Product and Strategy Notes: How to Deal with Real Debt Burden; Why He Madoff with Their Money; Great Writing Not to be Missed; Interesting Data Returns; Thought Provoking Research; and New Products

A Proposal to Kill Two Birds with One Stone in the Housing Market

As many commentators have noted (including us), the current crisis will persist, and quite possibly continue to worsen, unless and until a way is found to reduce the real debt burden household borrowers have amassed over the last decade. There are multiple means for accomplishing this objective, including revising bankruptcy laws and judicial processes, or a prolonged period of higher inflation (which would, however, help only those with fixed rate mortgages). However, based on our experience with LDC debt and corporate workouts, we believe that greater use of debt/equity type swaps is potentially a far more attractive approach. Here is how they might work. In the case of housing, borrowers would be given the option to refinance their current mortgage (which would help break the Gordian Knot of multiple securitizations and derivatives that has so far been a significant obstacle to effectively dealing with this issue). In place of their existing loan, they would enter into a smaller loan while also issuing to the lender the right to participate in a percentage of any future profit on the sale of the house securing the new mortgage. Logically, the percentage upside given away would be linked to the size of the loan reduction received. For tax purposes, the value of this participation right would be deemed equal to the difference in loan values, to avoid the adverse tax consequences that have stung homeowners who have been forced into short-sales up to now (where the forgiven amount is treated as taxable income to an already financially struggling borrower). The entity making the new loan and receiving the participation right (which would logically be either a government agency or program) would then bundle the participation rights into tradable securities that would track the performance of one or more residential property indexes. The government agency could then sell these for cash to institutional and retail investors seeking to further diversify their portfolios across asset classes (e.g., an individual renting a flat in San Francisco might want to add exposure to the residential property asset class to his or her portfolio).

A similar approach might be used to relieve borrowers of some of the burden of credit card debt. In this case, the lender reducing and refinancing the debt (logically at a fixed rate) would receive a right to participate in some portion of any increase in the borrower's income (which would be calculated and collected as part of the borrower's annual tax return) over some period in the future. These participation rights could then be repackaged into securities that track the performance of a wage index. In sum, creatively structured debt/equity swaps could not only achieve a widespread reduction in household debt burdens, but also create attractive new asset classes in which to invest.

Why He Madoff With Their Money

Sadly, it is really only scale that differentiates the Madoff story from dozens of scams that have preceded over the years. As always, red flags were ignored (e.g., the failure to separate asset management, trading, and custody; use of a very small accounting firm; lack of online statements; statistically improbable returns). As always, there were people who suspected something was amiss (e.g., apparently Goldman Sachs and some other large asset managers were in this category), some of whom (e.g., Boston money manager Harry Markopolos) tried to warn the Securities and Exchange Commission about potentially fraudulent activity at Madoff's firm. As always, regulators failed to heed these warnings and terminate the fraud before great damage was done. As always, there were people who were wiped out because they tossed prudent diversification (and skepticism) to the winds, and invested all their savings in what seemed to be such a great opportunity. As always, there were plenty of people who forgot or rejected one of life's great maxims: If something seems too good to be true, it's probably false. And, as always, some of the people who made this mistake were professional managers who collected substantial fees for their alleged investment skill. At the end of the day, we feel the most pity for the investors who trusted these professionals to be good stewards of their funds. They weren't directly taken in by Madoff's scheme, yet they must suffer its cruel consequences. When all is said and done, we suspect that it will be their painful stories that will have the most lasting impact, in the form of greater investor distrust of the financial services industry, less willingness to take risks, and, ultimately, fewer people reaching the financial goals they had once hoped to achieve.

