Product and Strategy Notes: Interesting Commodity Research; The Coming U.S. Muni Market Train Wreck; New Volatility Research; Harvard and Yale Endowment Results; and More Interesting Research

Interesting Commodities Research

With various regulators trying to decide whether investors in commodity index funds are evil speculators or a stabilizing force, we call your attention to four recent research papers that bear on this issue. In "How Important are Common Factors in Driving Non-Fuel Commodity Prices", Isabel Vansteenkiste of the European Central Bank analyzes commodity prices from 1957 to 2008, using an approach similar to the principal components methodology we use to analyze asset class risk and return regimes. Her results show that, in addition to idiosyncratic factors unique to one or just a few commodities, "there exists one common significant factor...[that] has recently become increasingly important in driving non-fuel commodity prices. However, during the seventies and eighties, comovement of commodity prices with this factor was much higher...[and] idiosyncratic shocks remain important" in explaining recent price changes for the 32 non-fuel commodities she studied. Vansteenkiste then conducted further analysis to identify the macroeconomic variables that were most closely linked to changes in this common factor. The finds that they include oil prices, the U.S. dollar exchange rate, the real interest rate and global industrial production. She concludes that "this would lead us to reject the hypothesis that speculation results in higher correlation between [changes in commodity prices]."

In "More on the Energy/Non-Energy Commodity Price Link", John Bafes of the World Bank analyzes a data set covering 1960 to 2008, covering energy and 11 non-energy commodities. He finds that the average price transmission elasticity from energy to non-energy commodities is .28 (e.g., a 10% increase in energy prices is, on average, associated with a 2.8% increase in the 11 non-energy commodities). In some cases the relationship is much stronger (e.g., precious metals, at .46). Bafes notes that this large value "reflects the association of high energy prices with inflationary pressures, slower economic growth and resource scarcity, all of which prompt investors to view precious metals (especially gold) as safe investment alternatives, therefore increasing their demand and hence their prices." Bafes concludes that "for as long as energy prices remain elevated, most non-energy commodity prices are also expected to be high." Elsewhere in his paper, Bafes also makes the interesting note that “nominal commodity prices do not exhibit a strong mean-reverting process, nor do they move around a linear trend; instead, they are best characterized by a long memory process."

At the U.S. Federal Reserve, George Korniotis has published "Does Speculation Affect Spot Price Levels? The Case of Metals With and Without Futures Markets." After analyzing a data set covering 1991 to 2008, he concludes that comovement of prices between metals in both catetories "has not weakened in recent years" and "has been driven by economic fundamentals because world GDP growth is strongly correlated with metal price growth, especially after 2002." He also uses returns on the S&P Goldman Sachs Commodity Index as a proxy for the alleged volume of speculative activity, and finds “that these returns are unrelated to metal prices." In sum, Kornioties finds that "the run up in spot metal prices after 2003 is related to economic fundamentals and not to speculation by financial investors."

Another very insightful paper is "Limits to Arbitrage and Hedging: Evidence from Commodity Markets" by Acharya, Lochstoer and Ramadorai. They describe a new model in which producers' desire to hedge commodity price risk is driven by their financial condition (as measured by default spreads on their debt in the credit default market), and speculators face constraints on their ability to deploy capital to buy the futures contracts commodity producers wish to sell. As producers desire to reduce their price risk by selling more futures, this will tend to depress futures prices and thus make hedging more expensive. In turn, this makes it more expensive for producers to hold inventories, so they sell more product in the spot market, which causes spot prices to decline by an even larger amount than futures. An increase in the capital constraints on speculators (which would limit their capacity to buy the volume of futures producers want to sell at a given price) would have the same effect. The authors test their theory using data on energy futures and producers from 1980 to 2006, and find support for it. "An increase in the default risk of energy producers forecasts an increase in the default risk of producers forecasts an increase in returns on short term futures for these commodities."

