The Case for Emerging Market Corporates - IndexUniverse.com

The Case for Emerging Market Corporates
William Perry
Individual Country or Broad-Market Exposure?
Christopher Philips, Roger Aliaga-Díaz, Joseph Davis and Francis Kinniry
Inflation-Linked Index Products
Brian Upbin, Anand Venkataraman and Scott Harman
Inflationary Quandaries: A Roundtable
Luis Viceira, Michael Ashton, Michael Pond and more
Plus Arnott and Kuo on selection bias, and Blitzer, Krein and Prestbo offering index-provider perspectives

www.journalofindexes.com
Vol. 14 No. 5
features
The Case For Emerging Market Corporates
By William Perry....................................10
An asset class grows up.
Individual Country Or Broad-Market Exposure?
By Christopher Philips, Roger Aliaga-Díaz,
Joseph Davis and Francis Kinniry . . . . . . . . . . . . . . . . . . . . 18
Getting perspective on emerging markets.
Inflation-Linked Index Products: An Overview
By Brian Upbin, Anand Venkataraman
and Scott Harman ..................................22
A guide to some tools for hedging inflation.
Inflationary Quandaries: A Roundtable
Luis Viceira, Michael Ashton,
Michael Pond and more.............................28
Experts weigh in on an uncertain topic.
10
Selection Bias
By Robert Arnott and Li-Lan Kuo . . . . . . . . . . . . . . . . . . . . 36
An exploration of matters of choice.
Considerations For The Index Shopper
By David Krein and John Prestbo . . . . . . . . . . . . . . . . . . . . 46
Different types of investors make different choices.
From A Provider’s Perspective
By David Blitzer ....................................48
Some insights on a unique business relationship.
Inflation Consternation ..........................64
A little fun to alleviate our readers’ anxiety.
news
MSCI Says Korea, Taiwan Still Emerging . . . . . . . . . . . . . . . 50
Russell Rebalances ...................................50
FTSE Acquires DJI’s Share In ICB . . . . . . . . . . . . . . . . . . . . . . 50
Case-Shiller Benchmarks Move Higher. . . . . . . . . . . . . . . . . 50
Indexing Developments...............................51
Around The World Of ETFs............................54
From The Exchanges .................................55
Back To The Futures..................................56
Know Your Options ..................................56
On The Move ........................................56
data
Selected Major Indexes .............................58
Returns Of Largest U.S. Index Mutual Funds . . . . . . . . . . 60
U.S. Market Overview In Style . . . . . . . . . . . . . . . . . . . . . . . 61
U.S. Industry Review ................................62
Exchange-Traded Funds Corner . . . . . . . . . . . . . . . . . . . . . 63
22
36
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September / October 2011
1

Contributors
Roger Aliaga-Díaz
Roger Aliaga-Díaz is a senior economist with the investment strategy group
at Vanguard. Before joining Vanguard in 2007, he was a visiting professor of
macroeconomics at Drexel University’s LeBow College of Business. Aliaga-
Díaz has presented his research to various groups, including the board of
governors of the Federal Reserve System. He earned his Ph.D. in economics
from North Carolina State University and his B.A. in economics from
Universidad Nacional de Córdoba, Argentina.
Robert Arnott
Robert Arnott is chairman and founder of asset management firm Research
Affiliates LLC. He is also the former chairman of First Quadrant LP and
has served as a global equity strategist at Salomon Brothers (now part of
Citigroup) and as the president of TSA Capital Management (now part of
Analytic Investors LLC). Arnott was editor-in-chief of the Financial Analysts
Journal from 2002 through 2006. He graduated summa cum laude from the
University of California, Santa Barbara.
David Blitzer
David Blitzer is managing director and chairman of the Standard & Poor’s
Index Committee. He has overall responsibility for security selection for S&P’s
indexes and index analysis and management. Blitzer previously served as chief
economist for S&P and corporate economist at The McGraw-Hill Companies,
S&P’s parent corporation. A graduate of Cornell University with a B.S. in
engineering, he received his M.A. in economics from George Washington
University and his Ph.D. in economics from Columbia University.
David Krein
David Krein is senior director of institutional markets for Dow Jones Indexes,
where he serves as a liaison to the institutional investment community globally,
and guides the research and development of new and enhanced index benchmarks.
Prior to joining DJI, Krein was president of DTB Capital, a firm he founded
in 2006 to develop indexes and structured investment products. Krein holds an
MBA with honors from the University of Chicago Graduate School of Business.
William Perry
William Perry is an executive director for Morgan Stanley’s emerging
markets debt team. He joined the firm in 2010 after 16 years at J.P. Morgan,
where he was the head of the Latin American team in the global special
opportunities group. Perry had previously been the credit deputy to the
global head of emerging markets and co-head of EM Corporate research
at J.P. Morgan. He received his MBA in finance from Columbia Business
School and his B.A. from Colgate University in international relations.
Christopher Philips
Christopher Philips, CFA, is a senior investment analyst for Vanguard
Investment Strategy Group. This group is responsible for capital markets
research, the asset allocations used in solutions for Vanguard’s funds-of-funds,
and maintaining and enhancing the investment methodology used for advicebased
relationships with high-net-worth and institutional clients. Philips has
authored several research papers on topics of concern to institutional and highnet-worth
audiences. He holds a B.A. from Franklin & Marshall College.
Brian Upbin
Brian Upbin, CFA, CAIA, is a director and head of Index Research in the Barclays
Capital Index, Portfolio and Risk Solutions group. His research is regularly published
in Barclays Capital’s publications, as well as in independent periodicals.
Upbin joined Barclays Capital in September 2008 from Lehman Brothers, where
he was the head of the US Fixed Income Index Strategies team. He received his
B.A. from the University of Pennsylvania and his MBA from Yale University.
2 September / October 2011

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Jim Wiandt
Editor
jwiandt@indexuniverse.com
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What’s really in your ETF index?
Market Vectors Index Methodology
For Emerging Markets ETF Investors.
➤ Liquid.
Each stock must meet minimum requirements for market capitalization and daily trading volume. 1
Improves ability to track index.
➤ Inclusive.
Includes publicly traded companies deriving at least 50% of their revenues from a country, even if the
company is listed, domiciled or headquartered elsewhere. Many emerging market companies list in
New York, Hong Kong, London and Toronto.
➤ Diversified.
Stock weightings are capped at 8%, often resulting in greater diversification by holding and by sector.
➤ Transparent.
Constituents and weights are updated and published daily, and are accessible for free at vaneck.com.
Market Vectors Indonesia Index ETF (IDX) 2
Based on the Market Vectors Indonesia Index (MVIDXTR) 3
➤ Inclusive and diversified Indonesia exposure.
➤ Constituents must meet minimum liquidity requirements.
➤ See the latest fund performance and get the full
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at least 250,000 shares per month over the last six months.
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The Fund is classified as a “non-diversified” investment company under the 1940 Act.
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Factors identified refer to the index.
The Fund is subject to elevated risks, including those associated with investing in foreign securities, in particular in Indonesian
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Investors should be willing to accept a high degree of volatility and the potential of significant loss. The Fund may loan its securities, which may
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Editor’s Note
Dueling Topics
Jim Wiandt
Editor
Setting aside the debt ceiling debacle for a moment, two interlinked topics have
been at the top of investors’ thoughts over the past several months: emerging
markets and inflation.
Emerging markets, of course, have been on a tear—at least compared with developed
economies—for the past few years. We kick off the issue with a comprehensive
article from William Perry of Morgan Stanley, who unrolls a wealth of data to support
his argument that emerging market corporate bonds have grown up into an asset
class worthy of attention. Christopher Philips—with Roger Aliaga-Díaz, Joseph Davis
and Francis Kinniry Jr.—follows with a succinct argument for taking a broad-based
approach when investing in emerging markets.
Next, we shift gears somewhat to examine the range of available inflation-linked
products, including those providing opportunities in emerging markets, with an offering
from Barclays Capital’s Brian Upbin, Anand Venkataraman and Scott Harman.
Inflation is, of course, on everyone’s mind, not just EM investors, so we’ve gathered
a panel of people in the know to offer their insights on the topic in our latest
roundtable, including Luis Viceira of Harvard Business School, Michael Ashton of
Enduring Investments, Michael Pond of Barclays Capital, WisdomTree’s Rick Harper,
Christopher Whalen of Institutional Risk Analytics, and IndexIQ’s Adam Patti.
Then, Rob Arnott takes us off-theme on a detailed comparison of the Fortune 500 and
the S&P 500 that focuses on the impact of selection bias. It’s sure to pique the interest of
any index nerd. David Blitzer weighs in with a meditation on the working relationship
between index providers and fund managers, from the index provider’s perspective. And
David Krein and John Prestbo offer some guidelines for the index end user.
We wrap up the issue with a brain teaser of our own, an inflation-focused crossword
puzzle. Whether the macro-economy is in an inflationary or deflationary environment
and your country is good for its debts or not, we send you best wishes for a healthy
investment portfolio heading into the fall.
Jim Wiandt
Editor
8
September / October 2011

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Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of companies in
emerging markets are generally more risky than stocks of companies in developed countries.
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© 2011 The Vanguard Group, Inc. All rights reserved. U.S. Pat. No. 6,879,964 B2; 7,337,138. Vanguard Marketing Corporation, Distributor.

The Case For
Emerging Market Corporates
An asset class emerges
By William Perry
10
September / October 2011

Over the last decade, emerging market (EM) economies
have benefited greatly from macroeconomic
stabilization and the liberalization of trade and
financial markets. Most of these countries have enjoyed
robust gross domestic product (GDP) growth both on an
absolute basis and relative to more developed economies.
As a result, they have experienced dramatic economic
transformations and accelerated public sector deleveraging.
Gradually, local regulators have improved bankruptcy
regimes, market transparency and investor rights. This
has resulted in higher levels of foreign direct investment
and capital markets activity, which has greatly benefited
the growth of local corporations.
Given this positive macro backdrop, improved legal
environment and supportive demographics, companies
from many of these EM countries have been able to
increase their access to the international markets for both
debt and equity, broaden their investor base and extend
their maturity profiles. In several instances, EM corporates
have grown into global leaders in their respective sectors.
Since early 2000, EM corporate debt has evolved from
a marginal market with $20 billion in annual issuance
volume (mostly from Latin American issuers) to a global
market with average annual issuance in excess of $100
billion with representation from all four major regions
(Asia, Latin America, Central and Eastern Europe, and
the Middle East/Africa). 1 EM corporate fixed income has
effectively become an asset class in its own right, with
projections that outstanding corporate debt will exceed
$1 trillion in the next several years.
As valuations for EM external sovereign debt reach alltime
highs, fueled by record inflows and reduced sovereign
issuance, traditional EM investors are selectively increasing
their allocations to EM corporate debt. Furthermore,
global high-yield and investment-grade fixed-income
investors—or “crossover” investors—are also becoming
more actively involved in the asset class. An additional catalyst
to interest in the sector is the recent development of
the Corporate Emerging Markets Bond Index, 2 or CEMBI,
for external hard-currency debt obligations. Today there
are approximately $10 billion in assets under management
benchmarked against various CEMBI indexes, with expectations
that this will double by the end of 2011.
We believe that an allocation to EM corporate debt
could be an attractive option for investors seeking an
opportunity to diversify away from other traditional
fixed-income asset classes and add potential excess riskadjusted
returns. In most instances, EM corporate debt
investments still offer a positive basis over both sovereign
benchmark bonds and comparable developed-market
high-yield and investment-grade corporate fixedincome
securities—which is particularly compelling in
the current low-interest-rate U.S. Treasury environment.
When comparing potential returns—taking into account
historical default levels of high-yield EM corporates versus
those of U.S. high-yield indexes—the argument for
allocating assets to EM corporates becomes, in our view,
even more compelling.
An Asset Class Emerges
The performance of emerging economies over the past
decade has been notable, both on an absolute basis and relative
to developed markets. Given both prudent economic
policies and supportive external conditions, EM economic
growth has been strong and remained positive throughout
the global recession of 2008-09 (Figure 1). Today the underlying
macroeconomic fundamentals of emerging markets
are, in many instances, superior to those of the developed
world—most emerging economies have lower debt levels,
healthier fiscal balances and stronger debt positions than
their developed counterparts (Figure 2).
Developing governments have also made significant
progress in other areas, such as strengthening property
rights, reinforcing legal frameworks and improving creditor
rights. This has resulted in greater investment flows,
burgeoning local equity markets and increasing international
capital-raising activity. Foreign direct investment
flows to emerging markets, for example, have grown
steadily from $139 billion in 1997 to a projected $251 billion
for 2011. 3
EM countries are also further diversifying their sources
of economic growth by gradually shifting their export
bases from developed countries to more intra-EM trade.
Intra-EM exports grew from less than $24 billion in 1999
to nearly $37 billion in 2009; at the same time, exports to
developed economies fell from nearly $74 billion in 1999
to less than $61 billion in 2009. 4
EM countries have further enjoyed more attractive
demographic trends (population growth, emergence of
middle-class consumers 5 ) and larger labor forces, which
will continue to drive domestic demand and economic
output. These new markets provide an important source
of diversification that continues to support emerging market
growth in spite of weak external demand. Geographic
and product diversification has reduced contagion risks
through lower exposures to one particular region or mar-
Figure 1
10%
8%
6%
4%
2%
0%
-2%
-4%
Emerging Market Growth Exceeds
Developed Market Growth*
‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09E ‘10F ‘11F
N Developed
N Emerging Markets
* Weighted average of 40 emerging economies.
Forecasts/estimates are based on current market conditions, subject to
change, and may not necessarily come to pass.
Source: MSIM, Official Source. Data as of August 2010.
www.journalofindexes.com September / October 2011
11

