Product and Strategy Notes: Two Interesting Papers on Commodities; News of Note for Advisors; Two Interesting Hedge Fund Papers; On the Product Front and Foreign Currency Bonds....Again

Two Interesting Papers on Commodities

Sometimes, it helps to put things in their proper historical perspective. In "Commodity Price Volatility and World Market Integration Since 1700", Jacks, O'Rourke and Williamson examine a very large data set, and reach three conclusions: (1) commodity price volatility has not increased over time; (2) rather, the authors find variation over time, rather than a trend: "three centuries of history show that economic isolation caused by war or autarkic policy has been associated with much greater commodity price volatility, while world market integration associated with peace and pro-global policies has been associated with less commodity price volatility; but (3) That said, "commodity prices have always been more volatile than the price of manufactured goods."

In "Risk Appetite and Commodity Returns", Erkko Etula looks at a much more recent data set, and finds that, from shortly after the launch of commodity futures contracts, "changes in the risk appetite of leveraged financial institutions such as security broker-dealers forecasts commodity returns at quarterly horizons...this result is particularly strong for energy commodities." While interesting, we're not sure about the conclusion of this study, which reminds us of the old warning that "correlation is not causation." Looking back over the past five years, we can see that rising commodity prices and returns occurred during a period when supply/demand conditions were tight, due to rapid economic growth, which was driven by high consumption by increasingly overleveraged U.S. consumers, whose addiction to borrowing was fed by very ample liquidity. In commodity markets, tight supply/demand conditions led to both more frequent price surprises (mostly on the upside, until the big downside move), and higher convenience yields (i.e., a higher value from owning physicals and hence a boost in spot prices relative to futures) which produced positive "roll yields". These same liquidity and economic growth conditions also led broker-dealers to use much more leverage, in part to finance much larger positions in lower rated tranches of mortgage based collateralized debt obligations which, as we now know all-too-well, later turned out to be highly toxic. To prove causation, Etula would have to show that a fall in the risk premium required by broker-dealers to hold long positions in commodity futures caused them to expand their purchases, which in turn caused the price surprises, generating higher returns and reinforcing this positive feedback loop. Clearly, people who blamed speculators for the run up in commodity prices during the summer of 2008, believed that this was the process at work. Yet, as we noted at the time, there was also evidence of very tight conditions existing in physical markets, just as today's much lower commodity prices are associated with clear evidence of substantial excess supply. As a result, we continue to believe that physical market conditions are a more important driver of commodity returns than is the extent of broker-dealer balance sheet leverage.

News of Note for Advisers

A number of recent studies contain interesting findings for financial advisers. In "The Influence of Financial Advisors on Household Portfolios", Gerhardt and Hackethal use an extensive German data set of 65,000 bank customers, and analyze the impact of deciding to obtain regular advice from an advisor. The authors observe that "many aspects of the differences between advised and non-advised investors can be attributed to differences in investor characteristics", rather than the actions of advisers per se. However, their analysis finds that, even after adjusting for investor characteristics, use of investment advisers still has a beneficial impact, including more diversification and less speculative trading. Hence, the authors conclude that "it is indeed worthwhile for most investors to hire an investment adviser." In another paper ("Smart Money: The Effect of Education, Cognitive Ability, and Financial Literacy on Financial Market Participation"), Cole and Shastry "provide the first precise, causal estimates of the effects of education on financial market participation." They find "a large effect, even controlling for income...one year of additional schooling increases the probability of financial market participation by 7-8%, holding other factors constant. They then test the hypothesis that increased participation is due to greater exposure to financial literacy education in school. They find that high school financial literacy programs do not affect financial market participation. Instead, after controlling for family background and other factors, they find that education increases cognitive ability, which in turn drives increased financial market participation. In sum, this study seems to confirm the observations and instincts of many of the financial advisers with whom we have discussed this issue over the years.