Finally, Roache and Rossi from the IMF analyze a question that has long interested us and many of our readers: "The Effects of Economic News on Commodity Prices: Is Gold Just Another Commodity?" After analyzing data for 12 commodity futures contracts from 1997 to 2009, the authors reach a number of interesting conclusions, finding that "gold behaves very differently from other commodities." Their starting point is the observation that "a number of key U.S. indicators, including inflation, GDP, and employment statistics, repeatedly show the ability to move some commodity prices; in general, energy prices have tended to be less sensitive, while gold has been the most sensitive." The authors note that "commodity prices, in common with financial assets, incorporate expectations regarding the future. As a result, the impact of news announcements should focus on the surprise component in the news." They find that energy prices show the least reaction to news announcements, and that agricultural and base metal prices tend to be pro-cyclical (e.g., rising with news of higher employment or faster GDP growth). "In contrast, gold prices tend to be counter-cyclical, with the price rising when activity indicators are surprisingly weak...For gold, this apparent counter-cyclicality in the very short-term contradicts the results from earlier research using sample periods that stretch between 1970 and the early 1990s. Previous work had tended to find that the gold price was pro-cyclical; i.e., it rose when U.S. inflation increased or activity indicators strengthened by more than the consensus had anticipated. Our results do not imply that the inflation-hedging properties of gold have diminished, but instead suggest two features of gold: first, in the short-term sensitivity is higher to market expectations for real interest rates; second, gold is seen as a safe haven during bad times...The shift to a more pro-active U.S. monetary policy stance in the 1980s effectively substituted real interest rate volatility for inflation volatility. This implies that positive inflation surprises increase the probability of counter-cyclical monetary tightening, and higher real interest rates, which tend to appreciate the U.S. dollar and depress gold prices." The authors also find that "Euro area indicators that point to stronger activity or higher interest rate tend to increase the gold price and depreciate the U.S. dollar, providing further evidence of gold's dollar-hedging characteristics." Finally, negative surprises have a much stronger impact on gold prices than positive surprises. The authors conclude that "this is consistent with the view that gold is a safe haven, and financial assets -- in this case, gold futures -- experience greater volatility during periods in which economic or financial conditions deteriorate."

The Coming U.S. Muni Market Train Wreck

According to the Federal Reserve's June 2009 Flow of Funds Report (Table L.211), U.S. state and local governments have $2,716 billion in municipal securities and loans outstanding. About $193 billion of this amount is industrial revenue bonds (where the primary obligor is a private sector corporation), and $2,117 billion is securities issued by state and local governments with maturities of more than 13 months. Who holds this paper? Households directly hold $969 billion, money market funds, $483 billion, mutual funds, $406 billion, property and casualty insurance companies, $375 billion, and commercial banks $214 billion. As you can see from these amounts, if something were to go badly wrong in the municipal securities market, another financial crisis would likely result. Yet that is what we believe is probably going to happen at some point in the next three years.

To understand the logic behind this conclusion, one needs to look at the liabilities, operating costs, current revenue streams, and political realities facing many municipal issuers. In terms of liabilities, many state and local governments were facing badly underfunded pension plans, even before the 2008 market crash, a trend that has been worsening since 2000. Moreover, as many commentators have noted, the size of many public plans' unfunded liabilities is likely understated, due to their assuming much higher average annual investment returns (often more than 8%) than comparable private sector plans. A further problem is that many of these plans may be using outdated actuarial tables, which underestimate the likely longevity of their plan participants. Beyond unfunded pension liabilities, state and local bond issuers also face growing liabilities for "other post employment benefits" ("OPEB"), the most important of which is healthcare for retirees. Until recently, the size of these liabilities has not been calculated, and they have been paid out of current revenues on a "pay as you go" basis. However, the Government Accounting Standards Board now requires that the present value of these future liabilities be reported.

On the operating cost front (excluding provisions for pension and OPEB funding), state and local government issuers are facing increased pressure from rising current salary costs (the most important of which is usually from the rising percentage of teachers at the top of the salary scale, due to declining enrollments in many districts), as well as the need to employ higher numbers of teachers to meet various mandates (e.g., for special education and the No Child Left Behind law). At the same time, governments face rising costs for infrastructure maintenance (due to both the ageing of facilities and deferred maintenance from previous years), and for various social safety net programs. The latter has both cyclical causes (the current recession) as well as structural ones (e.g., widening wage gaps, falling levels of private sector health insurance coverage, and rapidly rising health care costs).

Unfortunately, at the very time that state and local bond issuers face rising costs for funding liabilities and current operations, their revenues are under tremendous downward pressure. In the current recession, all major revenue sources, from sales, income and property taxes (and in many states, gambling), have seen declines. More important, recovery from the current recession is likely to be slow, with unemployment remaining stubbornly high, and house prices and consumer spending low. In the short-term, however, the seriousness of this revenue problem has been masked by a significant inflow of federal stimulus funds into state and local government coffers. However, even the federal government faces borrowing constraints, and the flow of federal funds can't be expected to last.