Figure 2
GDP (%)
300
250
200
150
100
50
0
-50
-100
Fundamentals In Emerging Markets
Are More Robust Than In Developed Countries
Japan
U.S.
Europe
Greece
Portugal
Spain
N Fiscal Deficit/GDP 2011 N Public Gross Debt/GDP 2010 (lhs)
L Real GDP Growth 2011
ket, opening up new markets for the corporate sector.
In this environment, we expect greater foreign direct
investment (FDI) allocations to EM countries, more global
M&A activity, local industry consolidation and greater
private equity involvement—all of which should be positive
catalysts for corporate credit. As the global economic
backdrop continues to improve and EM growth continues
to outpace other markets, we expect EM corporate credits
to be the major beneficiaries.
Poland
Brazil
Source: MSIM, Official Source. Data as of August 2010.
Figure 3
Spread (bps)
300
250
200
150
100
50
0
Dec
2001
Turkey
Mexico
S. Africa
Indonesia
Corporates Are The Fast-Growing Sector
Of The Emerging Market Asset Class*
Dec
2002
Dec
2003
Dec
2004
Dec
2005
Dec
2006
Dec
2007
N CEMBI Broad Div. 6 N GBI Global 7 N EMBIG 8
China
Dec
2008
Russia
12
10
8
6
4
2
0
-2
-4
Dec
2009
* Calculated as market capitalization of the index “deflated” by index performance.
Source: MSIM based on JP Morgan index data. Data as of August 2010.
(%)
Corporate Issuance Growing
Today corporate issuers comprise a growing component
of the outstanding debt stock of EM fixed income,
and now represent the fastest-growing sector of the EM
asset class (Figure 3). As of August 2010, outstanding corporate
issuance stands at more than $600 billion (Figure
4), or approximately 45 percent of the size of the outstanding
EM external debt market and more than 60 percent of
the U.S. high-yield market, with estimates that it will grow
to in excess of $1 trillion in the next several years.
The asset class has evolved into a diverse cross section
of geographies, with the four major regions—Asia, Latin
America and CEEMEA (Central and Eastern Europe, the
Middle East/Africa)—each representing about one-third
of the exposure with diversity across all major industries
(Figure 5). Interestingly, the majority of outstanding debt
is rated investment grade, particularly in Asia, where
more than 80 percent of the corporate debt is investment
grade (Figure 6).
Since early 2000, EM corporates have evolved from
a marginal market with $20 billion in annual issuance
volumes (mostly from Latin American issuers) to a global
market with average annual issuance volumes in excess
of $100 billion (Figure 7), with representation from all
four major regions. Several factors have contributed to
this increase in corporate issuance: 1) the maturity of the
major EM sovereign markets and their rapid evolution to
investment-grade status; 2) a concurrent reduction in sovereign
issuance; 3) accessibility to longer-term financing
than available in local markets; and 4) historically attractive
long-term funding rates.
With increased globalization and cross-border M&A, 9
many industries across the sector are undergoing greater
consolidation—whether expanding domestically or internationally—or
are being acquired by larger global players,
resulting in an even greater need for financing.
Credit Trends And Technical Support
In the current environment, EM corporates have been
on an improving trajectory, as measured by recent ratings
agency actions. Credit improvement can be seen in
the upgrades/downgrades ratio, 10 which fell to a cumulative
level of 1.3 year-to-date in mid-July from a monthly
high of 2.5 in April (Figure 8). On average, EM corporates
have better credit metrics than similarly rated U.S. and
Figure 4
USD $billion
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
Estimated Corporate Debt Stock
At Year End 2009
4,500
975
Source: JP Morgan. Data as of August 2010.
605
140
US IG US HY EM Euro HY
12
September / October 2011

international peers. Interestingly, many of the high-yield
ratings in the asset class are due to sovereign ratings constraints,
rather than to any underlying structural or legal
subordination more typically associated with traditional
high-yield issuers. 11 Consequently, as the underlying
sovereign ratings are reviewed, we would expect concurrent
upgrades to the respective sovereigns.
On the technical side, there are three forces at work that,
in our view, should all positively affect the performance of
EM corporate debt: 1) strong inflows into the entire EM
fixed-income asset class; 2) increasing corporate allocations
by both EM sovereign and crossover investors; and
3) a shortage of developed-market credit product.
Data from various market sources including Emerging
Portfolio Fund Research, Bloomberg and J.P. Morgan
suggest that inflows into EM for full-year 2010 should be
in the range of $70 billion to $75 billion. Inflows through
July suggest that we have already seen $50 billion to $55
billion come into the market, or $7 billion per month for
the first seven months of 2010, compared with $3.9 billion
per month in 2009. This includes inflows from strategic,
mutual fund and Japanese investment trust sources, with
mutual funds being the most significant contributors.
On the EM side, a recent investor survey by J.P.
Morgan suggests that traditional EM external sovereign
managers have increased their EM corporate allocations
on average by 500 basis points over 2009 levels, from 19
percent to 24 percent of assets under management.
As Figure 9 highlights, there has also been a decline
of approximately $1.3 trillion in developed-market credit
product since 2007, particularly following the disruption
in the structured product markets. We would expect this
to induce crossover investors to further consider EM corporate
debt as an alternative.
Development Of The CEMBI
An additional catalyst for the sector is the recent
development of the Corporate Emerging Markets Bond
Index, or CEMBI. Introduced in 2007, the CEMBI consists
of U.S.-denominated EM corporate bonds and was
created in response to investor demand for a representative
benchmark. CEMBI (Figure 10) is categorized by a
traditional market-weighted approach. Another index,
the CEMBI Diversified, was created to limit the weights of
index countries with larger corporate debt stocks.
Most EM corporate mandates (85 percent) are
benchmarked to the CEMBI Broad Diversified, given
the broader geographic composition, permitted investments
and limit on geographic concentration. 12 As of
mid-2010, there is already an estimated $8 billion to
$10 billion in assets benchmarked against the various
CEMBI indexes, with expectations for that to double by
the end of 2011. 13
The CEMBI utilizes a broad regional classification for
inclusion: countries in Asia ex Japan, Eastern Europe,
Middle East/Africa and Latin America, resulting in a
broader list of countries than in traditional indexes such
as the J.P. Morgan Emerging Markets Bond Index Global
Figure 5
100%
50%
0%
Asia
82%
18%
Asia, Latin America And
CEEMEA Diversity Across Industries
Metals
6.50%
Industrials
21.22%
Telecom
13.24%
Retail
3.19%
47%
53%
Emerging
Europe
Investment Grade
Oil
13.84%
Banks
31.24%
High Rates Of Investment-Grade Debt In
Asia, Latin America And CEEMEA
(EMBIG) or MSCI Emerging Markets Index 14 (Figure 11).
Portfolios, however, can be constructed to eliminate more
developed-country exposure for those investors looking
59%
41%
Latin
America
High Yield
Utilities
10.78%
Source: MSIM based on JP Morgan index data. Data as of August 2010.
Figure 6
Source: MSIM based on JP Morgan index data. Data as of August 2010.
Figure 7
USD billion
140
120
100
80
60
40
20
0
The Evolution Of Emerging Market
Corporate Issuance
88%
12%
ME &
Africa
‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 YTD
Source: Bond Radar. Data as of August 2010.
www.journalofindexes.com September / October 2011
13

Figure 8
Historical Emerging Market Corporate Improvement
As Displayed By Issuer Rating Upgrades And Downgrades
Number of upgrades/downgrades
45
40
35
30
25
20
15
10
Source: JP Morgan. Data as of August 2010.
Figure 9
$921
2004
5
0
1/10 2/10 3/10 4/10 5/10 6/10 7/10 8/10
Upgrades Downgrades
— Cum. upgrades to downgrades ratio (rhs)
Decline In Developed-Market Credit Issuance:
An Opportunity For EM Corporates
$1,226
2005
$1,565
2006
$1,515
2007
$242
2008
-$1.3tn decline
$345
2009
-$20
F2010
$292
F2011
HG HY Non-agency MBS EM Corporates BABs
Agency MBS CMBS ABS CLOs
Note: For EM corporates, about 46% are currently investment-grade corporates.
ABS includes Autos, credit cards and student loans.
Source: JP Morgan. Data as of June 2010.
to more closely approximate true EM exposure.
Given the broader geographic representation, the
CEMBI Broad is, in fact, predominantly investment grade,
with close to a 70 percent weighting. With continued
global issuance, the CEMBI Broad is now also sufficiently
diverse, with no major geographic concentrations and
wide-ranging representation across all major industry
sectors. At the time this article was written, Asia represented
nearly 41 percent of the index, followed by emerging
Europe at 12.4 percent, Latin America at 28.47 percent
and Middle East/Africa at 18.25 percent.
Lower Default Expectations
And Higher Risk Premia
From a peak of 11.5 percent in 2009, market strategists
expect default rates to come in below 2 percent for 2010,
which is in line with expectations for the U.S. high-yield
1.4
1.3
1.2
1.1
1.0
0.9
0.8
0.7
0.6
0.5
Upgrades/downgrades ratio
$389
F2012
market. 15 In the context of recent historical returns for
EM corporates, the securities have delivered higher risk
premia over the default and business-cycle risk than are
typically found in other asset classes.
Over the last decade, the average EM corporate
default rate was actually lower than the average U.S.
corporate default rate, and has only exceeded U.S.
default levels in three of the last 10 years. 16 If the compensation-to-default
risk is priced equally for all asset
classes, then EM corporate spreads should be around
the same level as U.S. corporate spreads, after accounting
for business-cycle risk.
To calculate the business-cycle risk, we take a capital
asset pricing model (CAPM) approach. 17 Using four
fixed-income asset classes—EM corporates, U.S. credit,
U.S. high yield and EM sovereigns—we regress monthly
excess returns since January 2003 on the historical excess
return of the S&P 500. We then calculate the required
risk premium associated with business-cycle risk from
this CAPM regression and subtract it from the prevailing
option-adjusted spread in each asset class. Figure
12 plots the evolution of spreads adjusted for businesscycle
risk for the four fixed-income asset classes.
As the chart illustrates, the risk premium from EM
corporate over business-cycle risk is higher than that of
U.S. investment-grade credit and EM sovereigns, and
is consistent with the level of premium found in U.S.
high yield. However, U.S. high yield should have higher
default realizations than those we showed earlier for
U.S. and EM corporates. Therefore, the effective premium
above default and business cycle coming from
EM corporates is unique and higher than those found in
other common fixed-income asset classes.
Economic And Diversification Rationale
The two principal reasons to consider incorporating an
EM corporate bond allocation to a global bond portfolio are
return enhancement and diversification from core markets.
For the last several years, EM corporate bonds have
Figure 10
CEMBI Characteristics Compared To Other Asset Classes*
CEMBI
Broad
Div
CEMBI
Broad
Div
Only
EM
EMBI
Global
Barcap
U.S.
Corp 18
Barcap
U.S.
High
Yield 19
Mkt Cap (USD bn) 114.7 71.6 381.2 2,716.7 830.3
Avg. Life (years) 7.8 8.1 11.8 10.3 6.8
Duration (years) 5.0 5.3 7.2 6.6 4.3
YTM (%) 5.9 6.8 5.4 4.1 8.7
Spread (bps) 395 457 289 182 687
Speed Duration (%) 5.2 5.2 6.8 6.4 4.2
Avg. Rating BBB BB+ BB+ A- B+
* Calculated using simple weighting. Data as of August 2010. Past performance is
no guarantee of future results.
Source: MSIM based on JPMorgan and Barclays index data.
14
September / October 2011

