In its August 10, 2009 issue, Barron’s ran an article about “Trouble in the Forest.” It concluded that timber is overvalued, and “could decline by as much as 50% in coming years.” We have a very different view.

The underlying diversification logic for investing in timber is quite simple: the key return driver is biological growth, which has essentially no correlation with factors driving returns on other asset classes. That said, the correlation of timber returns with other asset classes should be different from zero, as it also depends on the price of timber products (which depends, in part, on GDP growth) as well as changes in real interest rates and investor behavior – factors affect returns on other asset classes as well as timber.

One of the most frequently heard comments about the crash of 2008 is, “I didn’t see it coming.” This raises a critical question: How can you improve the accuracy of your financial forecasts, or, more broadly, the quality of your foresight?

We believe the answer to this question begins with understanding the nature of the system whose behavior we are trying to predict. At one extreme, physical systems are characterized by relationships defined by the laws of physics and chemistry that are stable over time. It should therefore be possible to use a single model to forecast the behavior of such a system with a high level of confidence over both short and long time horizons.

In response to the global recession, money supply growth rates are now at record levels in many parts of the world, which has significantly raised the chances of higher inflation in the years ahead. A number of recent research papers have re-examined the inflation hedging properties of different asset classes, and we will summarize their key findings here.

In “Inflation Hedging for Long-Term Investors”, Attie and Roache of the IMF begin with two important distinctions: first, between the one year and longer term response of nominal asset class returns to an increase in inflation, and second, between an increase in expected inflation and an unexpected increase in inflation. From our perspective, for a long-term investor, the key issue is the evolution of longer term asset class returns to both expected and unexpected increases in inflation.

For our subscribers to The Index Investor, we have regularly reviewed the asset class valuation and return impact of a “wild card” influenza pandemic scenario, and in particular, a step-function increase in the transmissibility of H5N1 – so called “bird flu.” Given the headlines over the past few days about a new strain of H1N1 influenza that is apparently spreading from Mexico, we have prepared this short background memo for our subscribers. It covers three issues: (1) Background on influenza, and its potential economic impact; (2) Warning Indicators to monitor; and (3) Our estimate of the possible implications of H1N1 Mexican influenza for asset class valuations and returns over the next twelve months.

Background on Influenza

Because adaptive markets are constantly evolving, the ability to explain what happened in the past does not guarantee an equal ability to accurately forecast the future. Yet without an understanding of the past, the future is bound to be even more surprising when it arrives. With this in mind, we have taken a closer look at the dynamics of real asset class returns over the past three years, and reached some conclusions about their implications for our future approach to asset allocation.

Our starting point is the following table, which shows the correlation of real monthly USD returns between a number of asset classes between January 2006 and December 2008.

WisdomTree Investments (WSDT.PK) is changing the investment strategy of two of its dividend-focused exchange-traded funds so that they exclude exposure to the Financials sector.

Beginning in late April, the WisdomTree Dividend Top 100 (NYSE: DTN) will be renamed the WisdomTree Dividend ex-Financials Fund; its international counterpart, the WisdomTree International Dividend Top 100 (NYSE: DOO), will be renamed the WisdomTree International Dividend Ex-Financials Fund.

By Jim Wiandt

It's raining locusts and fire today, as the Republicans bail out another financial giant. Will ETFs bear the brunt of this socialism?

Edward Tower, a professor at Duke University, and his masters student, Cheng-Ying Yang have recently published a new paper: “DFA Versus Vanguard: Has DFA Outperformed Vanguard by Enough to Justify its Advisor Fees?”

Needless to say, this is a subject about which reasonable people can and do disagree, so we read this with great interest. The analysis is based on data from 1999 to 2006. The authors perform their analysis by comparing the aggregate performance of DFA’s funds with the aggregate performance of what they claim to be a comparable portfolio of Vanguard funds. They find that the return of the DFA portfolio, “geometrically compounded, is 8.2% per year higher than Vanguard’s, and that DFA’s standard deviation of return is slightly higher.”

We recently conducted our own “after action review” of the events that roiled the world’s credit markets in August and September. Our objective was to identify any critical pieces of research that we had overlooked that would have better helped our readers prepare for what transpired. By far the most important was a report published in the Banque de France Financial Stability Review in May 2006. In “Market Liquidity Risk and Its Incorporation into Risk Management”, Arnaud Bervas presciently concluded that:

The excessively optimistic assessment of market liquidity (i.e., the belief that transactions can be settled at current prices without any notable delays or transaction costs) may be a serious threat to financial stability…

Well, Hallelujah! Somebody (in this case, State Street) has FINALLY launched an index product that invests in foreign currency bonds. The SPDR Lehman International Treasury Bond ETF (BWX) has an annual expense ratio of .50%. It tracks the Lehman Brothers Treasury Ex-US Capped Index, which includes bonds denominated in 11 currencies (basically, countries whose government debt has an investment grade rating).

As we wrote in December 2004, all debt indexes are problematic. In this case, Lehman uses an adjusted (i.e., capped) market capitalization methodology that risks giving greater weight than we would like to heavy issuers of government debt (e.g., Japan). On balance, however, we are very pleased to see this product finally launched.