In sum, many issuers of municipal securities are now facing very strong pressures to increase the funding of their liabilities, while operating costs are rising and revenues are falling. And the problem seems likely to only grow worse in the next few years. The obvious answer, of course, is to either cut costs or increase taxes. Unfortunately, many municipal issuers are likely to find either of these options extremely hard to implement. On the cost side, many costs are mandated by a higher governmental authority that provides only partial funding for them. In some cases, public employee pension liabilities are guaranteed in the state constitution, while across the country (with California recently providing the most vivid example) public sector unions have strongly resisted any reduction in their compensation, whether via pension benefit reductions, wage cuts, or furloughs (i.e., mandatory days off with no pay).

Tax increases also present steep challenges. With the Obama administration planning higher federal taxes on affluent taxpayers, it will be even harder for states to sustain significant differences in marginal rates on this group, as their sensitivity to this cost should increase as it rises. And make no mistake about the importance of the most affluent taxpayers to many states' revenues -- in California, for example, households with the top one percent of income pay forty percent of the state's income taxes.

Increasing income taxes on the much larger middle class, at a time when many are facing unemployment and struggling to make payments on mortgage and credit card debt would likely trigger a storm of political opposition. Resistance is likely to be particularly acute if the higher taxes will be used to fund public employee pension and retirement benefits that are substantially better than those facing the private sector workers and small business owners being asked to pay (even more) for them. Moreover, the often times dismal levels of service quality provided by too many state and local governments (in comparison to what taxpayers expect from customer service oriented private sector organizations), and the confrontational "entitlement" mentality displayed by too many public sector union leaders are also very likely to engender strong opposition to higher middle class income taxes. Raising property taxes is always an option, but with many homeowners facing negative equity, it seems likely to provoke the same reaction as a middle class income tax increase. Moreover, in more and more jurisdictions, limits have been placed on the maximum annual increase in property tax collections. This leaves sales taxes. Broadening the tax base (as to include a wide range of services (instead of increasing sales tax rates) is perhaps the best of a menu of bad options facing state and local governments. However, the revenue impact is likely to be substantially constrained by the overall decline in consumer spending.

Given this outlook, it seems inescapable that at the municipal level we may see a rising number of Chapter 9 municipal bankruptcies in the years ahead. However, that still leaves unanswered the particularly thorny issues that arise when a state government cannot, or will not, make payments on its General Obligation bonds, as there is no provision in the U.S. bankruptcy code for this scenario. In the past, state governments facing severe fiscal crises have defaulted on their debt, and subsequently either repudiated or renegotiated it (see, for example, two excellent papers by Wallis, Sylia and Grinath: "Debt, Default, and Revenue Structure: The American State Debt Crisis in the Early 1840s" and "Sovereign Debt and Repudiation: The Emerging-Market Debt Crisis in the U.S. States, 1839 - 1843"). At the international level, the sovereign debt crises that have occurred since 1982 have provided plenty of examples of negotiated bond exchange offers that substantially reduced the real value of an issuer's obligations. And most recently, the worsening financial situation facing many U.S. Tribal Gaming Casinos (whose debt, in some cases, has been issued by entities that consider themselves sovereign) may provide yet more examples of what lies ahead for some U.S. states.

In sum, for years many investors purchased municipal bonds for the tax advantages they provided, and largely neglected the underlying credit quality issues. In many cases, they relied on bond ratings which, at least in other cases (e.g., CDOs) have proven overoptimistic, or on guarantees provided by insurance companies, which have seen substantial reductions in their claims paying ability. Investors may also have paid insufficient attention to the underlying legal documentation for the municipal securities they own. In many cases, bond documentation was drafted by politically connected local attorneys, who lacked either the motivation or the experience to aggressively protect investors' rights, and who in any case regarded default scenarios as impossibly remote. Unfortunately, all these chickens are about to come home to roost. With the Securities and Exchange Commission pushing for much more extensive disclosure of the financial conditions facing municipal issuers, and with those conditions set to continue to deteriorate (possibly at an accelerating pace), and with increasing litigation set to expose poor underlying documentation, we believe that many owners of municipal bonds face a rising likelihood of a sharp reduction in the value of their portfolios as the current crisis increases in intensity.

