November 11, 2009



There wasn’t much news other than more bullish thinking that low interest rates are with us as far as the eye can see. Markets are getting a little overbought now as dip buyers have pounced on stocks once again. News was sparse other than most companies continue to post losses but are beating estimates. Applied Materials (AMAT) shares rose nearly 2% after they announced another 1,500 or so job cuts. Yeah, it’s a brutal business this.

WisdomTree, a leader in the fundamental ETF and currency fund spaces, has registered the Real Return Fund (RRF) with the SEC, the next step in bringing to market an ETF that is designed to protect investor capital against the ravages of inflation. According to the filing, the proposed fund would seek to “provide investors with total returns that exceed the rate of inflation over long-term investment horizons.” To achieve this goal, RRF will invest in a portfolio of inflation-linked securities, including TIPS, and other investment grade fixed income securities. RRF will also have targeted exposure to commodities and commodity strategies, including energy, precious metals, and agriculture. In order to gain commodity exposure, the fund may utilize a variety of options, including swaps and exchange-traded commodity products.

The Real Return Fund will be actively managed, with WisdomTree Asset Management serving as the adviser and Mellon Capital Management serving as subadviser. RRF will charge an expense ratio of 0.50%, a surprisingly low amount for an active ETF. Many actively-managed ETFs feature expense ratios above 1%, with some going as high as 1.5%

IndexIQ, a pioneer in the hedge fund ETF industry, has expanded its product line to include two new ETFs designed to provide protection against inflation: the IQ CPI Inflation Hedged ETF (CPI) and IQ ARB Global Resources ETF (GRES). These ETFs hit the market at a time when investors are becoming increasingly concerned about the intermediate and long-term impact of massive stimulus plans implemented to combat the recent recession. Although deflation is a more immediate concern, worries about runaway inflation over the next 24 months have investors seeking out options to provide a real return and protect their assets.

Inflation-protected securities funds such as TIP and WIP have seen huge surges in popularity as investors look to establish inflation hedges. But these products have never been truly tested in a hyperinflationary environment. Moreover, according to IndexIQ (pdf), TIPS may have a higher correlation to bonds than inflation and higher levels of volatility than CPI in certain environments.

I appeared last Friday on a the PBS program WealthTrack, where the topic was asset allocation, in particular, as host Consuelo Mack put it, how to build an all weather portfolio. I was the skeptic of the group. I don’t think there is some magic asset allocation that protects you from the buffetings of financial storms without it also trimming your sails during fair weather. Here is an encapsulation of my views from the program.

Asset allocation and risk appetite
One of the participants, asset allocation guru David Darst of Morgan Stanley (MS), proposed various portfolios to protect against a 100-year flood, 30 to 70-year flood, a 25-year flood, etc. Those portfolios boiled down to putting less in risky assets and more in bonds; the more severe the flood you anticipate, the less risk you take. Of course, that will do the trick. If by asset allocation you mean determining where to set your risk tolerance dial, we’re all on board.

It’s easier to tell where markets have been than to tell where they’re going. Similarly, it’s simpler to identify where institutional and individual investor money has been flowing than to identify where it will flow to in the future.

Nevertheless, EPFR Global is a world leader in tracking fund flow and asset allocation data. And last week, some fund types experienced their largest inflows of 2009.

The following table shows correlations of UUP, the US Dollar Bullish ETF, to five different fixed income ETFs over the past 18 months. The ETFs selected are BWX (International Treasury Bond), WIP (International Government Inflation Protected Bond), IEF (7-10 Year US Treasury), TIP (US Inflation Protected Bond) and PCY (Emerging Market Bond).

A brief definition of correlation from assetcorrelation.com:

There was a recently a Good article from Tom Lydon at ETF Trends detailing some of the International Bond ETFs on the market. I normally like international bond exposure as a source of diversification, so to show the diversification effects I went to Assetcorrelation.com, which is a free website. I compared the 4 international bond ETFs/closed end funds Lydon mentions in his article (BWX, BWZ, JGT, and WIP) to SPY (the S&P 500 ETF), EFA (the EAFE, or international equity ETF) and IEF (7-10 US Treasury ETF).

IEF, the US Treasury ETF, still showed signficantly lower correlation to SPY and EFA then the international bond ETFs. During the 'panic' of 2008, investors fled to treasuries while everything else dropped like a rock. Thus, investors diversified in US Treasuries helped cushion any blow to the rest of their portfolio. In addition, a moving average system like the one's tracked at Scott's Investments would have helped cushion additional drawdowns to one's equity portfolio.