Figure 11
Country Weights Of The CEMBI
7
6
6.7
6.6 6.6
6.4
6.3
6.0
5.8 5.8 5.7
5.0
5
Weight (%)
4
3
2
3.6
3.1 3.0 2.9 2.8
2.6
2.4
2.2 2.2 2.2
1.7
1.4 1.4 1.2
0.9 0.9 0.9
1
0
Hong Kong
Brazil
Russia
Korea
Mexico
UAE
India
Qatar
Singapore
China
Colombia
Malaysia
Chile
Kazakhstan
Indonesia
Jamaica
Thailand
Peru
S. Africa
Ukraine
Israel
Argentine
Philippines
Turkey
Saudi Arabia
Kuwait
Egypt
Taiwan
Barbados
Bahrain
Macau
Venezuela
Nigeria
Lebanon
Panama
El Salvador
0.7 0.6 0.5 0.5
0.3 0.3 0.3 0.3 0.2
Source: MSIM based on JP Morgan. Data as of August 2010.
enjoyed high returns in both absolute and relative terms.
The potential return enhancement of an EM corporate
portfolio is demonstrated in Figure 13, which provides
cumulative returns for various fixed-income asset classes
going back to 2002. To better understand the drivers of the
CEMBI, we have further reclassified the returns to reflect
both high-yield and investment-grade subcomponents
and created a “CEMBI-EM only” category to remove the
dilutive effect of returns from the more developed markets
included in the broader index.
As the chart illustrates, on an aggregate basis, the
CEMBI Broad high-yield subcomponent has outperformed
all other fixed-income asset classes since 2002.
As such, one can make a strong case for introducing EM
high-yield corporates to any of these fixed-income portfolios
as a means of adding potential alpha—particularly
so to U.S. corporate portfolios, when considering the
historical default data discussed above. Furthermore,
when comparing the CEMBI Broad Diversified with the
J.P. Morgan U.S. Liquid Index (JULI) 20 credit portfolios,
the index outperformed by an incremental 30 percent
and approximately 16 percent when comparing only the
investment-grade component of the CEMBI to the equivalent
U.S. benchmark.
The 2008-09 global financial crisis and the recent sovereign
debt problems in Europe have demonstrated the
benefits of diversifying away from core markets. Indeed,
even though all risky assets sold off during the global turmoil,
EM corporate debt recovered faster due to stronger
fundamentals and better growth prospects.
In addition to their different risk profiles relative to
the developed world, emerging market corporates are
diversified among themselves across country, region,
industry and credit quality. As such, an EM corporate
portfolio can help reduce regional and idiosyncratic
risks while also benefiting from differences in business
cycles across regions.
By applying modern portfolio theory, we can see that
EM corporates can be additive to an underlying fixedincome
portfolio. Figure 14 shows the efficient frontier
of two global portfolios including EM corporates. The
effects of adding EM corporates to a global fixed-income
portfolio can be beneficial, as risk/return combinations
potentially maximize the return while reducing the overall
risk of the portfolios.
Risk Considerations Of EM Corporate Thesis
An EM corporate investment strategy is not without
risk. Principal issues to consider include: size and liquidity;
market beta versus the underlying sovereign benchmark;
potential for foreign exchange mismatches; and
limited creditor enforcement rights.
r #Z UIFJS OBUVSF HJWFO UIFJS TNBMMFS TDBMF BOE NPSF
limited financing needs, EM corporate issues are typically
www.journalofindexes.com September / October 2011
15

Figure 12 Figure 14
Spreads Over Business-Cycle Risk Premia For EM
Corporates, U.S. Credit, U.S. High Yield And EM Sovereigns
Positive Potential Risk/Return Effects From Adding EM
Corporates To A Fixed Income Portfolio
1,600
(bps)
1,400
1,200
1,000
800
600
400
200
0
Dec
2006
Jun
2007
Dec
2007
Jun
2008
Dec
2008
Jun
2009
Dec
2009
EM CEMBI Barcap U.S. Credit Barcap U.S. HY EMBIG
Jun
2010
Note: EM corporate debt is represented by the JPMorgan CEMBI Broad Diversified
Index. EM sovereign debt is represented by the JPMorgan EMBIG Index. U.S.
investment-grade debt is represented by the JPMorgan JULI Index.U.S. high-yield
debt is represented by the JPMorgan Domestic High Yield Index. 21
Source: MSIM based in JP Morgan index data. Data as of August 2010.
Figure 13
Annualized Return (%)
12
10
8
6
7 8 9 10 11
Annualized Standard Deviation (%)
N EM Corps Vs Trsy Dev. ex-US
N EM Corps Vs US High Yield
EM Corporates Variance Minimizing Mix With:
EM Corporate Debt 75%
EM Corporate Debt 43%
U.S. High Yield 25%
Trsy Dev. ex-U.S. 57%
Note: EM Corps representatives of the JP Morgan CEMBI Broad Diversified Index.
Source: MSIM based on JP Morgan index data. Data as of August 2010.
CEMBI Broad
Div HY
GBI-EM Gbl Div
EMBI Global
US High Yield
CEMBI Broad
Div Only EM
CEMBI Broad Div
CEMBI Broad
Div IG
Trsy Dev. ex-US
US Corps IG
US Securitized
US Treasury
13.9%
13.7%
11.8%
10.1%
9.8%
8.8%
7.7%
7.4%
6.4%
5.4%
5.1%
48.9%
45.8%
59.7%
76.0%
72.1%
90.0%
107.3%
103.4%
132.7%
168.1%
164.0%
0% 20% 40% 60% 80% 100% 120% 140% 160% 180%
Annualized returns since 2002 Cumulative returns since 2002
"! Treasury Developed Ex-U.S. as represented by the JPMorgan GBI Broad excluding
the U.S. U.S. Corps IG is represented by the JPMorgan JULI Index. 20 U.S. High Yield is
represented by the JPMorgan Domestic High Yield Index. U.S. Securitized is represented
by the Barclays Capital U.S. Securitized Bond Index. 22 U.S. Treasury is represented by the
JPMorgan’s GBI Broad U.S. sub index.
!MSIM based on JPMorgan, Barclays and Bloomberg data. Data as of August 2010.
smaller and less liquid than their sovereign counterparts,
resulting in wider bid/offer spreads. The average issue
size as of September 2010 among EM corporate issuers
has been $450 million versus more than $1 billion for
EM sovereign issuers. 23 Many issuers, in fact, may only
have one bond outstanding, particularly as the number
of debut issuers increases. With the passage of time, however,
we are seeing companies build out more comprehensive
yield curves, though this is more typical for the
larger capitalized credits such as the telecoms, financials,
metals and mining, and oil companies.
r )JTUPSJDBMMZ JO UJNFT PG NBSLFU WPMBUJMJUZ XF IBWF
seen EM portfolio managers favor more liquid investments;
therefore, they reduce their corporate exposure
before their sovereign exposure. Thus, bonds can overshoot
on the way down, and be slower to rebound during
a recovery. Typically, these anomalies will correct themselves
over time, but investors should be sensitive to this
potential for higher associated volatility.
r8IJMFNBOZJTTVFSTUSZUPUBLFBEWBOUBHFPGUIFMPOHFS
BWBJMBCMFUFOPSTJOUIFJOUFSOBUJPOBMDBQJUBMNBSLFUTUIFZ
can, in certain circumstances, concurrently increase the
MFWFM PG UIF BTTPDJBUFE GPSFJHO FYDIBOHF SJTL JF JODVS
external debt obligations while only generating local
currency cash flows. While less relevant to exporters
and countries with more stable forex policies, corporate
defaults have arisen specifically due to these mismatches,
as was the case in Argentina in 2002-2003.
r 8IJMF SFHVMBUPST JO NBOZ DPVOUSJFT IBWF SFDFOUMZ
JNQSPWFEUIFJSCBOLSVQUDZDPEFTBOEBTTPDJBUFEDSFEJUPS
rights, investor enforcement rights are still significantly
XFBLFS UIBO JO NPSF EFWFMPQFE DPVOUSJFT 4IBSFIPMEFS
reputation and character of management are, therefore,
crucial factors in the investment analysis, as is an appreciation
for the issuer’s desire for continued access to the
JOUFSOBUJPOBMNBSLFUT
All of the above are important considerations when
evaluating an investment in EM corporate assets.
Depending on the issuer and its payment history, one
NVTU EFUFSNJOF XIFUIFS UIFSF JT BO BQQSPQSJBUF SJTL
premium over the relevant sovereign and comparable
EFWFMPQFENBSLFUTCFODINBSLDSFEJUT
16
September / October 2011

Conclusion
We believe that an allocation to EM corporate debt is an
attractive option for investors seeking the opportunity to add
potential excess risk-adjusted returns, whether considering
a CEMBI high-yield overlay to U.S. high-yield, investmentgrade
or the J.P. Morgan Emerging Markets Bond Index
Global (EMBIG) port-folios, or investing in a more traditional
CEMBI diversified portfolio compared with U.S. credit. The
fact that EM corporate default rates have been lower than
U.S. levels for seven out of the last 10 years is an additional
key consideration. There is still a positive basis between EM
corporates and U.S. investment-grade or high-yield indexes
of between 90 and 150 basis points, which while narrower
than historical levels, is in our view still compelling in the
current U.S. Treasury environment.
For the many reasons discussed above, we expect the
asset class to continue growing, as the various underlying
companies evolve or the credit metrics improve over time
with the growth of the underlying sovereigns.
A version of this story previously appeared in the Morgan
Stanley Investment Management Journal, Volume 1, Issue 1.
Endnotes
1. Source: Bond Radar. Data as of August 2010. As of October 5, 2010, year-to-date 2010 issuance stood at $143 billion.
2. The Corporate Emerging Markets Bond Index was created in December 2007 by J.P. Morgan to measure global liquid U.S.-dollar-denominated corporate EM bonds.
3. Sources: MSIM, official sources
4. Sources: MSIM and IMF
5. For example, Banco Bradesco estimates that the middle income (“Class C”) sector of the Brazilian population has grown from 38.73 percent to 53.4 percent from January
2004 to May 2010. Source: Banco Bradesco, October 2010.
6. The J.P. Morgan CEMBI Broad Diversified Index tracks U.S.-dollar-denominated debt issued by emerging market corporations. It includes fixed, floating, amortizing and
capitalizing instruments.
7. The J.P. Morgan Global Government Bond Index tracks total returns for fixed-rate government debt in developed government bond markets.
8. The J.P. Morgan Emerging Markets Bond Index Global tracks total returns for traded external debt instruments in the emerging markets.
9. Data from Dealogic indicates that EM targeted mergers and acquisitions (M&A) volume is up by more than 66 percent as of September 2010 to $575 billion versus $572
billion for the full year 2009. M&A by companies in EM now account for 30 percent of global activity. Data as of September 2010.
10. The upgrades/downgrades ratio is cumulative monthly corporate ratings upgrades from Moody’s, S&P and Fitch, divided by downgrades during the same period.
11. Rating agencies will typically not permit a corporate issuer’s ratings to exceed that of their sovereign domicile, unless there are extenuating circumstances such as hardcurrency
generation or substantial offshore assets.
12. Source: J.P. Morgan, August 2010
13. The CEMBI series includes fixed-rate securities, while the CEMBI Broad includes fixed, floating, amortizing and capitalizing instruments.
14. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets.
15. Source: J.P. Morgan, July 2010
16. Source: J.P. Morgan
17. See “Measuring Business-Cycle Risk In Fixed-Income Portfolios” by David Armstrong, July 10, 2010, Morgan Stanley.
18. The Barclays Capital U.S. Corporate Bond Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity,
liquidity and quality requirements.
19. The Barclays Capital High Yield Bond Index tracks the performance of below-investment-grade U.S.-dollar-denominated corporate bonds publicly issued in the U.S.
domestic market.
20. The J.P. Morgan GBI Index measures local-currency-denominated fixed-rate government debt issued in developed markets.
21. The J.P. Morgan Domestic High Yield Index is designed to mirror the investable universe of the U.S. dollar domestic high-yield corporate debt market.
22. The Barclays Capital U.S. Securitized Bond Index is an unmanaged composite of asset-backed securities, collateralized mortgage-backed securities (ERISA-eligible) and
fixed-rate mortgage-backed securities.
23. Source: Bond Radar, J.P. Morgan, August 2010
www.journalofindexes.com September / October 2011
17

Individual Country Or
Broad-Market Exposure?
Which makes sense in emerging markets?
By Christopher Philips, Roger Aliaga-Díaz,
Joseph Davis and Francis Kinniry
18
September / October 2011