New Volatility Research

In our model of financial markets as a complex adaptive system, the most basic building is the investor making buy and sell decisions. These decisions result not only from individual cognitive, emotional and social factors, but also from the information available to the investor, the incentives he or she faces, and the institutional rules and other arrangements that constrain his or her choices. The end result of all these individual decisions is the time series records of security and asset class returns we observe.

We are therefore always on the lookout for research which provides further insight into the various facets of this process. In this regard, we were very interested to read a recent neurobiology paper, "Uncertainty During Anticipation Modulates Neural Responses to Aversion in Human Insula and Amygdala" by Sarinopoulos, Grupe et al. As you may recall, the amygdala is a primitive part of the human brain that is deeply associated with our unconscious fear reactions, which, for example, can be triggered by loss, increased uncertainty, or a heightened chance of social isolation. In the current paper, the authors begin by noting that "uncertainty about potential negative future outcomes can cause stress and is a central feature of anxiety disorders. The stress and anxiety of uncertain situations may lead individuals to overestimate the frequency with which uncertain cues are actually followed by negative outcomes." Using functional magnetic resonance imaging of the activation of different brain regions in experimental subjects, the authors found that amygdala responses to unpleasant pictures were larger after the receipt of a stimulus designed to induce a higher level of uncertainty, and smaller after the receipt of a cue designed to raise certainty. Also, both pleasant and unpleasant pictures were shown to experiment participants, "nearly 75% of them overestimated the frequency of unpleasant pictures following uncertainty cues." In sum, increased uncertainty not only increases most people's estimated probability of negative outcomes, but it also leads to a stronger fear response if they occur. To cite a practical example of what this study means, for most people, the heightened degree of uncertainty triggered by the economic and financial events of the past year has not only increased the probability they attach to negative future outcomes (e.g., a recovery that falters), but will also trigger a stronger fear response if this happens (e.g., a very strong reduction in consumer spending, or greater susceptibility to populist appeals). Moreover, if this response is a strong one, it could have a long-lasting impact on investor decisions, in a manner similar to lifelong impact of the Great Depression on an earlier generation of investors. This view is reinforced by another paper, "How and Why Emotion Enhances the Subjective Sense of Recollection" by Phelps and Sharot. They find that the degree of amygdala activation "modulates the consolidation or storage of memories for arousing events so that they are more likely to be retained over time."

A third recent paper seems to directly link to the first one cited above. "In Asymmetric Responses to Good and Bad News: An Empirical Case for Ambiguity", Christopher Williams from Ross School of Business at the University of Michigan uses changes in the VIX index between 1986 and 2006 to capture changes in perceived ambiguity (uncertainty). He finds that “following increases in the VIX, investors respond asymmetrically, weighing bad earnings news more than good earnings news." However, following a fall in the VIX (i.e., falling uncertainty), the response to good and bad news is symmetrical. In sum, "ambiguity [uncertainty] shocks change how market participants process information." A closely related paper ("A Simple Model of Trading and Pricing Risky Assets Under Ambiguity" by Guidolin and Rinaldi) finds that "provided there is a sufficient amount of ambiguity [uncertainty], market break-downs where large portions of traders withdraw from trading are endogenous to the market, and may be triggered by modest re-assessements of the range of possible scenarios.... Risk premia increase with the proportion of traders in the market who are averse to ambiguity [uncertainty]."

In another paper ("Evidence on Investor Behavior from Aggregate Stock Mutual Fund Flows" by Ederington and Golubeva), the authors study data from 1986 and 2008 and "find a strong negative relationship between changes in the VIX index and net equity fund flows... which is entirely due to the effect of heightened volatility on fund outflows." Similarly, Graham and Harvey regularly survey CFO's to obtain their estimates of the current long-term equity market risk premium. In "The Equity Risk Premium Amid a Global Financial Crisis", they report that changes in these estimates have a strong correlation with changes in both the VIX and in the BBB minus AAA corporate bond yield spread. Finally, in "Tails, Fears and Risk Premia", Bollerslev and Todorov find that "compensation for rare event [i.e., downside tail] risk accounts for a large fraction of the equity and variance risk premia in the S&P 500 market index", and that the size of the rare event risk (or, more accurately, perhaps, uncertainty) premium tends to vary over time with the VIX. In sum, these papers provide further evidence that a portion of the observed variation in financial returns over time probably has deep roots in human beings' neurobiology.