Great Writing, Not to Be Missed

One silver lining in the 2008 crisis is the outpouring of great writing it has produced on the way the financial services industry has evolved over the past two decades, and how those trends led us to where we are today. In no particular order, we recommend taking a look at all of the following:

• "Barbarians of Yore Perish in Bonfire of Inanities" by John Helyar (on bloomberg.com)
  
  
• "Why Wall Street Always Blows It" by Henry Blodgett in the December 2008 Atlantic Monthly
  
  
• "The End" by Michael Lewis on portfolio.com
  
  
• "Wall Street Lays Another Egg" by Niall Ferguson in the December 2008 Vanity Fair
  
  
• "Risk Management" by Joe Nocera in the 4Jan09 New York Times

And lest any reader think that we have only been paying attention to great stories about the financial services industry, we also note the growing popularity of this quote from Alfred P. Sloan's 1963 book, My Years With General Motors:

"Success, however, may bring self-satisfaction...The spirit of adventure is lost in the inertia of the mind against change. When such influences develop, growth may be arrested or a decline may set in, caused by the failure to recognize advancing technology or altered consumer needs, or perhaps by competition that is more virile and aggressive...This is the greatest challenge to be met by the leaders of an industry. It is a challenge to be met by the General Motors of the future."

Some Interesting Returns Data

In the mass of returns data we've been wading through, five items caught our eye. Through the end of November 2008, the Harvard University Endowment, which is managed by some of the best (and well compensated) managers in the world, was down (22%) in nominal U.S. dollar terms. That is right in line with our USD 5% long-term target compound real return portfolio, which had returned -- in nominal terms -- (22.3%) YTD. By comparison, our USD 6% target real return portfolio was down (31.4%), our USD 4% target real return portfolio was down (18.9%), and our equally weighted USD portfolio was down (27.2%). The second number that caught our eye was the performance of the equity market neutral strategy (which we use in our model portfolios as a source of uncorrelated returns) in comparison to other hedge fund strategies. All the major hedge fund index providers (e.g., Tremont, HFR, etc.) showed it losing far less than other hedge fund styles. Of course that was before the Madoff scandal blew up, which will undoubtedly skew these returns (we expect to see future EMN returns reported in two forms: with and without Bernie).

The third number that caught our eye was the news that, through the end of November 2008, Bill Miller's Legg Mason Value Trust (ticker LMVTX) was down (55.7%) compared to the overall U.S. equity market (as measured by VTSMX) YTD return of (38.2%). Remember that Bill Miller outperformed the overall U.S. equity market every year between 1991 and 2005. Statistically, the chances that Miller accumulated this track record by luck were very slim; a conclusion that he posses true skill seems much better supported by the data. However, as we have repeatedly noted over the years, in a complex adaptive system like the economy and financial market, relationships between variables, as well as investor strategies, are constantly evolving, which eventually either makes superior forecasting models and sources of information obsolete, and/or leads to competition that eliminates the superior return returns they have delivered in the past. This raises an inevitable conflict between the normal human tendency to stick with what has been working and the need to constantly explore and innovate in order to remain successful in a constantly evolving environment (for an academic analysis of this issue, see "Path Dependent Preferences: The Role of Early Experience and Biased Search in Preference Development" by Hoeffler, Ariely and West). Sadly, it appears that this truism has finally caught up with Bill Miller, after a truly extraordinary run of investment success.

In the past, we have written about the controversy surrounding so-called fundamental and dividend based approaches to constructing equity market indexes. We therefore note how two EFTs that use these approaches stacked up in 2008 against a traditional, market capitalization based approach. Drum roll, please. In third place, with a 2008 return of (40.79%), was PRF, the PowerShares Fundamental Index Fund. In second place, at (36.50%) was VTI, the Vanguard (market capitalization weighted) Total Market Index. And in first place, at (34.96%) was DTD, the Wisdom Tree Total Dividend Fund. For us, the biggest surprise in this outcome was that DTD didn't outperform VTI by a greater amount, given the relatively high importance of dividend yields for long-term equity returns. So it looks like there's still a lot of life left in "old fashioned" market cap equity index weighting! Last but not least, we call your attention to the performance of two of the funds we have included in our allocation to uncorrelated alpha strategies. In 2008, the James Market Neutral Fund (JAMNX) returned (4.54%) and the J.P. Morgan Market Neutral Fund (OGNAX) returned (0.31%) -- both of these have performed as intended under extremely challenging circumstances, which raises our confidence in their management and the valuable role they can play in a portfolio.