With recent events in Egypt leading to suspension
of that country’s investment market activity and
the closure of its stock exchange on Jan. 27, 1 the
question of the risks inherent in emerging market investing
is on many investors’ minds. While we do not believe recent
events warrant a flight of capital from emerging markets,
we do believe that the situation represents an opportunity
for investors to consider the best way to access emerging
market stocks. We delve into the risks of shifting an emerging
market allocation away from broad, diversified coverage
to a more concentrated focus. We conclude that diversifying
across emerging market countries helps to minimize idiosyncratic
or uncompensated risks and is analogous to diversifying
across individual companies in developed markets.
Why Focus On Countries?
The appeal of investing in individual countries is the
potential for higher returns compared with a more diversified
investment. Figure 1 shows the range of annual
returns across MSCI Emerging Market Index countries
since 1988. An investor who correctly picked the topperforming
countries could have significantly outpaced
the broad global market. Of course, the obvious risk in this
strategy is that the investor might have instead selected the
country or countries that significantly underperformed the
market. And in emerging markets, the difference between
the winning countries and the losing countries can be
stark (much more so, for example, than when focusing on
sectors within the U.S. market); this can mean significant
volatility for portfolios focused on country selection.
Although the spread between best and worst performers
appears to have narrowed during the 2000s—perhaps
because of persistently rising correlations across emerging
market countries and regions—substantial risks still
remain for investors who use a country-selection strategy.
For example, investors tend to display a natural behavior to
migrate toward the winning sector or country. For instance,
in Russia, following strong returns through mid-2008 (largely
due to a rise in oil prices), cash flows into Russian
exchange-traded funds peaked that June. Subsequently,
the MSCI Russia Index fell -75 percent over the 12 months
ended February 2009. Cash flows bottomed in June 2009,
just as the Russian market was beginning its rebound. Then,
as Russian stocks accelerated in 2009 and into 2010, cash
flows picked up considerably. This relationship has not
been unique to the Russian stock market. Indeed, the correlation
between 12-month returns and 12-month cash flows
into China ETFs has been 0.61 since 2005.
Challenges Of Country Selection
A primary problem with attempting to predict the winning
emerging market country is that when evaluated
individually, countries can be much less efficient than the
broad market. In other words, stocks of individual countries
have generally exhibited greater volatility without
compensating investors with high enough returns. Figure
2 shows that from 1993 through 2010, the MSCI Emerging
Markets Index delivered a combination of risk and return
that exceeded the risk-adjusted performance of most of the
individual countries in the index over that period. Although
five countries offered proportionately higher risk-adjusted
returns, only one country (Chile) had volatility that was
lower than that of the broad market. Of course, to have
realized the lower average volatility, investors would have
had to be invested in Chile for the entire period without
adjusting their allocations. The question then is: Can those
countries with superior risk-adjusted returns be selected
in advance—and then held in a strategic allocation across
both good and bad markets?
Economic Performance
Often, economic performance is posited as a useful
metric when evaluating expected market performance
across countries. Vanguard’s research, however, has
shown no correlation between realized economic performance
and market returns. Figure 3 illustrates this
Figure 1
Total Annual Return
1,500%
700%
300%
100%
0%
-50%
-75%
-87.5%
The Range Of Returns For Individual Emerging
Market Countries Has Been Substantial
1990 1994 1998 2002 2006 2010
N Individual Country Returns N MSCI Emerging Markets Index Return
Note: Countries represent the constitution of the MSCI Emerging Markets Index as of
Jan. 31, 2011. Return data for Brazil, Chile, Indonesia, Korea, Malaysia, Mexico,
Philippines, Taiwan, Thailand and Turkey start in 1988. Return data for China,
Colombia, India, Peru, Poland and South Africa start in 1993. Return data for Czech
Republic, Egypt, Hungary, Morocco and Russia start in 1995. Figure 1 uses a log scale
to plot the returns to better represent the relative dispersion across individual
countries. To convert the log scale into a returns framework, we subtracted 1 from
each log value.
Sources: Vanguard, MSCI and Thomson Reuters Datastream
Figure 2
Average Annual Total Return
25%
20%
15%
10%
5%
0%
-5%
A Broad Emerging Markets Index
Offers Efficiencies In Risk And Return
Relationship between returns and volatility for individual MSCI
Emerging Market Index countries, 1993–2010
MSCI Emerging
Markets Index
Risk-neutral capital
market line
10% 20% 30% 40% 50% 60%
Annual Volatility (Standard Deviation Of Returns)
Note: Results are shown since 1993 to balance the number of observations
(16 countries) with a long-enough period.
Sources: Vanguard, MSCI and Thomson Reuters Datastream
www.journalofindexes.com
September / October 2011
19

Figure 3
Annual Real GDP Per Capita Growth
6%
5%
4%
3%
2%
1%
0%
Relationship Between GDP Growth
And Market Returns
-1%
-5% 0% 5% 10% 15% 20%
Note: Sample includes the 12 emerging markets that had both economic and market
return data available back to 1988. Evaluating alternative time periods (1993 or 1995,
for example) would not alter the results.
Sources: Vanguard, International Monetary Fund, MSCI, Thomson Reuters
Datastream and the World Bank
Figure 4
Annual Equity Market Return
20%
15%
10%
5%
0%
Emerging Markets, 1988-2010
Annual Real Return
Relationship Between Currency
And Market Returns
Emerging Markets
-5%
-10% -8% -6% -4% -2% 0% 2% 4%
Annual Change In Currency Value Relative To U.S. Dollar
Note: Sample includes the 21 emerging market countries with data back to 1995. We
excluded Russia and Turkey from the sample as outliers. (Including Russia and Turkey
would not alter the results, but would significantly alter the scale of the graph.)
Sources: Vanguard, MSCI and Thomson Reuters Datastream
in striking fashion: The correlation between long-run
economic growth (as measured by real gross domestic
product growth per capita, a standard proxy for a country’s
productivity growth) and long-run stock returns
across emerging markets has been effectively zero. 2 The
challenge facing investors is that while economic growth
is certainly important for equity investors (economic surprises
and the price paid for economic growth are the true
critical factors), expected economic performance alone
has not shown a strong positive link to equity returns. In
other words, investors are not compensated for investing
on the basis of economic growth that is expected and
therefore priced into financial markets. And because outperformance
is more dependent on unexpected growth,
in order to profit, investors must be able to accurately
predict unexpected growth, a decidedly difficult task.
Foreign Currency Appreciation
A second metric often used to make the case for overweighting
a particular country concerns expectations of
Figure 5
Subsequent Annualized
10-Year Return
50%
40%
30%
20%
10%
0%
-10%
-20%
Do Low P/E Countries Offer Higher Returns?
Relationship Between Initial Valuations And Returns
0 10 20 30 40
50
Initial P/E Ratio
Note: All countries in the MSCI Emerging Markets Index are represented that had at
least 13 years of reported P/Es and returns (to supply at least 36 ten-year return
observations for each country) as of January 31, 2011. P/Es as of 1/31/2001; ten-year
returns as of 1/31/2011. The data represent 21 countries, accounting for 1,646
observations. For presentation, we truncated the x-axis for observations less than 0 or
greater than 50. Those outliers accounted for 10% of the observations. By removing
the outliers from the analysis, the theoretical relationship between initial valuations
and subsequent returns appears, albeit to a lesser extent than observed in the United
States. Returns denominated in U.S. dollars.
Sources: Vanguard, MSCI and Thomson Reuters Datastream
foreign currency appreciation (and subsequent depreciation
of the U.S. dollar), perhaps due to differences in a
country’s fiscal standing, national balance sheets and/or
economic growth. Again, however, while seemingly theoretically
sound, the historical data do not support this relationship.
Figure 4 compares currency return with market
return across emerging markets. The regression trend line
indicates that differences in currency values may largely
be priced into equity prices. If investors were able to benefit
from currency, we would expect a positive relationship.
However, just as with economic performance, investors
have not been rewarded for expected currency movements.
And as with unexpected economic performance, accurately
predicting unexpected currency movements is no easy task.
Valuations
Finally, we turn to a third metric, valuations, which
have been found to be the critical factor in explaining
relative performance. For example, in the United States,
low initial price/earnings ratios have historically led to
higher subsequent returns. This relationship has been
shown to be particularly valid during periods of extreme
valuations (Davis, Aliaga-Díaz, and Ren, 2009; Philips
and Kinniry, 2010). Based on this relationship, we conducted
a similar analysis with emerging market countries.
Unfortunately, however, Figure 5 demonstrates
that the relationship between initial P/E ratios and subsequent
returns breaks down when we extend it to individual
emerging markets. 3 We clearly see that low initial
P/E ratios have not signified higher subsequent returns,
nor have high initial P/E ratios led to low subsequent
returns. The trend line overlaid on the chart reveals the
lack of any relationship.
Although Figure 5’s results are informative, it’s important
to note that the absolute relationship between valuations
and returns may obscure relative relationships.
20
September / October 2011

Indeed, sovereign risk, varied economic growth rates, or
idiosyncratic economic uncertainty can lead to systematically
different valuation levels from country to country. We
therefore replicated Figure 5 using normalized P/E ratios,
or a ratio of a country’s P/E in any given period relative to its
average historical P/E. It is interesting that the results using
normalized P/Es were nearly identical to those shown in
Figure 5. While several countries displayed the traditional
markets (as with individual stocks), valuation ratios
could be low not just because prices are depressed but
possibly because of expectations of slower future earnings
growth. Indeed, in the case of Venezuela, geopolitical
risks prevailed, and Venezuela was removed from the
public investment space as private assets and foreign
capital were seized by the government, thus making the
potentially attractive P/E multiple meaningless.
The key difference among individual emerging markets
in terms of the relationship between valuations and
return is idiosyncratic, or country-specific, risk.
relationship between valuations and subsequent returns, a
significant majority did not.
We also replicated this analysis with local returns, using
the hypothesis that the volatility of currencies has overwhelmed
the underlying relationship between valuations
and returns for local investors. However, the results were
again identical to those shown in Figure 5.
The key difference among individual emerging markets
in terms of the relationship between valuations and
return is idiosyncratic, or country-specific, risk. A case
in point is Venezuela. From December 2004 through
October 2006, the Venezuela stock market was valued at
less than 10x earnings. Historically speaking, if a diversified,
developed market such as the U.S. stock market
were so valued, this would be a strong indicator of aboveaverage
future performance. However, for concentrated
Conclusion
The evidence presented here suggests that accurately
selecting an emerging market country that will outperform
is difficult, at best. At worst, an investor or advisor
can experience significant volatility and underperformance,
not to mention the potential for nonmarket risks.
Although individual emerging markets have outperformed
the broad emerging markets index over both the short and
long term, selecting them in advance is extremely difficult
and fraught with risk. Indeed, as with most concentrated
and volatile asset classes or strategies, the risk of getting
it wrong can far outweigh the gains from getting it right.
The message, then, is simple: When investing in emerging
markets, diversification is key. For a greater chance of
success, investors have found broad-market vehicles to
be their most reliable tool.
Endnotes
1. It has since reopened.
2. The result in Figure 3 was first documented in the book “Triumph of the Optimists: 101 Years of Global Investment Returns” by Elroy Dimson, Paul Marsh and Mike
Staunton, of the London Business School (Princeton University Press, 2002). See also Davis et al. (2010) for an in-depth analysis of this result.
3. P/E or other valuation metrics have proven to be much more useful at the broad-market level. For example, a positive historical relationship between initial valuations
and subsequent returns has been shown to exist for the MSCI Emerging Markets Index. Similarly, Davis et al. (2010) showed that the relative spread between valuations in
developed vs. emerging markets has been a significant reason for the outperformance of emerging markets since 2000.
References
Davis, Joseph H., Roger Aliaga-Díaz, C. William Cole, and Julieann Shanahan, 2010. “Investing in Emerging Markets: Evaluating the Allure of Rapid Economic Growth.”
Valley Forge, Pa.: The Vanguard Group.
Davis, Joseph H., Roger Aliaga-Díaz, and Liqian Ren, 2009. “What Does the Crisis of 2008 Imply for 2009 and Beyond?” Valley Forge, Pa.: The Vanguard Group.
Philips, Christopher B., and Francis M. Kinniry Jr., 2010. “2009: A Return to Risk-Taking.” Valley Forge, Pa.: The Vanguard Group.
Disclosure
All investments are subject to risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are
generally riskier than stocks of companies in developed countries. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of
any particular investment, as you cannot invest directly in an index. Diversification does not ensure a profit or protect against a loss in a declining market.
www.journalofindexes.com September / October 2011
21

Inflation-Linked Index Products:
An Overview
Considerations for fixed-income investors
By Brian Upbin, Anand Venkataraman and Scott Harman
22
September / October 2011