When State Street introduced the first foreign bond ETF nearly 2 years ago, I was ecstatic. The SPDR Barclay International Treasury Bond Fund (BWX) offered an annual income stream above 4.25%, a natural hedge against the U.S. dollar, potential for some capital appreciation and a history of non-correlation to stock assets.

Today, BWX produces an income stream of 2.25% while trading at a 0.6% premium to net asset value. Clearly, the desire to hedge against U.S. dollar devaluation – even at a premium, even with a dwindling income component — is still very vibrant.

As the ETF industry has expanded in recent years, a significant percentage of the expansion has come from equity ETFs embracing new regions and investment styles and from commodity funds offering small investors exposure to resources that were previously available only to the ultra-rich (although position limits are threatening to restrict access to numerous commodity funds). Despite the importance of fixed income instruments in investor portfolios (as proven by their performance relative to stocks during the recent downturn), fixed income ETFs lag behind their equity counterparts in terms of number of funds. According to our ETF Database, there are currently about 70 fixed income ETFs, compared to more than 600 equity funds.

As worries about the ability of fixed income investments to perform inside of an exchange-traded structure have been shown to be unfounded, we are beginning to see an increase in bond ETF activity. According to State Street’s July ETF snapshot, 10 new funds have been launched this year, and fixed income ETFs have seen assets grow by almost $26 billion.

The global economy is showing 'clear' signs of a rebound and central banks are unlikely to raise borrowing costs for many months. The signs are clear, if still tentative, of renewed growth

Managed futures has been long recognized to be an excellent portfolio diversifier.

However, long only commodity investment is not good enough. For example, in this 2008-2009 period, commodity ETFs such as DBC, GSG based on broad based commodity indexes and most of ETFs based on narrow commodity industry indexes such as DBA, DBE, DBB did not do well.

Since the U.S. equity markets bottomed out in March, many key benchmarks have surged more than 30%, causing many pundits to declare that we have emerged from the recession and are now back on the path towards economic growth and national prosperity (although some disagree). The massive stimulus plans implemented by the U.S. government and other developed nations around the world, although highly controversial once upon a time, appear to have worked (at least in the sense that the “worst case scenario” feared by many has been avoided).

But there are many who fear that we are about to be blindsided by a post-recovery hangover, one stemming from the massive current debt levels and huge infusions of cash into our financial system. It is very likely that we have not yet paid the full price of the economic stimulus plans enacted last year, and that hyperinflation will soon rear its ugly head. While the CPI is widely expected to experience an uptick in the future, investors are divided as to when prices will begin climbing again. Some expect inflation to increase significantly by the end of 2009, while others believe that the time to pay the piper won’t be until 2010.

In the short run, this is deflationary, since deleveraging by banks and by consumers is offsetting cheap money from the Fed. This is leading to slow GDP growth, falling home prices, and stubbornly high unemployment.

Studies have shown that asset allocation is the most important determinant factor in a mutual fund's performance: according to a study by Gary Brinson, Randolph Hood and Gilbert Beebower, asset allocation strategies are responsible for over 90% of variations in portfolio performance.

The tumultuous 2008 taught us an important lesson: static asset allocation over diversified assets is not effective enough to shield us from severe market loss. What's called for is tactical asset allocation which re-allocates capital based on the current and future economic and market conditions. In previous articles, we introduced several tactical asset allocation strategies including cross-asset momentum strategies. Those strategies are based on quantitative price or value evaluation. Another way is to simply follow the great investors' asset allocation decisions.

If you are in the camp that thinks that all this government spending and a resurgent global growth (after this recession is over) will cause an above average inflation scenario, and want an investment strategy that could help in such a scenario, then read on.

There are several ways one can hedge against inflation. One can invest in commodities, gold, oil, and the more traditional US TIPS. However, each comes with its own flavor of risk and a variety of factors that can cause the returns of the strategy to differ from just “Breakeven inflation” (term used interchangeably with “inflation expectations”).

August 3, 2009



Let's see, should you subvert your emotions and logic by staying systematic and disciplined? Well, that's not me standing on the tracks. I'm just sayin'.

Inflation protected treasuries remain in an uptrend against non inflation protected Treasuries both in the US and internationally.

The 2008 markets taught us a valuable lesson that just merely holding once considered 'diversified' assets in a portfolio is not sufficient or, at best is very difficult, to reduce the systemic risk: during the 2008 market stress, almost all of assets (other than the US Treasuries and cash) were suddenly correlated and declined simultaneously.

Looking ahead, as the global economics is going through the painful deleveraging process to shake off years of excess buildup; such a process is going to take years if not decades.