Thought Provoking Research

As if disappointing returns, client fund withdrawals, and Bernie Madoff weren't enough, the hedge fund industry now has to contend with a growing number of papers questioning the source of the profits that have driven the 20% manager payouts under the famous "2 and 20" formula. In "Large Stakes and Big Mistakes", Ariely, Gneezy, Loewenstein and Mazar find evidence that high potential monetary rewards can deter performance in cognitively complex tasks. This further confirms the so-called Yerkes-Dodson law, that higher arousal only stimulates better performance up to a certain point, after which further arousal degrades performance (possibly because it interferes with the functioning of various cognitive processes). The authors note, that "many institutions provide very large incentives for tasks that require creativity, problem solving and memory. Our results challenge the assumption that increases in motivation would necessarily lead to improvements in performance. Across multiple tasks...higher monetary incentives led to worse performance." However, they also noted that "in general, the optimal level of arousal [as one would expect higher monetary incentives to produce] should be higher for more practiced tasks, particularly if prior practice has occurred under conditions of high incentives." Count on some hedge fund manager to repeat that sentence at some point in the future.

In another study ("Hedge Fund Alphas: Do They Reflect Managerial Skills or Mere Compensation for Liquidity Risk Bearing?"), Gibson and Wang find that "the outperformance [of many hedge fund strategies] disappears or weakens dramatically...once the effect of liquidity risk is incorporated into the performance evaluation framework...alphas are reduced to insignificant levels for most hedge fund styles but Equity Market Neutral, Fixed Income Arbitrage and Multi-Strategy."

Finally, here is some good news as we finish a hard year, and enter another one that may turn out to be even worse. So-called "happiness research" has been a hot topic among academics for the past few years, as they try to develop a better real world understanding of the theoretical, if hazy, concept of "utility." As one would expect, attempting to compare happiness across populations has triggered more than a few disagreements over the right methodology to use. These issues are well summarized in a new paper by three researchers from the RAND Corporation, Arie Kapteyn, James Smith, and Arthur van Soest. In "Comparing Life Satisfaction", they employ a very innovative new approach to eliminate response biases and different interpretations of survey questions that have called the results of previous studies into question. Using this methodology, they conclude that "life satisfaction is well described by four domains: social contacts and family have the highest impact, followed by job and daily activities, and then by health. Income has the lowest impact." While we all hope for better economic and financial market performance in 2009, investors and their advisers should not forget that it isn't income and financial returns that generate happiness.

Interesting New Products

In Europe, Pictet has launched the PF (Lux) Timber Fund. It will invest in the stocks of companies with high timber exposures. As we have noted in the past, we believe the best way for retail investors to access this asset class is via timber REITs, such as Plum Creek (PCL) and Rayonier (RYN) which limit exposure to industrial operations (e.g., as one would get via an investment in Weyerhauser). While a substantial portion of the Pictet's fund is invested in timber REITs or similar companies, it also includes exposure to forest related industrial assets. Still, we regard the creation of more vehicles that offer retail investors relatively liquid exposure to timber as a very positive development.

As frequent readers know, we have long advocated an allocation to commodities in most portfolios, and have frequently presented research on this asset class. On the basis of our analysis over the years, our preferred vehicles for gaining access to this asset class have been products that track the Dow Jones AIG Commodities Index. The main reason for this choice has been the fact that in comparison to other indexes, the DJAIG offers the most evenly balanced exposure to agricultural, metals and energy commodities, and should therefore maximize the so-called "diversification" return from a portfolio of futures contracts on different commodities. However, we have also noted a limitation of the commodity index products available to investors: they were all "long-only" and could not take short positions in so-called contangoed commodities (where futures prices are higher than spot prices). Because of this limitation, long-only commodity indexes were guaranteed to produce negative roll-yields (the profit or loss when a futures contract about to mature is sold and replaced by one with a longer tenor) when a commodity was in contango. In this regard, a critical (and still unresolved question) is whether increased investment interest in commodities as an asset class has substantially increased the probability of contango occurring, as more investors are bidding to buy futures contracts, and thereby driving up their price relative to the spot market.