Harvard and Yale Endowment Results

Like many other asset allocators, we always look forward to the publication of the annual reports for the Harvard and Yale University endowment funds, as these organizations have long been held up as leaders in our field. This year proved no exception to that rule. During the fiscal year ended June 30, 2009 Harvard reported that its portfolio underperformed its strategic asset allocation policy benchmark by 2.1%. Of this amount, 1.0% was due to underperformance (versus the relevant benchmark) in private equity (which includes both venture capital and buyout funds), and another 65 basis points was due to underperformance in absolute return (which includes a range of hedge fund strategies). As the report notes, "while diversification has been a mainstay and a driver of the portfolio's return over the long-term, the benefits of diversification did not bear out through the rapidly evolving and widespread events that unfolded [last year]." On the other hand, HMC also notes that "the [performance of the] natural resources portfolio was nearly flat in an environment of negative returns for virtually all other growth assets, confirming the diversification benefit of this category of investments even in turbulent markets." Elsewhere in the report, HMC notes that one of the major errors in its policy portfolio was taking on too much liquidity risk in light of the university's ongoing need for the endowment to produce annual cash flows to support its operating budget. The impact of this "lesson learned" can be seen in shift in the policy portfolio's allocation to cash from negative (5%) - i.e., net leverage -- to positive 2%. Other policy portfolio shifts were also interesting. These include a 14% reduction in allocations to a range of fixed income asset classes, 4% reduction in the allocation to domestic equity, a 6% increase in the allocation to emerging market equity, and a 4% increase in allocations to absolute return strategies. In broad terms, HMC appears to be repositioning its portfolio to achieve two objectives: ensuring adequate liquidity while also seeking higher returns to make up for some of the losses sustained in 2008. Looking forward, the HMC report notes "we continue to debate the dueling threats of inflation and deflation, and can make cases for both. In any event, we expect a prolonged period of instability and slower growth in some markets. For the economy overall, we do not anticipate a quick return to the rapid, sustained growth experienced in recent times."

Yale's report is equally interesting, particularly with respect to its portfolio division into just six broad asset classes (Fixed Income, Domestic Equity, Foreign Equity, Private Equity, Absolute Return and Real Assets) its strategies within them, and its expectations for their real returns and volatility. With respect to its overarching allocation philosophy, the Yale report notes that "the need to provide resources for current operations as well as preserve the purchasing power of assets dictates investing for high returns, causing the Endowment to be biased towards equity. In addition, the University's vulnerability to inflation further directs the Endowment away from fixed income and toward equity instruments. Hence, 96% of the Endowment is targeted for investment in assets expected to produce equity-like returns, through holdings of domestic and international securities, real assets, and private equity."

Yale also explicitly notes its willingness to take on illiquidity risk in order to earn higher returns: "the heavy allocation to non-traditional asset classes stems from their return potential and diversifying power...The Endowment's long-term time horizon is [also] well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber and real estate." Yale's comments about individual asset classes are also quite interesting. In domestic equity, it looks for active managers with "exceptional fundamental bottom-up research capabilities" since "superior stock selection provides the most consistent and reliable opportunity for generating excess returns" [i.e., positive alpha from outperforming an index benchmark].... "The bond portfolio exhibits a low covariance with other asset classes and serves as a hedge against financial accidents or periods of unanticipated deflation"...[We have] "a skepticism of active fixed income strategies"..."Emerging market [equities] with their rapidly growing economies, are particularly intriguing"...Within absolute return, "approximately half the portfolio is dedicated to event driven strategies...the other half is dedicated to hedged value based strategies"..."Yale's private equity assets concentrate on partnerships with firms that emphasize a value-added approach to investing. Such firms work closely with portfolio companies to create fundamentally more valuable entities, relying only secondarily on financial engineering to generate returns"..."Real estate, oil and gas, and timberland.... provide attractive return prospects, excellent portfolio diversification, and a hedge against unanticipated inflation."

After reading these reports, we have the following observations:

• In our view Harvard is much more on target when it includes private equity with other equity asset classes. We question Yale's treatment of it as a separate asset class -- the underlying return generating process is fundamentally very similar to those for domestic and foreign (developed market) equities, as can be seen in Harvard's performance last year -- public market equities were down 28.3%, while private equity was down 31.6%.
  
