Ellis Connolly concludes that rather than falling, voluntary savings has increased slightly since superannuation plans were introduced.

The second paper examines a particular U.S. experience, where individuals (in this case, college professors) have both a traditional defined benefit pension plan (to which both they and their employers contribute) and a defined contribution plan. In "Pension Plan Characteristics and Framing Effects in Employee Savings Behavior", Card and Ransom find that "each additional dollar of mandatory employee contribution to the defined benefit plan led to a $.70 reduction in contribution to the defined contribution plan...[In contrast], each additional dollar of employer contribution to the defined benefit plan reduced employee contribution to the defined contribution plan by only $.30."

Pension plan design, while a bit of a dry subject for some, is in fact a critical issue, as evidenced by two new reports. The first is from the Center for Retirement Research at Boston College. In their paper "Is There Really a Retirement Savings Crisis?", Munnell, Webb and Golub-Sass effectively criticize a number of recent articles that have concluded that America's retirement savings crisis might not be as severe as first thought. The authors note that the percentage of people whose retirement income adequacy (measured as a percentage of preretirement income) is at risk is substantially increased when "realistic assumptions about earlier retirement, reluctance to annuitize 401k balances or tap housing equity, and the impact of increasing longevity and rapidly rising health care costs" are included in the analysis. They conclude that the percentage of savers at risk of falling short of acceptable post-retirement income goals rises as age declines; while only 35% of "early boomers" (born between 1946 and 1954) are at risk, 49% of Generation Xers (1965 to 1972) are in this category, rising to 60% of GenXers in the bottom third of income. Very similar conclusions are found in the second paper, which looks at retirement savings adequacy in the U.K. In "There's No time Like the Present: The Cost of Delaying Retirement Saving", Byrne, Blake, Cairns and Dowd perform a stochastic simulation analysis and find that "the levels of [pension] contributions required for individuals who start saving late are so high it is questionable whether they are affordable for anyone not on a high income."

With so much at stake, it is no surprise that much political capital is being spent on both sides of the Atlantic this year by varying interest groups clashing over the proper default asset allocation in defined contribution pension plans. In the U.K. Byrne, Harrison and Blake have produced an excellent report for the Pensions Institute on this issue. In "Dealing With the Reluctant Investor: Innovation and Governance in Defined Contribution Pension Investment" they begin by noting that a very high percentage of plan members choose the default asset allocation. From a governance point of view, this raises some interesting issues, in that while plan participants may believe that plan sponsors have a fiduciary responsibility to choose the optimal default allocation, this is not the case in law. The report also finds that while most plans offer too many fund choices (a consequence of choosing providers, who then make a wide range of their funds available to the plan), many plan sponsors are reluctant to reduce the number of funds offered for fear of incurring liability if the selected funds do not perform as well in the future as those they have removed. The authors note the rising popularity of lifecyle and target date funds as default options, but also note that they may be inferior to "pre-packaged risk graded" strategies that employ a wider range of asset classes. This would also require better "safe harbour" rules to protect employers who fear the potential liability associated with anything that smacks of providing fiduciary advice.

The latter issue has already been addressed in the United States, where a range of interest groups are now clashing over the acceptable choices in the Labor Departments upcoming ruling on defined contribution plans' default asset allocation. The insurance industry is fighting tooth and nail to preserve the role of its products (so-called "stable value") funds in the default mix, even though these products provide very low returns and are ill-advised, in our view, for most investors. Meanwhile, the mutual fund industry has been fighting hard for the inclusion of so-called target retirement date or lifecycle funds as the default 401k allocation. As we have noted in the past, we have quite a few problems with these products, including the narrow range of asset classes most of them include, their heavy use of expensive actively managed funds, and their underlying asset allocation philosophy, which begins with a heavy allocation to equity and ends with a heavy allocation to money market funds, regardless of the minimum required real rate of return a given investor needs to earn to achieve his or her retirement savings or post-retirement income and bequest goals. From our perspective, too many of these products force naive but trusting investors to take on too much risk on their way to a sharply lower post retirement standard of living. Put differently, we believe a lot of investors in these products may get one or more nasty surprises from them in the future.

So what would we do differently? First, we'd adopt an Australian style mandatory defined contribution plan system. Second, we'd set our default asset allocation within these plans to an equally weighted mix of broadly defined asset classes. If history is any guide (and, as we all know, sometimes it isn't) this mix could reasonably be expected to produce a compound real return of between 4% and 6% per year. Third, we would implement this allocation via low cost index funds, similar to the approach used by the Thrift Savings Plan available to U.S. Federal Government employees. Fourth, we would restrict the availability of actively managed products in the plan to (a) a maximum percentage of total assets, and (b) funds with returns that are expected to have a low correlation with returns on the broad asset class index funds. Finally, we would provide user friendly tools that would enable investors to adjust the default asset allocation to reflect differences in individual goals (and required portfolio returns) and risk preferences. Unfortunately, we're not holding our breath waiting for the U.S. Congress to adopt such a common sense plan.

Last but not least, we just have to mention one more new product launch. The DWS Scudder Alternative Asset Allocation Plus Fund (AAAAX) "is designed to be a simple solution that gives the average mutual fund investor access to components of what [its sponsor] believes are some of the best alternative ideas, through one easily accessible strategy." The fund "gives shareholders access to non-traditional or "alternative" asset categories and investment strategies such as market neutral, inflation-protection, commodities, real estate, and emerging markets bonds and equity." Scudder's press release notes that the fund "offers the potential for adding return and minimizing risk through investing in a diversified set of asset classes that are largely uncorrelated to the core U.S. equity and bond markets." And all this for the bargain price of a 5.75% front end load (sales commission) and annual expenses of 1.90% per year. Think about that. For an investment of $50,000, the front end load would be $2,875, and the annual fee (on the money left to invest after paying the load) would be $895 the first year, for a total cost of $3,770. Makes $59 a year for The Index Investor look like a quite a good deal, don't you think?

| Should We Treat Art as a Separate Asset Class? | This Month's Letters to the Editor: How Do You Value Indexes?; How Does One Invest Now?; and Currency Overlay Strategies | 2006-2007 Benchmark Portfolios - All Currencies | Global Asset Class Returns | Asset Class Valuation Update | Estimating the Future Real Risk Free Interest Rate | Product and Strategy Notes: Bad News for Technical Trading Rules; Investing in Emissions Certificates: An Update; More Evidence on Why Active Managers' Success is So Often Self-Defeating; Interesting New Products - For a Variety of Reasons; and Pension Plan Design and Retirement Saving Adequacy | Comments on the Recent Market Excitement | This Month's Issue: Key Points | Jeremy Grantham's Case Against Private Equity |