In his article Measuring the True Cost of Active Management, Ross Miller showed how expensive the “active” portion of traditional long-only mutual funds really is.

Earlier this year, he followed up with another article on the same subject. Stansky’s Monster: A Critical Examination of Fidelity Magellan’s Frankenfund” makes even more painfully clear how expensive actively managed mutual funds can really be to investors.

A lot of ink has been spilled recently on the subject of so-called “sovereign wealth funds.” Traditionally, countries accumulating foreign exchange reserves invested them in low risk and very liquid government securities – e.g., U.S. Treasury and Agency bills, notes and bonds. However, as the size of some countries’ reserves have grown to levels well in excess of any conceivable precautionary needs, they have established new vehicles (Sovereign Wealth Funds) to invest in a wider variety of asset classes to earn higher long-term returns.

Norway was among the first nations to take this approach when its North Sea oil revenues rose; a number of Persian Gulf oil exporters have also gone this route, such as the Kuwait Investment Office.

Vanguard introduced earlier this year a new ETF that tracks the FTSE All-World ex US Index (VEU), with an expense ratio of .25%. The FTSE index differs somewhat from the indexes tracked by Vanguard’s Total International Stock Market mutual fund (VGTSX; .32% expenses).

The latter is a combination of the MSCI EAFE and Emerging Markets Index, which excludes Canada. The former includes Canada at a 5% weight.

A new family of ETNs called Elements Spectrum (www.elementsetn.com) launched by Nuveen Invesetments, Merrill Lynch, BNP Paribas, and Swedish Export Credit Corporation. Swedish Export Credit Corporation is the ETN issuer, and has a strong credit rating. Thus far, they have launched three products. Two ETNs track the metals (RJZ) and energy (RJN) subsegments of the Rogers International Commodities Index.

We have often made the point that from our perspective, the best commodities index product is one that equally weights exposure to three groups whose returns usually have low correlations with each other – energy, metals, and agricultural products. In terms of broad indexes, the DowJones AIG Commodities Index comes closes to this ideal. However, the introduction of subsegment commodity index products (e.g., by ETF Securities in the U.K. and Europe, or PowerShares in the United States) enables an investor to achieve an even better balance (though at the cost of more time spent rebalancing between them). In this regard, the new Elements ETNs are effectively more of the same.

The Bearlinx Alerian MLP Select Index Exchange Traded Note (ticker BSR) was launched in July. We wrote about the Alerian MLP Index in our December 2006 issue, and concluded that since natural/geologic processes (e.g., oil and gas field depletion) were a key component of many MLPs, it could provide attractive diversification benefits to a portfolio.

We also noted the caveat that the overall amount of MLPs outstanding was quite small in comparison to the major asset classes, and the cost of access might therefore be prohibitive.

In Canada, a preliminary prospectus has been filed by GHG Emission Credit Participation Corporation (www.ghgemissioncredit.com). The new company is a vehicle for investing in this new asset class. While it remains to be seen how whether a straightforward tax on carbon emissions or tradable emission certificates (which would create a new asset class) will end up as the dominant approach to managing the global warming problem (as the Wall Street Journal recently noted, economists favor the tax, while politicians favor tradable credits), we expect to see a growing number of retail oriented products launched in this area in the months ahead.

At least in the short term (while the carbon market is in its infancy), there may be substantial opportunities for skilled managers to earn active management profits. Further confirmation of this comes from a recent research paper (“Are the European Carbon Markets Efficient?”) by Daskalakis and Markellos, which concluded that restrictions on short selling and market fragmentation mean that, at least for the time being, this market is still far from efficient.

Investors in the U.S. now have a wider variety of funds to choose from to gain exposure to non-U.S. commercial property (real estate). In the beginning, there were actively managed funds from Cohen and Steers [IRFAX] and Fidelity [FIREX]. Then came the first index product, State Street’s SPDR Dow Jones International Real Estate ETF (RWX), which rapidly accumulated over $1 billion in assets. Now there are two more index offerings, one from Barclays Global Investors -- the iShares S&P World ex U.S. Property Fund (WPS), with an expense ratio of 0.48% compared to the SPDR’s 0.60%, -- and the Wisdom Tree International Real Estate Fund (DRW) with an expense ratio of 0.58%. While the State Street and BGI products use market capitalization weighting, the Wisdom Tree fund, in keeping with the firm’s fundamental indexing approach, weights its holdings by their respective dividend yields.

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

Investment News called a deal imminent, and highlighted two potential acquirers: E*Trade (ETFC) and Invesco PLC (IVZ) (formerly Amvescap). The latter company recently bought the exchange-traded funds provider PowerShares Capital Management, in a deal worth $60 million up front, and an additional $670 million in incentive payments. At the time, PowerShares had $3.5 billion in assets under management.

Let's start with the three main reasons an investor might want to use a sector product instead of a broad market index. In Bill Sharpe's Princeton lectures, he succinctly summarized these as differences in position, preference, and prediction.