From an investment perspective, the first step towards addressing this potential issue was the introduction of new indices in 2008 by Morningstar and Standard and Poor's that were based on taking long (in cases of backwardation) and short (in cased of contango) positions in commodity futures. For years, Mount Lucas Management has offered a similar index, but its use was limited to a fund offered by this company to high net worth and institutional investors (the MLM index also invested in currency and bond futures, and not just energy, agriculture and metals). The new Morningstar and S&P indices both employ moving average and momentum measures in the algorithms they use to determine whether to be long or short a given commodity. Both were also constructed with target limits on the volatility the index would generate. And most important, the new indexes were made available to ETF and index fund sponsors. Two new products were launched in mid-2008 that track the S&P Commodity Trends Indicator Index: An exchange traded note from Elements (ticker LSC, expenses .75bp, note obligor, HSBC bank), and a mutual fund from Direxion: the Commodity Trends Strategy Fund (ticker DXCTX, expenses 1.84%, minimum investment US$ 25,000). From June to September, the new products closely tracked the performance of DJP and PCRDX, and ETN and mutual fund, respectively, which track the DJAIG. However, once the crisis fully hit, the performance of these products significantly diverged, with the S&P-based products substantially outperforming the DJAIG-based products over the last four months of 2008, presumably because of their ability to take short positions in a falling market. Up to now, we have hesitated to recommend switching to these products, because we were not sure they would perform as promised. That issue has now been put to rest. However, these products are still not perfect - with the ETN, an investor must accept credit risk exposure to HSBC bank, as one takes exposure to Barclays with DJP (we know more than a few RIAs who have put clients back into PCRDX because of this issue). On the other hand, the $25k minimum for DXCTX is high, as is its expense ratio. On balance, we need to see a better product before we can wholeheartedly recommend a switch. But clearly, these new long/short commodity indexes seem to hold great promise for improving the performance of investors' portfolios.

Another alternative to traditional long-only investment in the DJAIG is use of a product that only invests in oil futures (e.g., an ETF like USO). The logic in this case is as follows. Between 1992 and 2007, the real return (with US CPI used to adjust for inflation) on the IMF's crude oil price index (which equally weights WTI, Brent and Dubai) averaged 9.8% per year with a standard deviation of 23.9%, or .41 units of return per unit of risk. Over the same period, the average annual real return on the DJAIG excess return index was 4.6%, with a standard deviation of 16.8%, or .27 units of return per unit of risk. The correlation between the two return series was .74. This was significantly higher than the correlation between the DJAIG and the IMF industrial metals price index (.30) and the IMF grains price index (.28). Moreover, because it is more difficult to store, and because stockouts are more costly to users, the convenience yield of oil is thought to be high, which raises the chances its future curve will be profitably backwardated, and not unprofitably contangoed. Based on the most recent IEA outlook, it also looks like oil supply and demand will be tightly balanced when the global economy recovers. And in the meantime, oil's deep and liquid futures markets appear to have made it an attractive destination for assets that are fleeing the U.S. dollar and/or seeking a hedge against inflation. In sum, evolving changes in both commodity markets and commodity investment products are making alternatives to long-only DJAIG-based products increasingly attractive.