  
• While we don't question the sincerity of Yale's intention to invest in private equity funds that "work closely with portfolio companies to create fundamentally more valuable entities, relying only secondarily on financial engineering to generate returns", we remain highly skeptical of Yale's ability to find them. We have seen and heard of too many cases where former investment bankers raised a private equity fund and thought it would be easy to buy companies and improve their operating performance. Beyond their naivete about what it takes to improve sustainable operating cash flow, we have seen too many investments that were poisoned from the start by an unbridgeable cultural gulf between the world views of former investment bankers and experienced operating managers. Former bankers reinvented as fund managers tend to assume (not illogically, considering their career experience) that human beings are primarily motivated by financial incentives, and tight legal documentation is required to control their naturally self-serving behavior. Frankly, I cannot fully describe to you what it is like to watch a 30 something banker tell an older, more experienced CEO who has built and sold more than one multi-billion dollar company that he wants to cut his salary "to ensure he'll be sufficiently hungry and motivated." That certainly sets a long-term tone for the relationship, which inevitably filters down the corporate organization. Fund managers with experience beyond Wall Street are much more likely to recognize that high performing teams are motivated by purpose and excellence as much as financial rewards, and that overly tight formal controls too often block the learning and adaptability that is critical to success in highly uncertain and fast changing environments (see, for example, a new working paper from INSEAD, "Blue Line Management: What Value Creation Really Means" by Kaiser and Young). This is not to say that enlightened private equity partners who can help management teams build great companies that generate great investor returns don't exist -- I also know from personal experience that they do. But they are very much the exception, not the rule. And even if Yale and Harvard can find them, and gain access to their funds on acceptable terms (i.e., fees that are less than the expected incremental returns above an appropriate public market equity index), then it must be the case that achieving this goal is well beyond the capability of the average individual investor, or fund-of-funds manager. So in our model portfolios, we stay away from private equity. In our view, anybody wanting to replicate the returns in this area can just as easily buy a small cap ETF on a leveraged basis, and pay far lower fees along the way.
  
  
• Absolute return funds raise similar issues with respect to the average investor's ability to identify truly skilled managers who can generate after tax returns in excess of their fees, and then gain access to their funds. On the other hand, as we frequently note, there is an undeniable mathematical attractiveness to adding uncorrelated alpha funds to a portfolio that increases with the portfolio's long term real return target. Our compromise has been to include a small (relative to Harvard and Yale) allocation to low cost (compared to the 2% of fees and 20% of profits hedge funds typically charge investors), publicly listed uncorrelated alpha investments to our model portfolios.
  
  
• We agree with Harvard and Yale on the diversification benefits of commodities and timber, though (as we have noted) we are probably less enthusiastic than they are about real estate (commercial property). And by investing in publicly traded vehicles in these asset classes, we forego potential additional returns that can be earned for bearing illiquidity risk.
  
  
• Unlike Harvard (and perhaps Yale, which doesn't break it out), we do not use high yield debt (or, for that matter, emerging market debt) in our model portfolios. In both cases, our analysis shows that the underlying return drivers are too similar to equity to warrant treating these as separate asset classes. And given a choice, we prefer the greater upside that comes from investing in equity rather than high yield debt.
  
  
• As we have also noted in the past, we are quite skeptical about the argument that higher rates of economic growth in emerging markets (relative to developed markets) in the years ahead will translate into higher returns on their public market equities. Having spent many years working in the developing world, we recognize that a substantial portion of equity in these markets is privately owned (often by family groups), minority shareholder protections are weak, public markets are often illiquid, and the institutional environment is often prone to finding ever more creative ways to siphon off profits from successful private sector companies. Put in statistical terms, we believe that any estimate of relatively high long-term real returns from emerging market equities not only includes compensation for bearing illiquidity risk, but is also subject to a high level of possible estimation error, which warrants caution when making a policy allocation to this asset class. In addition, as we note in our Global Asset Class Valuation Analysis, rising demand for the available supply of publicly traded emerging market equities has driven their valuations to levels we believe to be excessively high, which should logically lead to lower long-term returns for investors buying it at current price levels. On balance, we think 10% to 15% is the maximum one should allocate to emerging market equities, and that this allocation should only be implemented when valuations are at attractive levels.
  