Inflation is an important risk factor for investors concerned
about the purchasing power of future cash
flows to be received or future liabilities to be paid.
This is true for traditional debt investors seeking a positive
real return on assets; for pension plans; and for other
asset owners with future cash flow obligations that must
be funded by their investment portfolios. It is also the case
for bond issuers who must compensate for inflation risk
in the interest rate they are required to pay.
To address these risks, bond investors may seek high
positive real returns with traditional fixed-income assets
or tap into a large and growing component of the fixedincome/OTC
derivative universe that is directly linked to
inflation. These inflation-linked bond and swap instruments
offer returns or payoffs that are linked to inflation,
but have also created an opportunity to express directional
market views on expected inflation by comparing
the valuations of inflation-linked and nominal assets.
Inflation-Linked Bonds: Though not eligible for broadbased
bond benchmarks, inflation-linked bonds (or “linkers”)
have become a relevant part of many traditional
fixed-income portfolios because of the growth in and
increased liquidity of the asset class. Some investors will
treat inflation-linked debt as a component of their existing
government bond allocations, as a separate inflation-linked
allocation in their overall fixed-income mix, or as a tactical
out-of-index investment to generate portfolio alpha.
Regardless of the treatment of inflation-linked bonds in a
bond portfolio allocation, debt investors still need objective
and rules-based indexes to measure this inflation-linked
asset class. Barclays Capital publishes a family of developed
market and emerging markets inflation-linked bond
indexes for investors, offering both an explicit performance
target for these assets and an informational measure on the
risk and return characteristics of the market.
Inflation Swaps: Inflation swaps are an important index
tool used by a different set of fixed-income investors
seeking liability-driven investment (LDI) benchmarks
to measure future cash flow obligations and therefore
the performance hurdle required to fund such obligations
properly. Barclays Capital also offers a rules-based
family of inflation swaps indexes that can be used in
isolation or blended with other debt and nominal swaps
indexes as benchmarks for LDI portfolios.
This article discusses the landscape for both inflation-linked
bonds and inflation swaps, covering the
basic mechanics of these instruments and details on
the structure and growth of the overall market. We also
discuss other inflation-linked index products that are
used by market participants when accessing, evaluating
and managing inflation.
Inflation-Linked Bond Mechanics
In simple terms, inflation-linked bonds are securities
where the promised cash flows (coupon and principal)
are linked throughout the life of the security to
changes in a specified price index (most commonly a
consumer price index, or CPI). 1
The inflation “earned” is generally captured by an “index
ratio,” which measures the growth of the price index from a
base reference level. This index ratio is used periodically to
“inflate” the par amount of the security and determine how
much principal is owed and on what denominator actual
coupon cash flows will be paid. Price index data are usually
available with a monthly frequency. In practice, a reference
index value typically needs to be derived for each trade
settlement date using the monthly series, with the base
reference level being the calculated reference index for the
date from which inflation is accrued on the security.
The stated coupon will remain constant as a percentage
of principal owned, 2 but investors will receive larger
cash flows throughout the life of the bond for increases in
notional due to inflation. Cash flows on an inflation-linked
bond tend to be more back-ended compared with a nominal
bond; later coupons will be bigger than initial ones and
the principal repayment at maturity will usually be above
the initial par value when it was purchased. For a particular
issuer and maturity, this back-ended nature of cash flows
can be interpreted as a bigger credit risk in holding an
inflation-linked bond compared with a nominal bond.
Example Of Inflation-Linked Bond Mechanics
For a nominal bond paying an annual coupon of 5
percent, the final payment at maturity would be $100
plus the $5 coupon, with a fixed 5 percent coupon each
year during the life of the bond. For an inflation-linked
bond, the principal and coupon are fixed in real, not
nominal, terms. So, if the price index rose by 25 percent
over the life of the bond, the index ratio would be 1.25
and the principal repayment at maturity would be $100 x
125 percent = $125. Similarly, the final coupon payments
would also be adjusted in nominal terms to reflect the
changes in the price index, so instead of receiving $5, the
investor would receive $6.25 (5 percent of the adjusted
principal) and would therefore be protected against
inflation. Interim coupon payments will also take into
account the growth of the price index. Typically, if the
price index level is lower than the base reference level,
coupon payments will also be adjusted lower. In other
words, while the principal of many inflation-linked
bonds is protected against deflation by the maintenance
of a floor of 100—the par value—coupon payments may
fall to below the level at issuance.
Inflation data is typically calculated and published by
the relevant government authorities and often takes several
weeks to gather. Therefore, the price index referenced
in any inflation-linked bond will usually be calculated
with a lag of a few months to allow for the delay. The index
ratio incorporates this lag by a daily interpolation of the
reference price index, lagged by two to three months, or
alternatively by simply referencing the price index with,
for example, a lag of a month. The former methodology
is the most widely followed in inflation-linked bond markets,
and is usually referred to as the Canadian model. 3
www.journalofindexes.com September / October 2011 23

Inflation-Linked Government Bond Market
Inflation-linked government bonds 4 are the most common
type of inflation-linked bond, with an increasing number
of sovereign issuers maintaining or initiating inflationlinked
bond programs. Currently, 13 of the 20 largest countries
in the world by GDP (including all G7 countries) have at
least one government inflation-linked bond outstanding.
Why Issue Inflation-Linked Bonds?
A government will generally issue inflation-linked
debt if it makes economic sense to do so and if there is
sufficient demand from investors for such a product.
r'PSBHPWFSONFOUUIBUFYQFSJFODFTIJHIJOGMBUJPOUIF
issuance of inflation-linked debt may attract more investors
to its debt and thereby lower its effective borrowing costs.
r #Z JTTVJOH JOGMBUJPOMJOLFE EFCU B HPWFSONFOU DBO
also signal strength to the market in the institutional
arrangements it has put in place to maintain an antiinflationary
bias.
r(PWFSONFOUTUIBUIBWFFGGFDUJWFMZCSPVHIUEPXOMPOH
term inflation may also issue inflation-linked bonds while
JOGMBUJPO FYQFDUBUJPOT SFNBJO IJHI JO PSEFS UP TBWF UIF
JOGMBUJPOSJTLQSFNJVNTUJMMFNCFEEFEJOGJYFESBUFEFCU
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investors with inflation-linked liabilities. These investors
may prefer inflation-linked to nominal government
bonds for liability matching.
r 'JOBMMZ JTTVJOH JOGMBUJPOMJOLFE EFCU NBZ QSPWJEF B
method of diversifying a government’s debt portfolio and
matching its future debt-servicing costs with its revenues.
While there are many reasons to issue inflation-linked
EFCUUIFSFBSFTPNFESBXCBDLT#ZGBSUIFCJHHFTUDSJUJcism
of inflation-linked bonds is that these securities
tend to be less liquid and trade with larger bid/ask
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as those that occurred in 2008 and 2009.
Developed Inflation-Linked Bond Markets
The first government inflation-linked bond was issued
CZ 'JOMBOE JO CVU UIF GJSTU JOGMBUJPOMJOLFE 6, HPWernment
bond (“gilt”), issued in 1981, is widely considered
BTIBWJOHHJWFOCJSUIUPUIJTBTTFUDMBTT5IF6,TMFBEXBT
Figure 1
$ Trillion
Aggregate WGILB Inflation-Linked Debt Gross Issuance
250
200
150
100
50
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Barclays Capital
N Linker Issuance
followed by other developed economies such as Australia,
$BOBEB BOE 4XFEFO BMM PG XIJDI FOUFSFE UIF NBSLFU CZ
UIFFBSMZT5IF645SFBTVSZCFHBOJTTVJOHJOGMBUJPO
MJOLFE CPOET NPTU DPNNPOMZ LOPXO BT 5*14 5SFBTVSZ
inflation-protected securities), in 1997, while the European
NBSLFUHBJOFEBEEJUJPOBMJNQFUVTXJUI'SBODFTGJSTU$1*FY
UPCBDDPJOEFYMJOLFETFDVSJUZJOBOEUIF&VSP)*$1Y
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since followed, with Italy now the largest issuer in the euro
&.6)*$1MJOLFETFDUPS*O"TJBUIF+BQBOFTFNJOJTUSZPG
GJOBODF .P' IBT CFFO JTTVJOH JOGMBUJPOMJOLFE +BQBOFTF
HPWFSONFOUCPOET +(#JTTJODF.BSDI
Developed market government inflation-linked bonds
BSF SFQSFTFOUFE CZ UIF GMBHTIJQ #BSDMBZT $BQJUBM 8PSME
(PWFSONFOU *OGMBUJPO-JOLFE #POE 8(*-# *OEFY UIF
measure of the asset class most widely used by global debt
investors. The largest and most liquid markets within the
8(*-# *OEFY BSF JO PSEFS PG NBSLFU DBQJUBMJ[BUJPO 64
QFSDFOU6, QFSDFOUBOEFVSP QFSDFOU
which, taken together, constitute 91 percent of the market
WBMVFPGUIFJOEFY5IFFVSPDPNQPOFOUJODMVEFTJTTVBODF
GSPN 'SBODF (FSNBOZ BOE *UBMZ XJUI UIF NBSLFU TIBSF
split 14 percent, 4 percent and 9 percent, respectively.
+(#JTPODFSFQSFTFOUFEPWFSQFSDFOUPGUIF8(*-#IPX-
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FSBUFSFQVSDIBTFTPG+(#JTBOEDFBTFEBVDUJPOBDUJWJUZ#Z
UIFFOEPG+VOFUIFXFJHIUJOHPG+(#JTJOUIF8(*-#
JOEFYIBEGBMMFOUPKVTUPWFSQFSDFOU
Inflation-Linked Bonds In Emerging Markets
Inflation-linked bonds are not confined to developed
markets. Many emerging market economies, including
*TSBFM$IJMFBOE#SB[JMIBWFCFFOJTTVJOHUIFTFTFDVSJUJFT
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more EM governments have chosen to issue inflation-
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,PSFBBMMJNQMFNFOUJOHQSPHSBNTJOSFDFOUZFBST4PNF
of this growth can be attributed to changes in the investment
mandates of institutional investors in the EM world.
"OPUIFSSFBTPOJTUIFHSPXUIJOTJ[FBOETPQIJTUJDBUJPOPG
the local institutional investor base.
In many emerging markets with higher levels of inflation,
inflation-linked bond issuance represents a higher
portion of government debt than in developed markets.
'PS TPNF NBSLFUT TVDI BT #SB[JM BOE $IJMF UIF UPUBM
JOGMBUJPOMJOLFE EFCU PVUTUBOEJOH BDUVBMMZ FYDFFET UIF
value of nominal debt outstanding, and the inflationlinked
yield curve tends to cover a greater range of matur-
JUJFT 'PS FYBNQMF QFSDFOU PG PVUTUBOEJOH $IJMFBO
JOEFYFMJHJCMFHPWFSONFOUEFCUJTJOGMBUJPOMJOLFE
EM government inflation-linked bonds are measured
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-JOLFE #POE &.(*-# *OEFY XIJDI XBT MBVODIFE JO
0DUPCFS"TPG+VOFUIF&.(*-#DPWFSFE
&.HPWFSONFOUJTTVFSTBOEIBEBNBSLFUDBQJUBMJ[BUJPO
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#SB[JMBMPOFBDDPVOUJOHGPSPWFSQFSDFOUPGUIFJOEFYT
24
September / October 2011

Figure 2
Barclays Capital World Government Inflation-Linked Bond (WGILB) Index Characteristics
June 30, 2011
Market
Cap
Local Bn
Market
Cap
$ Bn
Weight %
WGILB
Number
Of
Bonds
Real Yield
(%)
Mod
Duration
$
Unhedged
Returns
YTD (%)
Local
Returns
YTD (%)
Index
Rating
WGILB
US
UK
Euro Government
France
Germany
Italy
Canada
Japan
Sweden
Australia
1-5 year
5-10 year
>10 year
1,820.3 106 0.91 10.06 7.69 4.60
By Country/Region
715.9 715.9 39.3% 31 0.86 8.05 5.84 AAA
272.4 437.4 24.0% 17 0.47 16.02 7.02 4.37 AAA
343.0 497.3 27.3% 27 1.74 7.73 3.08
177.4 257.2 14.1% 13 1.21 8.03 11.13 2.83 AAA
50.3 72.9 4.0% 4 0.71 5.23 10.41 2.17 AAA
115.3 167.2 9.2% 10 2.79 8.35 12.26 3.87 A
54.8 56.8 3.1% 6 0.97 16.28 7.61 4.52 AAA
4,450.4 55.1 3.0% 16 0.67 5.32 3.52 3.08 AA
232.3 36.8 2.0% 5 0.92 8.40 11.36 4.52 AAA
19.6 21.0 1.2% 4 2.38 8.34 10.08 5.40 AAA
WGILB By Maturity
484.3 484.3 26.6% 30 -0.24 2.82 3.27
570.2 570.2 31.3% 33 0.62 6.81 5.19
765.8 765.8 42.1% 43 1.12 17.07 4.98
Source: Barclays Capital; data as of June 30, 2011.
Figure 3
Barclays Capital Emerging Market Government Inflation-Linked Bond (EMGILB) Index Characteristics
June 30, 2011
Market
Cap
$ Bn
Weight (%)
EMGILB
Number
Of
Bonds
Real Yield
(%)
Mod
Duration
$
Unhedged
Returns
YTD (%)
Local
Returns
YTD (%)
Index
Rating
EMGILB
LATAM
Argentina
Brazil
Chile
Colombia
Mexico
EEMEA
Poland
South Africa
Turkey
Israel
ASIA
South Korea
1-5 year
5-10 year
>10 year
469.1 80 4.92 6.86 5.66 1.96
By Country/Region
343.7 73.3% 52 5.78 6.93 7.39 1.93
16.4 3.5% 5 10.19 5.93 -15.21 -12.40 B
264.1 56.3% 13 6.24 6.69 9.95 3.48 BBB
10.8 2.3% 20 2.92 5.31 1.07 1.20 AA
2.6 0.6% 4 3.52 4.77 12.25 3.65 BBB
49.7 10.6% 10 3.35 8.98 6.28 1.05 BBB
121.4 25.9% 26 2.49 6.68 1.13 1.97
6.7 1.4% 2 2.71 6.61 13.23 5.21 A
31.3 6.7% 6 2.51 9.41 2.49 5.02 A
41.9 8.9% 8 2.28 4.08 -3.92 1.38 BB
41.6 8.9% 10 2.54 7.26 4.18 0.09 A
3.9 0.8% 2 1.48 6.58 11.25 4.66
3.9 0.8% 2 1.48 6.58 11.25 4.66 A
EMGILB By Maturity
195.5 41.7% 34 4.78 2.40 6.94 3.71
99.9 21.3% 21 4.59 5.80 4.93 1.25
173.7 37.0% 25 5.04 12.50 4.59 0.32
Source: Barclays Capital; data as of June 30, 2011.
www.journalofindexes.com
September / October 2011 25