Advisers with high net worth clients may find "Emotional Assets and Investor Behavior" by Campbell, Koedijk, and de Roon an interesting read. The authors "use a broad range of indices on a number of emotional assets, such as art, wine, stamps, watches, atlases and books, which make up more than fifty percent of HNWIs' investment into the luxury goods sector. The reason for investing in such emotional assets goes beyond investment value alone. They also have a consumption value and provide the owner with greater utility in the form of aesthetic value and can act as a signal of the owner's wealth." The authors then note that a number of funds have been established that invest in these emotional assets. This raises a number of questions, including "just how large is the consumption or emotional value from holding these assets directly, instead of via a fund? Does this render the financial return insufficient to warrant investment into emotional asset funds?" The authors "find evidence that direct investors are willing to forgo financial returns to invest in certain emotional assets, such as clocks and watches, atlases and stamps." They conclude that "the consumption or emotional value of such assets is therefore very large." Based on their analysis of the data series they use, the authors also conclude that investment in these emotional assets provide diversification benefits. However, as we have noted in the past with respect to the potential diversification benefits from investing in fine art (or fine art funds), the construction of these data series raises a number of serious issues about their comparability with time series data for traded financial assets. Moreover, as we have noted in the past, given that prices of emotional assets tend to rise and fall with overall economic conditions, their diversification benefits are likely to be lower than what the time series data indicate. Still, the author's findings on the value that HNWIs' attach to emotional assets should either reinforce or sharpen advisers' view of this often important client issue.

We also read two new studies that bear on the issue of active versus passive management. The first is "When is Stock Picking Likely to Be Successful?" by Duan, Hu and McLean. They find that "mutual fund managers have stock picking ability in stocks with high idiosyncratic volatility, but not in stocks with low idiosyncratic volatility." Using a U.S. data set, they assert that this is "consistent with a situation in which high arbitrage costs for such stocks insulates mispricing." However, they also find that "the stock-picking ability of the average mutual fund manager declined after the extreme growth in the number of both mutual funds and hedge funds in the late 1990s." This latter conclusion is consistent with one found in the second paper, using a different data set. In "The Performance of Actively and Passively Managed Swiss Equity Funds", Ammann and Steiner study data from 1989 to 2007 for funds investing in Swiss equities using active and passive strategies. They find that "the average manager of an active Swiss equity fund systematically overweights small-cap and value" shares. They also find that both active institutional and active retail funds underperform comparable passive funds. However, most of this underperformance is concentrated in the retail funds, where fees and expenses are higher. Moreover, the underperformance has worsened since 2000, with the authors asserting that this is evidence of the Swiss equity market becoming more efficient.

Finally, we all know that the role of a financial adviser in his or her client's life often goes well beyond investments and planning. With that in mind, we will highlight the key findings from some other interesting studies we've recently read that seem quite timely in light of current economic conditions. In "Life Satisfaction", Kapteyn, Smith and van Soest analyze the determinants of life satisfaction in the Netherlands and the United States. They find that "life satisfaction is well described by four domains: (1) job or daily activities; (2) social contacts and family; (3) health; and (4) income." Among these four, "social contacts and family have the highest impact on life satisfaction, followed by job and daily activities, and health. Income has the lowest impact, though it is relatively more important in the United States than in the Netherlands." A closely related study is "Am I Going to Be Happy and Financially Stable? How American Women Feel When They Think About Financial Security" by Talya Miron-Shatz. The author's goal was to "reconcile the conflict between research findings suggesting that income does not substantially predict life satisfaction, and the commonly held belief that finances account for a substantial portion of well-being." Miron-Shatz focuses her study on women, because other research has found that they tend to worry more about finances than men. Her research confirms her hypothesis is that "measures of subjective financial security take precedence over monetary measures of income and assets in determining life satisfaction" and offers as a possible explanation for this findings from other studies that show how financial aspirations tend to rise with achievement, which prevents satisfaction from rising with the latter.

Two other studies dig deeper into the underlying factors that may be driving these results. In "Gender Differences in Risk Behavior", Booth and Nolen find "gender differences in preferences for risk taking are sensitive to the gender mix of the experimental group, with girls being more likely to choose risky outcomes when assigned to all-girl groups." They conclude that "observed gender differences in behavior under uncertainty found in previous studies might reflect social learning rather than inherent gender traits." Finally, the fourth study looks at the underlying causal drivers of work success. In "How the Rich (and Happy) Get Richer (and Happier)", Judge and Hurst find that higher "core self-evaluations" (essentially a construct that captures self-image and self-efficacy) "were associated with both higher levels of initial work success and steeper work success trajectories over time." They also found that "individuals with high core self-evaluations have more ascendant jobs and careers, in part because they are more apt to pursue further education and maintain better health." From an investment perspective, we found this study fascinating because it highlights a fundamental tension between the factors that drive long-term career and income generation (e.g., optimism, confidence, and a belief in one's ability to control events) and those that drive investment success (e.g., avoiding over-optimism and overconfidence, and recognizing the limits to one's ability to predict the future). In our view, all of these studies offer a glimpse into underlying mediating role played by the best financial advisers, particularly those who counsel very successful clients.