  
• Last but not least, we note the absence from both the Harvard and Yale portfolios of a policy allocation to volatility as an asset class. As we have noted in the past, this allocation is essentially an insurance policy against tail risk -- i.e., uncertainty shocks. The size of the premium equals the reduction in portfolio returns under the normal regime compared to what they would have been in the absence of the allocation to volatility. Based on the multiple regime analyses we have published over the past few months, and assuming equal asset class weights (which, clearly, won't always be the case), the cost of this insurance averaged between 12 and 23 basis points per month between 1992 and 2008. As we have noted, we are already analyzing this issue, and we may well include a policy allocation to volatility in some of our restructured model portfolios. We also know that PIMCO has been examining this same issue, and we suspect that Harvard and Yale are too.

More Interesting Research

• Khandani and Lo have published an excellent paper on "Illiquidity Premia in Asset Returns: An Empirical Analysis of Hedge Funds, Mutual Funds, and U.S. Equity Portfolios." The authors "establish a link between illiquidity and positive autocorrelations in asset returns...in portfolios of securities that are generally considered less liquid, [such as] small cap stocks, corporate bonds, mortgage backed securities and emerging market investments." They "conclude that illiquidity premia are generally positive and significant, ranging from 2.74% to 9.91% per year among the various hedge funds and fixed income mutual funds." They also find that the illiquidity premia vary over time, as investors observe market returns, adjust their strategies, and interact with each other: "while 1998 was a difficult year for most funds with large illiquidity exposure, the following four years yielded significantly higher illiquidity premia that led to greater competition in credit markets, contributing to much lower illiquidity premia in the years leading up to the financial crisis of 2007-2008."
  
  
• Another excellent paper is "Leverage Causes Fat Tails and Clustered Volatility", by Thurner, Farmer, and Geanakoplos. Our basic mental model is that financial markets operate as a complex adaptive system. One of the characteristics of such systems is their tendency to operate in different phases or regimes, and to change from one to another when one or more system parameters pass a critical level. Hence a key part of our research agenda has been an exploration of just what these key "control parameters" might be (see, for example, "Explaining What Leads Up to Stock Market Crashes: A Phase Transition Model and Scalability Dynamics" by Yalamova and McKelvey, and "Dragon Kings, Black Swans, and the Prediction of Crises" by Didier Sornette). In this paper, Thurner, Farmer and Geanakoplos present strong evidence that the amount of leverage in a system is one of those key control parameters. "When funds use leverage, price fluctuations become heavy tailed and display clustered volatility...The immediate cause of the increase in extreme risks in our model is the risk control policy of the banks [which lend to the funds]. A prudent bank makes itself locally safer by putting a limit to leverage, so when a fund exceeds its leverage limit, it must partially repay its loan by selling the asset. Unfortunately, this sometimes happens to all the fund simultaneously when the price is already falling [a situation exacerbated, as many have noted, by the use of common approaches to risk management, like Value at Risk models]. The resulting non-linear feedback amplifies downward price movements. At the extreme, this causes crashes, but the effect is seen at every timescale, producing a power law of price disturbances." Of course, this raises the question of what the other key control parameters are in this complex adaptive system. Our current view is that the most important of these is the level of uncertainty perceived/felt by investors. As this increases, many important changes take place, including rising feelings of fear (which are easily socially transmitted through verbal and non-verbal means), increased social connections (which raises the likelihood of herding), and an increase in the perceived probability of negative developments occurring. In sum, the combination of rising uncertainty, modern technology (which facilitates network formation), and high leverage can push a financial system into a new phase in which crash probabilities sharply increase. Finally, uncertainty and leverage may also be linked. As Geanakoplos points out in another paper ("The Leverage Cycle"), "the crash always involves the same three elements. First is scary bad news that increases uncertainty. This leads to tighter margins as lenders get more nervous. This in turn leads to falling asset prices and huge losses by the most optimistic, leveraged buyers. All three elements feedback on each other; the redistribution of wealth from optimists to pessimists further erodes prices, causing more losses for optimists, and steeper price declines, which rational lenders anticipate, leading them to demand more collateral, and so on."
  