Figure 4
Universal Government Inflation-Linked Bond (UGILB) Index Composition
Universal Government Inflation-Linked Bond Index
World Government Emerging Markets Government Other
Australia
0.91%
Canada
2.47%
France
11.07%
Italy
7.21%
Germany
3.17%
Sweden
1.65%
UK
19.51%
US
30.93%
Japan
2.45%
Argentina
0.72%
Brazil
11.05%
Chile
0.43%
Colombia
0.11%
Mexico
2.38%
Poland
0.29%
South
Africa
1.34%
Turkey
1.85%
South
Korea
0.17%
Israel
1.81%
Greece
0.47%
Source: Barclays Capital; data as of June 30, 2011.
Figure 5
Universal Government Inflation-Linked Bond (UGILB) Index Characteristics
June 30, 2011
Market
Cap
$ Bn
Weight (%)
In UGILB
Number
Of
Bonds
Real Yield (%)
Mod
Duration
$
Unhedged
Returns
YTD (%)
UGILB
WGILB
EMGILB
Others (Greece)
2,300.0 188 1.57 9.41 7.23
1,820.3 79.1% 106 0.91 10.06 7.69
469.1 20.4% 80 4.92 6.86 5.66
10.6 0.5% 2 9.83 10.41 -2.51
Source: Barclays Capital; data as of June 30, 2011.
debt outstanding. Due to the large concentration of Brazil
in the market-value-weighted EMGILB, the more popular
choices among fund managers are constrained versions
of the EMGILB Index that cap an individual country’s
exposure at 25 percent of the benchmark. Other popular
variants are the EMGILB Constrained ex-Colombia
ex-Argentina 7 Index, which excludes the two named
markets, and the EM Tradable Inflation Linked Index
(EMTIL), which measures a narrower universe of more
liquid EM inflation-linked bonds. 8
Blended Developed And Emerging Markets IL Debt (UGILB)
The Universal Government Inflation-Linked Bond
(UGILB) Index is Barclays Capital’s broadest measure
of the government inflation-linked bond universe. The
UGILB presently has a market capitalization of around
$2.3 trillion and combines the country coverage of the
WGILB and EMGILB. 9 WGILB represents 79.1 percent
of the universe by market value, with EM inflationlinked
bonds representing 20.4 percent.
Breakeven Inflation Indexes
The growth of inflation-linked products has also created
the opportunity for fixed-income investors to express
directional views on inflation expectations and real rates.
Breakeven inflation, which can be defined as the rate of
inflation that will equate the returns on an inflation-linked
bond and a “comparator” nominal bond of equal term, is
central to most derivations of inflation expectations from
market prices. The Fisher equation estimates the relationship
between interest rates and inflation as follows:
(1 + Nominal Interest Rate) = (1 + Real Interest Rate)
x (1 + Inflation Rate)
Breakeven inflation indexes, which measure returns
of long inflation-linked bonds/bond indexes and short
nominal comparator bonds/bond indexes, can be used as
benchmarks for passive as well as active managers.
Inflation Swap Indexes
The growth of the international inflation-linked government
bond market has also facilitated the growth of the inflation
derivatives market. Inflation swaps enable one party to
pay or receive inflation from another and are a common
instrument used by the LDI community both to measure risk
and to set performance targets for future obligations.
The Barclays Capital inflation swap indexes are designed
to replicate the performance of a portfolio investing in two
different types of inflation swap: zero-coupon inflation
swaps and real rate swaps. The former is an exchange of
an inflation-linked cash flow and a fixed cash flow at maturity
with no interim payments, whereas the real rate swap
involves an exchange of Libor-based payments with a fixed
real payment, plus payments for realized inflation.
Inflation swap indexes can be created for almost any
26
September / October

Figure 6
Figure 7
A Zero-Coupon Inflation Swap Transaction
Fixed Breakeven Rate
A Real Rate Inflation Swap Transaction
Libor
Counterparty
Bank
Fixed
Breakeven
Rate
Counterparty
Bank
Actual Inflation
Fixed Nominal
Swap Rate
Source: Barclays Capital
tenor and offer fund managers a tool to match the specific
cash flows and weights of their pension liabilities more
accurately than inflation-linked bonds. Mismatches in
maturity, index, profile and size between assets and
liabilities can be bridged by the use of such swap indexes,
and also preclude the need to continuously reinvest the
coupon payments and principal redemptions that are
inherent within a bond portfolio.
Conclusion
Inflationary pressures and low growth rates in the developed
world are among a number of new challenges faced
by fixed-income portfolio managers. These factors have led
Source: Barclays Capital
Bank
Actual Inflation
many investors who have not naturally been drawn to the
inflation-linked asset class to consider it as an alternative.
In the EM world, this trend has been most notable, with
an increasing number of EM credit managers evaluating
EM inflation-linked bonds. With recent research suggesting
that EM inflation-protected bonds have the potential
to enhance the risk/return profile of an international EM
investor, it is likely that this trend will continue. 10
Endnotes
1. Although the price index will normally increase over the course of time, it can also decrease during the life of the bonds in periods of deflation. Most government
inflation-linked bonds have an implicit guarantee that the bonds would be redeemed at no less than par value of the bond, which means that investors have essentially
bought an inflation “floor” at maturity.
2. Because future cash flows are linked to inflation, an inflation-linked bond’s coupon rate as a percentage of par will generally be lower than that of nominal bonds with
the same maturity.
3. A number of EM inflation-linked bonds are also issued in a format similar to Canadian-style bonds; however, the inflation adjustment calculation can be very different.
In most emerging markets, inflation adjustment values are not determined via linear interpolation like they are in the Canadian model, but by assuming a geometric
increase between the known published values.
4. There are two main types of categories of inflation-linked (“linker”) debt: government inflation bonds and nongovernment bonds. The market for government bonds
is substantially larger and more liquid than the market for corporate or other nongovernment bonds, and will be the focus of this market overview.
5. Greece was removed from the flagship WGILB and Euro Government Inflation-Linked Bond (EGILB) Index in December 2009 following a downgrade of below A3/A-,
the minimum rating requirement for the WGILB and EGILB indexes.
6. Data as of 2010 year-end. Note: Chilean Central Bank inflation-linked issuance is not index eligible, and therefore the total amount of inflation-linked government
debt excludes such issuance.
7. Key reasons why portfolio managers may choose to avoid these markets in their benchmarks are the unfavorable taxation treatment of Colombian inflation-linked
bonds for international investors and the unreliability of CPI reporting in Argentina, notwithstanding relatively poor liquidity in these markets.
8. The EMTIL Index also rebalances on an annual basis, compared with more standard benchmarks, which rebalance monthly.
9. Greece was excluded from the WGILB in December 2009, due to a ratings downgrade, but remains eligible for the UGILB.
10. See “Emerging Markets Inflation-Linked Bonds” by Laurens Swinkels for a recent study of the diversification benefits of EM inflation-linked bonds.
References
Barclays Capital Research, 2010. “Global Inflation-Linked Products – A Users Guide.”
Brière, M., and Signori, O., 2009. “Do inflation-linked bonds still diversify?,” European Financial Management 15(2), pp. 279-297.
Deacon, M., Derry, A. and Mirfendereski, D., 2004. “Inflation-Indexed Securities: Bonds, Swaps and Other Derivatives,” 2nd edition, John Wiley and Sons.
Hunter, D.M., & Simon, D.P., 2005. “Are TIPS the ‘real’ deal? A conditional assessment of their role in a nominal portfolio,” Journal of Banking and Finance, pp. 347-368.
Swinkels, L., 2011. Emerging Markets Inflation-Linked Bonds, Robeco Quantitative Strategies, working paper series.
www.journalofindexes.com September / October 2011 27

Inflationary Quandaries:
A Roundtable
Do investors need to worry?
28
September / October 2011

With inflation and deflation both looming possibilities, and
theories being tossed around like beach balls in July, the
Journal of Indexes staff decided to check in with some inflation
experts to get some perspective on what’s really going on
Luis Viceira, George E. Bates Professor,
Harvard Business School
JOI: Should investors be using TIPS
[Treasury Inflation-Protected Securities]?
Viceir: When we think of what the safest asset
is, the definition actually changes with investors’ horizons.
For investors with very short horizons, typically Treasury bills
or cash is the riskless asset. But over longer horizons, cash can
be quite risky because the return on cash, after adjusting for
inflation, actually does change quite a bit over time.
For longer horizons, the assets that basically provide you
with the safest investment are TIPS, for two reasons. First,
they protect you against inflation. Second, they protect you
against unexpected falls in real interest rates, or the interest
rate that you get after correcting for inflation on nominal
interest rates, because if real interest rates fall, TIPS are
going to experience capital gains.
So, the idea in the popular press about TIPS being an
exotic asset is, I think, incorrect. On the contrary, TIPS are
one of the most elementary and fundamental pieces, in my
view, in the construction of the portfolio of any long-term
investor, such as someone saving for retirement, or an
endowment or a pension fund with long duration of liabilities.
That is the safe asset.
JOI: Are there any common misconceptions that investors
have about TIPS?
Viceira: The big misconception is that of considering them
to be exotic assets. They are actually fundamental pieces of
any long-term investment portfolio.
There is this issue about investors understanding how
they work, and this situation where investors say, “Well, the
coupon can change. And if there is deflation, then the coupon
that I get paid might decline.” And that’s true in nominal
terms. But in real terms, on an inflation-adjusted basis,
you’re always getting the same coupon.
There is also the misconception that was highlighted in
recent times, when there were a few occasions during which
long-term TIPS were trading at negative yields. Many wondered
how this could be possible, but it’s very possible. TIPS
have a very particular feature, which is that you are always
protected. The principal at issuance is always protected
against deflation. If the Treasury issues TIPS today at $1,000 of
principal value, and we have a prolonged period of deflation
over the next 10 years, and this was a 10-year Treasury TIPS,
you still would get $1,000 at the end of those 10 years even
though the CPI inflation was negative over that period.
That’s what the experts call a deflation put, which is really
deflation protection on the par value of the bond. And when
there is this expectation that deflation might happen, in
that case, TIPS of issuance can be quite valuable assets. It’s
perfectly possible that investors are willing to pay a little bit
more than principal value to get that bond, because they are
acquiring the bond and a put option on deflation.
JOI: Should investors be using passive products for their
TIPS exposure?
Viceira: I’m not sure we have any evidence that one can
make money by investing actively in TIPS. Now, when we are
talking about hedge funds or investment vehicles that would
be unconstrained, they could invest in TIPS and regular
Treasurys, and in the so-called inflation swap market. There is
evidence that there is money to be made by playing between
the markets, but for someone who is just saving for retirement
and wants to just get inflation protection and real interest rate
protection, a passive investment in TIPS should be fine.
However, there is the question of whether an investor
should be investing in a constant-duration TIPS mutual
fund [or ETF]. Mutual funds that invest in fixed income tend
to target some type of duration: For example, a TIPS mutual
fund might be targeting a duration of five or six years. For
an investor who is saving with a horizon of 20 years, it’s not
clear to me that investing in that mutual fund with a constant
duration would make sense.
There is an additional advantage for long-term investors
to be in TIPS, which is that the TIPS market is less liquid than
the Treasury market. There is a liquidity premium built into
TIPS. I have recently done research with Carolin Pflueger,
a Harvard Business School graduate student, in which we
have been estimating that liquidity premium; we currently
estimate it at anything between 40 basis points and 70 basis
points. This means that’s the extra return that those who
buy and hold TIPS have been enjoying over time. If you’re
a short-term investor, you’re going to pay that premium
because those TIPS are less liquid. But if you are a buy-andhold
TIPS investor, that’s a premium that you enjoy because
you get to buy TIPS at a discount which is 40 to 70 basis
points in normal times.
That has another implication as well, which is that the
spread between nominal Treasurys and TIPS yields, which
is called breakeven inflation, understates expected inflation
by this premium because TIPS have this liquidity premium
embedded into that spread. So, when we use breakeven
inflation as a measure of expected inflation, we need to add
anything between 40 and 70 basis points to get a more accurate
number for expected inflation.
JOI: Are we facing inflation or deflation?
Viceira: I think we have never had a period like the present
one regarding the uncertainty we have about inflation versus
deflation. On the one hand, we have a very expansionary
monetary policy and a booming commodities market, which
would indicate that inflation is around the corner. On the
other hand, if you look at inflation expectations as reflected
in the TIPS market, at inflation expectations reflected in the
inflation swap market, or at inflation expectations from Wall
Street economists or professional forecasters, they expect
that inflation will be tamed. The reason they’re expecting
that is because the macroeconomic data have indicated
there’s plenty of spare capacity in the economy.
www.journalofindexes.com September / October 2011 29