Two Interesting Hedge Fund Papers

As noted by ourselves and many other authors, the term "hedge funds" covers a multitude of investing approaches and seems to obscure important issues rather than clarify them - such as the fact, often emphasized in our writing, that most hedge funds are not intended to deliver the uncorrelated alpha that is so beneficial to a portfolio. At best, the term "hedge funds" today refers to a common approach to compensating active managers, which usually includes two fees, one a percentage of the value of assets under management, and one a percentage of profits earned each year above a given benchmark (e.g., the famous 2% and 20% formula). Some would argue that it also captures the ability to use investing techniques like leverage and shorting. However, we note that these are increasingly becoming more common in the mutual fund, as it moves closer to the hedge fund model. The first of the new research papers is cleverly titled "Crowded Chickens Farm Fewer Eggs." Weidenmuller and Verbeek, the paper's authors, examine data covering over 2,000 individual hedge funds that operated between 1994 and 2006. Their first finding replicates one made by other researchers: "on a fund-specific level, performance is concavely related to fund size and negatively related to inflows, with the latter effect contingent on fund size. More precisely, while small funds are hurt by inflows, larger funds are not, as the negative effect [on returns] of being past an optimal size predominates." More interesting is the authors second finding, that "on the strategy segment level [e.g., long/short, equity market neutral, global macro, emerging markets, convertible arbitrage, etc.], we also observe a concave relationship with segment size and a negative one with segment flows, implying that the increase in capital allocated [to popular strategies] eradicates the alpha returns available." The authors conclude that "the main contribution of this paper is that it shows that fund-specific and segment-specific inflows separately and differentially affect future fund performance." In sum, this paper reinforces the growing sense of many researchers that there is an optimum size for both a fund and for the amount of assets dedicated to a given hedge fund strategy. Once these are exceeded, returns decline. On the bright side, by reducing the crowding in many popular strategies, the current sharp reduction in the number of hedge funds that is now underway bodes well for future hedge fund returns, if you accept the conclusions of these papers. On the other hand, if the surviving hedge funds have a larger average size than before, this should result in lower returns (even before factoring in the impact of lower leverage and tighter regulation).

The previous paper referred to hedge fund and strategy level returns. However, the returns actually realized by investors depend not only on the assets in the fund and the overall strategy, but also on when they invested in a given hedge fund (e.g., those who invest after a period of rising fund or strategy returns are likely to be disappointed). This issue is analyzed in "Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn" by Dichev and Yu. They use "dollar weighted returns to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns." They find that "annualized dollar weighted returns are on average about four percent lower than buy-and-hold returns. This performance gap rises to as much as 9 percent for 'star' funds with the highest buy-and-hold returns [and the highest inflows from investors chasing strong past performance]." The authors also find that "dollar weighted returns, in aggregate, are below comparable returns for broad-based stock indexes." They conclude that "the combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought." Taken together, these two papers suggest some general rules for hedge fund investors: (1) focus on small or medium size funds; (2) avoid crowded strategies; and (3) avoid chasing good performance. To which we would also add, and focus on hedge fund strategies that are intended to produce uncorrelated alpha, and not those that combine both asset class returns (which you can obtain more cheaply via index products) and active returns (for which you should be willing to pay higher fees, assuming you believe the manager is skilled and can generate returns in excess of fund expenses and taxes generated by its trading).

On the Product Front

"Source ETF" the new European joint venture between Goldman Sachs and Morgan Stanley, has registered its first fifty ETFs in Ireland. It is largely a "me too" list that fails to break new ground in terms of asset classes or uncorrelated alpha strategies. Instead, the new offerings are focused on global equity markets and various tilts within them (the EPRA Eurozone Commercial Property Index ETF being a notable exception). On the bright side, more product should lead to lower fees for investors, and more advertising and other types of distribution support should result in more investors taking advantage of index products. In the United States, the most interesting new product registration involves new MacroShares ETF products that will enable investors to take long and short positions on the different residential real estate markets tracked by the S&P/Case Shiller Indexes. While we applaud the launch of a product that will give retail investors access to a new asset class, we continue to believe that getting overborrowed households, in the U.S., U.K. and elsewhere, out from under onerous mortgage burdens could best be done by creating a mechanism for swapping a portion of this debt into equity that could be combined into index products that facilitate investment in residential real estate as an asset class. On the gold front, a sharp eyed reader sent us a heads up about another financial product that is exchangeable into physical gold, that is similar to the Swiss ETF products discussed last month. The Perth Mint Gold product is a commodity call warrant (i.e., long-dated option) which trades on the Australian Stock Exchange under the symbol ZAUWBA. The warrants expire at the end of 2013, and can be settled in either cash or one troy ounce of gold (per 100 warrants). As we noted last month, any investor considering the purchase of a product that is potentially redeemable in physical gold should first ascertain the process, cost, and tax consequences associated with physical redemption. Finally, we note the publication of an interesting research paper by Lu, Wang and Zhang. In "Long Term Performance of Leveraged ETFs", the authors conclude that these products (which enable an investor to earn double or more of the return or the inverse of the return on a given index) "are not long term substitutes for long or short positions in the benchmark indexes" because of their substantial tracking errors for holding periods greater than one month.