  
• Another new paper ("Global Equity Fund Performance, Portfolio Concentration, and the Fundamental Law of Active Management" by Huij and Derwall) investigates the relationship between portfolio concentration and the performance of global equity funds, in the context of Grinold and Kahn's Fundamental Law of Active Management. This posits that the performance of an active investment strategy is driven by a combination of the fund manager's forecasting skill and the "breadth" of the strategy - that is, the number of independent investment decisions to which the manager’s forecasting skill is applied. Previous studies have implied that there is a tradeoff between these two drivers, with skill declining as breadth increases - many have found that more concentrated active portfolios, or those that most differ from a benchmark index, tend to earn higher returns. This study aimed to more closely examine the skill versus breadth tradeoff. The authors focus on global equity funds, because of the potential breadth of decisions to which they are potentially exposed, including country, sector, size and style exposures. As expected, they find that the extent of deviation from a benchmark index is, at first pass, correlated with the extent of outperformance compared to the index. However, after further analysis, the authors find that fund managers' outperformance is driven not only by simple deviation of portfolio weights from the overall benchmark, but by the number of decision factors to which they are exposed - i.e., by breadth -- as measured by the manager's deviation from a variety of country, sector, size and style sub-benchmarks. The authors' conclude that their results have significant implications: "investors who strive to select the best performing funds should not only consider fund managers' preference for taking big bets. More important is that investors take into account the extent to which fund managers concentrate their portfolio holdings across multiple decision factors [i.e., potential tilts]." Time will tell whether and when fund analysis companies like Morningstar will make this type of data easily available to mutual fund investors.
  
  
• PIMCO has published a very interesting research note on "Passive Versus Active Management of TIPS." As one of the best active fixed income managers in the world, their views are always interesting. When it comes to TIPS, their key arguments in favor of active management are that (a) relatively illiquid markets and predictable index fund activity (e.g., "market on close" buy and sell orders, and index rebalancing around auctions) facilitate arbitrage by active managers and reduce the return to passive investors. We don't doubt that these costs are real. However, PIMCO's note fails to put them into any type of context. So we'll do that for them. PIMCO's actively managed Real Return Bond Fund (PRTNX) has a 3% front end load and a 1.15% annual management fee. Over the past three years, it delivered average annual nominal returns of 5.56%, with a standard deviation of 10.08%. In comparison, Vanguard's Inflation Protected Securities Fund has no front end load and annual expenses of .20%. Over the same three year period, its average annual return has been 5.20% with a standard deviation of 8.66%. On balance, while we respect the arguments made by PIMCO, when you put the additional costs they cite in context, it is hard not to conclude that the Vanguard fund is the superior offering.
  
  
• Last but not least, we call your attention to a fascinating new paper by Jacobs, Muller and Weber from the University of Mannheim. In "How Should Private Investors Diversity: An Empirical Evaluation of Alternative Asset Allocation Policies" the authors examine different approaches to diversifying both within the global equity asset class, and across a portfolio of global equities, European fixed income, and commodities. In the former case, they conclude that "none of the Markowitz based [i.e., mean-variance optimization] portfolio models is able significantly outperform simple heuristics." Among the latter, they find that GDP weighting is superior to market capitalization weighting. As we have noted with respect to Fundamental Index weighting, we respect the conclusion, but observe that if all investors adopted this approach it would become equivalent to the market capitalization weighted strategy, which is the only one that all investors can simultaneously hold in their portfolio. To put it differently, market cap weighting is the only truly passive strategy. In the broader case, with multiple equity asset classes as sell as European fixed income and commodities, they again conclude that "almost any form of well-balanced allocation over asset classes offers similar diversification [benefits] as even very sophisticated and recently developed portfolio optimization approaches." This paper is very much in line with our thinking on this issue as it has evolved over the years, and our use of a portfolio that gives equal weights to broadly defined asset classes as the benchmark for measuring the performance of our model portfolios. Going forward, in the construction of our updated model portfolios, we are using a shrinkage approach, with final portfolio weights resulting from a combination of the equally weighted portfolio and a portfolio that is based on the results of a more complicated multi-regime asset allocation methodology (for a paper on this type of approach, see "A Generalized Approach to Portfolio Optimization: Improving Performance by Constraining Portfolio Norms" by DeMiguel, Garlappi, Nogales and Uppal).

| Feature Article: What Causes Failure? | September 2009 Economic Update | Product and Strategy Notes: Interesting Commodity Research; The Coming U.S. Muni Market Train Wreck; New Volatility Research; Harvard and Yale Endowment Results; and More Interesting Research | This Month's Letters to the Editor: Index's Position on Timber; Right Question to Ask a Fund Manager; Why not 7 Year Forecasts?'; Credit Beyond HYG | September 2009 Issue: Key Points | Global Asset Class Valuation Updates Detail | Global Asset Class Returns | Table: One Year Asset Class Valuation Conclusions and Recent Momentum | Table: Market Implied Regime Expectations | Uncorrelated Alpha Strategies Detail |