So, on the one hand, we have a very expansionary monetary
policy, and that could result in inflation if the Fed were
not able to actually withdraw that liquidity should banks start
deploying their reserves again. On the other hand, we have
plenty of capacity in the economy that says there’s plenty
of room for growth, so why should there be any inflationary
pressures on wages or any other prices in the economy? I
think we are in a period where we have very modest signals
in both directions. Certainly, we are trusting that the Fed
will be able to drain liquidity in time if necessary—I call that
the Bernanke call. We used to talk about the Greenspan put.
Now I think we have the Bernanke call. Markets are trusting
that Bernanke will do his job and take that liquidity off the
table when the time comes.
There’s another thing that could breed inflation—a
sudden revaluation of emerging market currencies, particularly
in China. We all think that inflation in China is
much bigger than its official statistics acknowledge, and
it has been avoiding exporting that inflation into whoever
buys the goods from China, which is the United States and
other developed economies. China has tried to neutralize
the effect on the exchange rate, and it looks like those
policies are reaching their limits. If that’s the case, China
might decide to have a sudden revaluation of its currency,
which immediately would make goods more expensive in
the United States. And that could trigger inflation. I think
the inflationary situation in the United States is actually—
in more ways than we dare to think—dependent on the
inflationary situation in emerging economies, which are
our main providers of consumer goods.
Michael Ashton, Managing Principal,
Enduring Investments LLC
JOI: Should investors be using TIPS?
Ashton: We know that investors are supposed
to be trying to maximize their real
after-tax return over time. If that’s true, then it means that
the true risk-free instrument is not a Treasury bond, but an
inflation-linked Treasury bond. That’s really where their
investments should be when they don’t have an opinion.
They shouldn’t be in Treasurys, they should be in inflationlinked
Treasurys because they have to be neutral on the
subject of inflation, and the TIPS allow you to be neutral.
JOI: Are there any common misconceptions that investors
have about TIPS?
Ashton: I think one mistake that people make is that they
think that when they buy TIPS, they’re making a bet on inflation.
And that’s not the case. When you buy regular Treasurys,
you’re making a bet on inflation. You’re betting that inflation
will be lower, or certainly no higher, than the expected inflation
embedded in the yield of a Treasury bond. But when you
buy TIPS, you’re not making a bet. You don’t care whether
inflation is high or low. Your real outcome will be the same.
As investors, we tend to think in nominal terms because
that’s the way we were taught, to think about what percentage
return we have achieved. We don’t tend to think in real terms.
But the right way to think is in real terms, and so that says you
should always go back to the touchstone of TIPS.
Right now, TIPS yields are ridiculously low. That probably
reflects the overall investment landscape right now, that real
returns in every asset class are low. And that sort of makes it
harder to invest in TIPS at the moment, but I think they still
should be your sort of “null” investment.
JOI: Should investors be using passive products for their
TIPS exposure?
Ashton: I think that for basic exposures, the cleanest way
is to invest in the TIPS directly. We know that investing in
bonds directly is expensive, relative to stocks, if you’re going
to be buying and selling them. That’s changing over time, of
course, but it’s still harder to get into and out of a bond than
a stock. You can buy TIPS for free from the Treasury, but selling
them is more difficult.
Having said that, there are not many groups that have
demonstrated over time that they can add much alpha to
a simple, long-only investment mandate in TIPS. And as a
consequence of that, I think that arguing for active management
in straight TIPS doesn’t seem to make a lot of sense
to me. Buying indexed TIPS products is probably the most
efficient way for most investors to invest.
JOI: Are we facing inflation or deflation?
Ashton: I think that we’ve conducted a marvelous experiment
over the last couple of years about whether economic growth or
monetary policy has more effect on inflation. And the examples
of inflationary outcomes in countries that have slow growth
are myriad. There are quite a few examples. In the 1970s in the
United States, we had slow growth, and we had a lot of inflation.
That doesn’t fit the Keynesian model. It was a similar—but
more extreme—case with Zimbabwe in the 2000s.
All major inflation occurs with large increases in transactional
money. Not bank reserves, but in M2 money, in our
case. In that context, we are now in a very risky time where
there is a huge wall of money in bank reserves that have not
passed into M2. Now, in the last couple of weeks, as it turns
out, M2 has started to accelerate quite alarmingly, but it’s
still too early to say that’s happening.
We don’t really know how to drain all these bank reserves
without having them pass into M2. If they do come to M2, if
the money multiplier suddenly goes back up to its historical
level for some reason, then you’re going to have a massive
problem of inflation. I don’t think that’s likely, but it is possible.
The way I’d sum it up is to say that there are many
inflation risks right now. The long tail’s on the upside and
it’s critical for investors to be protecting themselves against
the potentially inflationary outcome. And when the head of
the Federal Reserve says he’s “100 percent” confident that
he can control inflation, he’s either an idiot or a liar. And that
should make you doubly concerned.
JOI: Should investors be concerned about global inflation?
Ashton: It turns out that the inflation experienced in this
country—roughly two-thirds or a little more of it—comes
from global sources. Some guys at the ECB did a wonderful
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September / October 2011

paper a couple of years ago showing that most interconnected
economies share much of the experience of inflation. And
that’s because money is fungible. When the Fed eases aggressively,
it doesn’t just drive up our domestic money supply, it
drives up the global money supply. People take those dollars
and they buy euros with them. And they borrow in the country
where money is cheap, and spend it elsewhere.
And so, it turns out that the more interconnected our
economies get, the more concern investors should have
about global inflation, or inflation from non-U.S. sources.
What that means is that investors, in looking to protect
themselves, should look beyond just holding U.S. TIPS.
I think that investors, when they’re looking at inflationlinked
investments, especially bonds, really should look to
unhedged global TIPS for the best inflation-linked protection.
Because a lot of our inflation does come from global sources.
JOI: Are there any key differences in the available
TIPS indexes?
Ashton: From the major index suppliers—the Merrills, the
Lehman/Barclays—in TIPS, I don’t think there’s a whole lot
of difference. There are only a handful of bonds in the TIPS
market, so there are only so many ways you can combine
them. It gets more interesting when you look at global indices,
because then, your definition of which markets should be
included matters a great deal. Is Greece in your index? Greece
has inflation-linked bonds, and right now, they’re a joke. But
how long do they stay in the index? Italy is the fourth-largest
issuer of inflation-linked bonds, behind only the U.S., U.K.
and France. There’s $150 billion worth of inflation-linked
bonds in Italy. How quickly are they going to drop out of the
global index? I would pay a great deal of attention to what
the rule is in the index you’re using, because when Italy falls
out and you’re forced to reinvest a very large proportion into
other parts of the index, that can have a major effect.
Michael Pond, Fixed Income Strategist,
Barclays Capital
JOI: Should investors be using TIPS?
Pond: We’ve seen studies in the past which
indicate that TIPS add value to a well-diversified
portfolio, whether it be a fixed-income portfolio or
a broad asset class portfolio, by providing an asset that’s
linked to inflation, and adding diversification properties relative
to other asset classes. TIPS, over time, tend to improve
the risk/return of a portfolio. Investors are also becoming
more worried about the long-term prospects of inflation and
are looking to real assets to hedge the value, the real value,
of their portfolios—the purchasing power of their returns,
rather than just the absolute nominal returns. TIPS are the
only asset directly linked to CPI inflation, even if there are
some other asset classes that correlate well with inflation.
What many investors are realizing is that while they certainly
don’t want to shift 50 percent, or 80 percent, of their
portfolio into TIPS, or real return in general, zero is not the
answer. We’re seeing investors settle on different numbers.
Some are looking to add or shift, say, 15 to 20 percent of their
portfolio into real return strategies or TIPS specifically; and
some, 3 percent. But we are consistently seeing investors
realize that zero is not the right answer.
JOI: Are there any common misconceptions that investors
have about TIPS?
Pond: There are many. Probably the biggest one is that
TIPS will perform well or poorly depending on inflation
itself. These are real rate instruments. During times of
strong growth, when it’s typical to get high inflation, TIPS
may actually perform poorly on an outright basis simply
because that’s a situation where real rates are rising, and the
price of the asset is likely going down, even though you have
compensation through higher inflation. TIPS perform well
when inflation goes up relative to nominal fixed-income
investments, even if real yields are rising and the outright
performance isn’t strong.
Conversely, when inflation was low in 2008 and 2009, TIPS
actually performed quite well, because real yields were moving
lower, and many investors who had thought that TIPS’ outright
performance correlates with inflation were surprised when
TIPS did so well, and have continued to do well this year.
Another misconception is that TIPS are a tax disadvantage
because investors have to pay what some refer to as a
phantom tax. The inflation accretes on the principal rather
than being paid out, so you don’t actually get the inflation
compensation until maturity, or when you sell the security,
and yet you have to pay tax on that inflated principal on
an annual basis. Some see that as a tax disadvantage. Our
analysis shows that on an after-tax return to maturity, there
isn’t a disadvantage, although many investors may shy away
from TIPS because of what we do see as a cash-flow disadvantage.
The fact that you have to pay tax on cash that you
didn’t actually receive, while it doesn’t present a return disadvantage,
does present a cash flow disadvantage. You have
to somehow come up with that cash in order to pay taxes,
even though you didn’t receive it.
I would also point out that often TIPS are said to be illiquid.
And that’s just not the case on a relative basis versus
many other asset classes. They are less liquid than Treasurys,
so that’s where that misconception comes from. But they’re
a $740 billion market that is still quite a bit more liquid than
many other asset classes out there.
JOI: Does the Fed assess inflation correctly?
Pond: The Fed, in particular, focuses on the PCE, the personal
consumption expenditures index, for inflation. TIPS
accrue inflation off of the CPI. The Fed prefers the PCE,
which is generally lower by about 40 basis points, because it
allows for what’s known as the substitution effect: As prices
rise, say, on beef, consumers may switch to eating more
chicken, because it’s at a lower price. It’s not necessarily
wrong that the Fed prefers that measure over others, but
consumers often tend to think that inflation is actually quite
a bit higher than shown in published reports.
Most economic studies show that consumers think this
is so because their inflation experience is driven more by
recently purchased goods. And because consumers tend to
www.journalofindexes.com September / October 2011 31

experience food and energy price inflation more frequently
than, say, inflation in TV prices or computer prices or autos,
etc., they base their own inflation expectations or inflation
experience on a smaller subset of goods rather than on a
broad-based subset of goods.
JOI: Should investors be concerned about global inflation?
Pond: We think investors in the United States should be
concerned about global inflation pressures pushing up
on domestic inflation, particularly through import prices.
Many have been surprised, given the amount of slack in
the economy over the past several years, that the United
States has not slipped into deflation. One of the reasons
we have not is because while the United States has had
plenty of slack, other countries did not. China and other
emerging market economies continued to put upward
pressure on goods prices globally, and we are actually
experiencing the result of their inflation pressures
through import prices, which have been rising pretty significantly
over the past couple of quarters.
If you’re a U.S. investor worried about domestic inflation,
then you would look to U.S. TIPS. We have seen global
clients—central banks and other foreign official institutions—look
to global inflation-linked bonds. However,
U.S. investors are looking at global linkers as a diversification
tool and as a way to access higher real yields than they
can find in the United States.
Rick Harper, Director of Currency & Fixed
Income, WisdomTree Investments Inc.
JOI: Should investors be using TIPS?
Harper: TIPS do have a role within a
portfolio. But they are by no means a
comprehensive solution to an inflation protection strategy.
They do have weak spots. Obviously, they can get
bid up, and right now the whole U.S. Treasury market’s
been bid up. And there’s also the question of whether
CPI is a good proxy for inflation, etc.
I think it is in investors’ interest to pursue inflation-linked
debt securities globally as well, and to look for disciplined
commodity strategies, which might help provide a little
more participation in surges in commodity prices when
investor anxiety about inflation appears really fired up.
JOI: Are there any common misconceptions that investors
have about TIPS?
Harper: Yes, that real yields cannot go higher. I think some
people don’t think they can actually lose principal. They
don’t think they can lose money on them. They think it’s a
one-stop elixir, but nothing is a one-stop elixir. There are
pitfalls to every investment, and that’s why we would take
a multi-asset approach when we look to provide as much
protection as possible against inflation.
JOI: Should investors be using passive products for their
TIPS exposure?
Harper: Within the bond area, we have obviously developed
quite a foothold in actively-managed ETFs. We’ve found that
investors really like the flexibility, and they like the fact that
people are monitoring the risk in an investment portfolio
on a consistent basis. Passive investments do have their
place, specifically among investors who understand all the
idiosyncrasies of the indexes. But for most investors, I think
offering some responsibility to the investment manager in
giving them the flexibility to make investment decisions is
probably a more prudent way to go.
JOI: Are we facing inflation or deflation?
Harper: I think the historical backdrop would argue that
if you look back over the 40 years we’ve been off the gold
standard, inflation has averaged roughly in the 4.5 percent
range. And over the last 20 years, it’s been 2.5 percent. In
the fixed-income market, expectations are for around 2.5
percent going forward. So, they’re projecting this benevolent
inflation environment going forward, but I think there
is a possibility that we see higher inflation, which incidentally
could allow the government to float away a little of their
debt. In terms of measuring inflation, you’ve really got to just
understand the market environment, because different signals
work differently. From my previous life as an economist
and strategist, I know that in different environments, I was
relying on different signals. Market-based indicators, I think,
tend to be the most useful.
JOI: Should investors be concerned about global inflation?
Harper: There’s a fairly well-developed global inflationlinked
debt market, and actually some of the emerging markets
are a little more attractive in terms of levels than are the
developed markets, like the United States, Europe, and the
United Kingdom. And they do offer real yields, they do offer
some upside and some good returns.
Global inflation, that’s the $64,000 question. How do
you measure it? And can you find enough people that will
collaborate to care about it, because they have their own
agendas and concerns about taking care of their own countries
and their own job security. I think the commodity price
markets provide pretty good inflation signals on a global
basis, because they’re actually a real global marketplace, as
well as the fixed-income markets.
I always come back to market-based indicators. It’s sort of
the best reflection of what people are thinking about inflation
expectations. And I think that would probably be the best
guide in terms of what the actual inflation experience will be.
JOI: How do emerging markets figure into considerations
about global inflation?
Harper: Well, emerging market inflation-indexed instruments
have offered some of the most attractive risk-adjusted
returns over the last five to six years. Our WisdomTree Real
Return ETF has a pretty broadly diversified global inflationlinked
portfolio, complemented by a disciplined commodities
strategy. Within that global inflation-linked portfolio,
a third of the portfolio is in inflation-linked securities from
emerging market issuers. And in addition to that, we also
tend to favor a lot of the commodity-exporting countries,
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September / October 2011