Finally, in the United States, the ever-creative product developers at Barclays Global Investors have launched a series of new target-date and target risk-based ETFs, based on new ETF-based indexes from Standard and Poor's. We were particularly intrigued with the latter, and wondered to what extent they match the allocations in our long-term target real rate of return model portfolios. Here is what we found. The risk ETFs have attractive annual expense charges, ranging from .31% to .34% (i.e., 31 to 34 basis points per year). However, we were less impressed with the range of asset classes (represented by EFTs) in which they can invest. These include: large cap (IVV), mid cap (IJH) and small cap (IJR) U.S. equities; the EAFE index (EFA); emerging equities (EEM); large U.S. REITs (ICF); the Lehman Brothers Aggregate Bond Index (AGG); U.S. real return bonds (TIP); and short term U.S. Treasury bonds (SHV). From our perspective, this amounts to only six asset classes: real return and domestic U.S. government bonds, U.S. property, and U.S., foreign and emerging markets equities. Missing from the list are other asset classes we use in some of our portfolios, including foreign government bonds, foreign commercial property, commodities, timber and equity market neutral strategies, and one (equity market volatility) we would add if a retail index product was available. For example, the absence of a wider range of investment alternatives results in the "Aggressive" ETF having a 64.8% allocation to U.S. equities, and a 90.8% allocation to U.S., foreign and emerging market equities. That is significantly higher than the allocations to these asset classes in our most aggressive (7% long term target real rate of return) portfolios.

Unfortunately, neither Barclays nor S&P discloses the long-term expected real returns these four target risk ETFs are expected to produce. Rather, they disclose target risk thresholds for each fund (below which a "shortfall" is said to have occurred) and the maximum allowable probability that a target-risk fund will exceed this threshold, as shown in the following table:

Each fund's asset allocation appears (from the public documents) to be determined once per year in the following manner. First, S&P surveys the asset allocations used by the "ten largest asset allocation fund managers for whom asset class exposures are readily available on their respective websites." These averages provide inputs into the ETFs' asset allocations, which are then refined using an optimization model that incorporates the past 30 months of historical returns (with more recent returns given more weight, but assuming normal distributions) and the above shortfall constraints. We have two basic problems with this approach. First, it assumes the future will be like the recent past. There is no attempt to use forward looking asset class assumptions or to model regime switching or any of the dynamics that give rise to fatter tails (i.e., more extreme returns) than are found in the normal distribution. More importantly, its underlying philosophy appears to be that investors essentially have but one choice to make: what level of risk are they comfortable with? On the basis of that answer, one presumably "backs into" expected retirement income and bequests over time, as a function of the savings contributed to your portfolio, when you choose to retire, and the returns produced by the evolving asset allocation that is consistent with your risk choice.

Quite simply, we don't think that this reflects the way real life investors think about the challenges they face and what they can do about them. Instead, we believe that investors realize they have a series of tradeoffs to make, between levels of annual savings, target retirement date, the extent of part-time work after retirement, target post-retirement income and bequests, the extent of annuitization, rebalancing strategy, and allocations to different asset classes that imply different (and necessarily imperfectly estimated) probabilities of achieving specified objectives. We don't start out with the assumption that everything proceeds from an investor's target risk appetite, or that said risk appetite is immutable. Rather, we believe that, while most investors have a risk and uncertainty "comfort zone", depending on circumstances, they may be willing to move out of it to varying degrees that change with their financial and life circumstances. Moreover, that comfort zone might also shift in the other direction, for example, if a large bequest was received or one's health suddenly deteriorated. If that all sounds a bit messy and complicated, it is because we believe it is an accurate description of the way most people experience life. In our view, the great challenge facing the financial services industry is to provide a better experience for their customers, and not the other way around. So while we applaud S&P and Barclays for moving in the direction they have with these products, we believe that their innovation efforts should continue along the path they are on.

| 2008 Year End Double Issue: Key Points | This Month's Letters to the Editor: Commodies: Supply, Demand and Equilibrium; Construct of DJAIG; Benefits of ENM in Model Portfolios; Liquidity Reserves; and the Purpose of our Monthly Asset Valuation Update | Global Asset Class Returns | Asset Class Valuation Update | What Will We Tell The Clients? | 2008 Year End Situation and Methodology Update | Product and Strategy Notes: How to Deal with Real Debt Burden; Why He Madoff with Their Money; Great Writing Not to be Missed; Interesting Data Returns; Thought Provoking Research; and New Products | 2007-2008 Benchmark Portfolios - All Currencies |