Foreign Currency Bonds...Again

Long-time readers of our publications will recall that, at least until recently, we would regularly receive and answer questions related to our model portfolios' allocations to unhedged, developed market, foreign currency government bonds as an asset class. Briefly summarized, our logic has always rested on two premises: (1) evidence that, in local currency terms, foreign currency bond returns had low to negative correlations with returns on the domestic equity market, and (2) that along with foreign equities and foreign commercial property, foreign currency bonds provided a hedge against a sharp depreciation of the local currency, and thereby help to preserve the real purchasing power of a portfolio. Over the years, we have also noted that, when it comes to foreign currency exposures in a portfolio (via currency holdings or different foreign asset classes), reasonable people can disagree. For example, we have noted the traditional view that foreign bond holdings should be currency hedged, while some portion of foreign equity holdings should not (foreign property holdings, or holdings of other US dollar denominated assets like commodities, timber or various uncorrelated alpha strategies have yet to receive an academic analysis of whether they should be currency hedged).

Given our commitment to airing all sides of this debate, we recommend a new paper by Campbell, De-Medeiros, and Viceira. In "Global Currency Hedging", the authors consider the Australia, Canadian and U.S. dollars, Yen, Pound, Euro and Swiss Franc between 1975 and 2005. They find that "at one extreme, the Australian dollar and the Canadian dollar are positively correlated with local currency returns on equity markets around the world, including their own domestic markets. At the other extreme, the Euro and the Swiss Franc are negatively correlated with world stock returns and with their own domestic stock returns. The Yen, Pound and U.S. dollar fall in the middle, with the latter most similar to the Euro and Swiss Franc." Hence, from the perspective of hedging equity market exposures, an optimal currency position is long the Swiss Franc, Euro and U.S. dollar. The authors also find that, over holding period from one month to one year, most currency returns are almost uncorrelated with bond returns. On the basis of their analysis, they recommend fully currency hedging foreign bond investments. They note that "this is consistent with common practice of institutional investors" but also note that "global bond mutual funds are available without currency hedging." And they also note that, "the U.S. dollar is an exception to this general pattern, in that it tends to appreciate when bond prices fall -- that is when interest rates rise around the world. This generates a modest demand for U.S. dollars by risk minimizing bond investors." What the authors do not do is reach an integrated conclusion on currency hedging for an investor who holds a portfolio that is diversified across a wide range of asset classes. However, taking all of their analysis into consideration, it would appear that, for an investor who chooses not to hold foreign currency, but still wants the benefits of the hedge it provides, a position that is long unhedged foreign currency bonds (with a particular emphasis on Swiss Francs and Euro for U.S. dollar based investors, and on Swiss Francs, Euro and U.S. dollars for other investors) appears to make good sense. Events over the past year have certainly reinforced this impression. So it may be that after all this time we are finally getting closer to a more widely shared understanding of the role of unhedged foreign currency bonds in a portfolio.

| Letter from the Publisher | March 2009 Issue: Key Points | This Month's Letters to the Editor: Why Academic Research? and Why Not More Frequent Updates on Where Markets are Headed?; Why Not Currencies as an Asset Class? Is Your Use of Uncorrelated Alpha Strategies in some of your Models Inconsistent with Your Belief in Passive Investing? | Global Asset Class Returns | Uncorrelated Alpha Strategies Detail | Asset Class Valuation Update | Economic Update: Situation, Scenarios, and Asset Allocation Implications | Product and Strategy Notes: Two Interesting Papers on Commodities; News of Note for Advisors; Two Interesting Hedge Fund Papers; On the Product Front and Foreign Currency Bonds....Again | 2008-2009 Benchmark Portfolios - All Currencies |