which include many emerging markets, but also countries
like Canada and Australia. Commodity currency and exposure
to commodity currencies tend to offer a fairly good
hedge against inflation, and also provide some information
about future commodity prices.
JOI: Are there any key differences between the available
TIPS indexes?
Harper: I think some of the global indexes have Greece
exposure. But I’m not particularly fired up about that. It’s
about knowing what you hold. There’s some that weight by
market cap, and some do equal-weighted, but I think at the
end of the day you have to know what you hold. ETFs are
great vehicles for that, because every day we show our portfolios
to the world, and I think it’s really valuable.
Just like any fund, with any index you’ve got to be very
careful about what could come into the index, what kind of
risks there may be. There are so many different structures
in the global inflation market in terms of little idiosyncratic
things that tend to have a little bit of an effect, like day count
differences, different reset frequencies, and things of that
sort. It’s important to do that homework, really looking at all
products that provide this exposure.
Richard Christopher Whalen,
Co-Founder of Institutional Risk
Analytics and Author of Inflated:
How Money and Debt Built The
American Dream
JOI: Does the Fed assess inflation correctly?
Whalen: Oh, no. Going back to the late ‘70s, early ‘80s,
when the United States first saw a real fall-off in growth
and employment, you also had inflation. This is the era
right before Paul Volcker’s efforts to clamp down on what
was essentially a demand-led inflationary surge. So, the
Fed started tinkering with how it calculated inflation. This
had large implications because it was not only for public
policy consumption and public perception, but it also
started to affect products that are indexed against inflation.
Today, you have even more of that. They’ll exclude
fuel, they’ll exclude food, and whatever it is—all because
they’re trying to manipulate public perception. And this
has large implications for investors.
If you buy TIPS, for example, or if you buy any other
product that is benchmarked against public indices of
inflation, you’re not being paid what you should be paid.
The whole point of inflation indexing is that the government,
the Fed, is not doing its job. Therefore, I want to
have a security which adjusts for the rate of inflation. And
this goes back to the Humphrey-Hawkins legislation. The
problem in U.S. policy and political life in the last half
century and more is that we want to have our cake and
eat it, too. We want to pretend that we have a low inflation
mandate, but we want full employment. And the two are
inconsistent. You can’t have both. So even today, the Fed
is still driven by that duality, even though the two objectives
are completely inconsistent.
JOI: Are we facing inflation or deflation?
Whalen: Both. Why limit yourself? You can have both. If you
go back to Irving Fisher’s great essay that he wrote in 1933 for
Econometrica—he was one of the founders of that journal—
he talked about inflation and deflation. It’s essentially the
playbook that Ben Bernanke is using today, as are the rest of
the members of the Federal Open Market Committee. What
he said basically was that you can use monetary policy to
fight deflation, but you also have to restructure. We haven’t
done the restructuring part. We’re still trying to temporize;
we’re still trying to preserve the illusion of par value, if you
will, in a nominal sense of securities. You see this in Europe.
In fact, John Taylor recently had a brilliant essay in the Wall
Street Journal talking about the need for a reset. And what
he’s saying is that we have to mark down the debt, lower
the cost of debt service to companies and individuals, and
countries, really—and then we can start again.
This implies a lot of really radical changes here in the
United States, particularly regarding the New Deal institutions.
If you look at it this way, we cover entitlements with
tax revenues today. And so, we fund the rest of it with debt.
That’s kind of like Argentina in the 1970s, but Americans
don’t want to admit that. They don’t want to admit the
prosperity of the past 90 years was basically a function of the
two world wars and America winning those wars, and then
making peace. Of course we prospered. We destroyed the
whole world and we rebuilt it. And our money was substituted
for gold: Gold and the dollar were essentially seen as
interchangeable after Breton Woods. We’ve come full circle
as a society and we’re pretty much repeating the mistakes of
other societies in the past.
[As for evaluating the risks] you clearly see inflation in
the cost of living, in services, food, fuel, all of the things that
still have a free market component. But you have deflation
in financial assets because we have excessive debt, and also
this amazing bubble in the housing market that accelerated
really from 2003-04 to today. Unwinding that asset bubble in
housing—which is 60 percent of the U.S. banking industry’s
exposure, by the way—is a painful process.
So, you have both inflation and deflation at the same time,
and what I think it means for investors is that you have to gravitate
toward real assets that will allow you to protect principal.
But you have to be careful, because we also had a bubble in
metals—copper, even gold. I don’t think gold’s going to trade
off significantly, but it certainly reflects fear. People are piling
into gold, platinum, copper—anything they can.
What I tell people is that you want to move to liquidity, you
want to keep your powder dry. And when we bottom—and
I think we’re going to go down again in terms of housing for
the next couple of years—then you want to start buying really
well-placed, high-quality real estate. But be mindful that the
urban sprawl, the suburbs, all of that, is over. The tract housing,
the kind of manufactured housing that we saw over the
last couple of decades, that’s really over. We’re going back to
the old ‘50s and ‘60s model where the bank makes you a loan
and the bank keeps it. It was not normal for banks to do all
the securitization, and indeed, that contributed to the bubble
in housing prices. So, it’s tough for investors now because
www.journalofindexes.com September / October 2011 33

government is such a big part of the equation, and you see the
prospect of default either explicitly or implicitly.
JOI: Should investors be concerned about global inflation?
Whalen: Oh, definitely. I think all the major industrial
countries are going to have to basically print their way out
of trouble. What this implies is that the fiat currencies in all
of these systems are going to decline in real terms, in terms
of their purchasing power, and then you may even see some
interesting developments.
I think you’re going to see countries that have the ability
to compete with higher-quality currencies, starting to do
that. Maybe not this year or next, but I think it’s going to
evolve. Because the dollar was the 20th century currency
following the war. I’m not sure that’s going to continue to be
the case, and I think it would be good for the United States if
ours was no longer the global reserve currency, because the
dollar has been overvalued by any measure. If you look at
the debt we have, the dollar should be much lower against
other global currencies. The only reason it hasn’t collapsed
is because it’s still the means of exchange for commerce. It
has nothing to do with the Treasury market.
The other thing that really supports the dollar is that
most commerce is still priced in dollars, just as a means of
exchange, not as a store of value. Nobody wants to sit in dollars
for a long time, at least not in the United States.
JOI: How do emerging markets figure into considerations
about global inflation?
Whalen: That’s more of the irony, isn’t it? Twenty years ago,
these were heavily indebted countries with high inflation
rates. I used to do a lot of work with Mexico. Mexico used
to have to pay 18 percent, 20 percent for T-Bills. Not today.
And you see this in Brazil, India, and China, all of which
used to be clients of the IMF and the World Bank. They’ve
all paid off their debt. So, you have this kind of “changing
places” phenomenon where the developing economies are
attracting a lot of capital. Much of it’s going to be lost, by the
way. Look at China. All of the private equity guys I know are
desperately trying to get out of China now because they see
the writing on the wall.
It’s kind of a cyclical thing. But the funny part is, the chaotic
American political economy is still the most attractive
because we’re still a relatively free society. You don’t see
Chinese Communist party officials hiding money in China.
They want to go buy an apartment in San Francisco or in
Canada. Meanwhile, the credulous [investors] in the United
States and Europe are investing in China.
Adam Patti, CEO and Founder, IndexIQ
JOI: Should investors be using TIPS?
Patti: The issue I have with TIPS is the fact
that many investors don’t really understand
how they work and, more important, how a
laddered portfolio works, which is what you get when you’re
buying a packaged product. If you buy a TIPS bond when it’s
issued by the government and you hold it to maturity, you’re
fine. You’re getting your inflation protection. The problem
is when you buy a TIPS ETF, the price of the TIPS ETF is in
many respects driven by market sentiment. If billions of dollars
are flowing into what is not an extremely liquid market,
it’s driving the prices of these bonds higher. And because
this is a laddered portfolio, you’re getting pretty significant
duration risk embedded in that portfolio.
The prices of the TIPS ETFs have gone sky high on the
back of very low interest rates. And the problem is that when
interest rates ratchet up, you’re going to see the price of that
ETF fall off a cliff. And to me, that’s potentially one of the biggest
disasters for retail investors in the future, of which they
just aren’t aware. Not only will they not get their inflation
protection, but they will get a pretty significant drawdown in
the price of the product for their investment.
JOI: Are we facing inflation or deflation?
Patti: Well, I think we’ve clearly seen inflation in the form
of food inflation and energy inflation. The one inflation that
we’re really not seeing at this point is real estate inflation,
and that’s a very big piece of the Consumer Price Index.
That, I believe, has held inflation rates at bay to some extent,
but I think the reality is that we are seeing inflation, and that
is only going to be getting worse, given all the stimulus that
has been sloshing into the marketplace and the debt issues
that we have in the United States as well as overseas. The
prices of food are not coming down—they’re only going up.
And I think the same thing holds true for energy.
I think investors absolutely need to be very fearful of inflation
today, particularly as many analysts are recommending
taking money out of stocks and putting it into cash. You’re
not getting any return on your cash, given the interest rate
environment. And if inflation ratchets up, that cash is simply
going to be worth less. I think that investors need to find a
new way to hedge inflation. Packaged laddered portfolios of
TIPS bonds are not necessarily the best solution—it’s a solution,
but it shouldn’t be your only solution.
What we found is that the best solution for inflation hedging
is a multi-asset-class approach. We have a white paper
on our website that we did with our academic board, which
looks at inflation going back to 1900, to try to determine
what the key drivers of inflation are, and what the most efficient
way is to hedge your portfolio.And that’s why we built
a product around that research.
JOI: Should investors consider investing in international
TIPS-style products?
Patti: I don’t know that the average investor needs to be
buying global TIPS products unless they’re looking for capital
appreciation. I think you need to hedge your inflation
risk in dollars in your home country, where you’re spending
your capital. But again, if you look at capital appreciation,
at what’s happened in the domestic TIPS market
where the price of the laddered TIPS portfolio has gone sky
high, it could very well happen overseas, where those TIPS
pools of capital are even less liquid. So, I think that’s the
only reason I would ever recommend that an investor look
overseas at this point.
34
September / October 2011

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Selection Bias
How an index chooses stocks really does make a difference
By Robert Arnott and Li-Lan Kuo
36
September / October 2011

An important contributor to performance for
any portfolio is the selection of companies for
inclusion, no less so for indexes than for active
portfolios. Rather than exploring this topic broadly, as
many have done, we focus on the differences between
two well-known lists of companies: the Fortune 500 and
the Standard & Poor’s (S&P) 500.
The Fortune 500 and the S&P 500, launched in 1955 and
1957, respectively, offer similar cap-weighted returns, with a
scant 21 bps difference over a 53½-year span. While this seems
trivial, the two indexes share most of their largest names, leading
to an almost 92 percent overlap, by some measures. If 21
bps of return difference is attributable to as little as 8 percent
of our portfolio, then the nonoverlap holdings must have
materially different returns. Indeed, they do.
In fact, the closer we look at the nonoverlap portfolios,
the more significant the differences seem. Some companies
are in the Fortune 500 but not the S&P 500, and other
companies are in the S&P 500 but not the Fortune 500.
When these two nonoverlap lists are cap weighted, the former
list outperforms the latter by 198 bps per year for over
50 years. To be sure, there is substantial volatility around
this mean, but this performance gap does achieve statistical
significance and invites questions on the basic principle
of selecting stocks based on market capitalization.
It is neither our intent to promote the Fortune
500—which does not exist as an index—nor to criticize
the S&P 500. The S&P 500 is arguably the most widely
used benchmark in the world, for many legitimate reasons.
Our intent is simply to show that selection rules
make a very significant difference … even for indexes.
A Question Of Selection Bias
Selection bias is an interesting and often-explored topic
in the investment industry, and the differences between
the Fortune 500 and S&P 500 exemplify its impact. Both
lists were intended to be “representative” of the broad
market, albeit in different ways. The Fortune 500, which
is objectively selected to include the 500 largest U.S.-
domiciled companies as determined by the previous year’s
revenues, might be viewed as an effort to capture the broad
economy, focusing on business success. In contrast, the
S&P 500 was launched to capture the performance of the
U.S. stock market. The S&P 500 is subjectively selected
by a committee with a preference for large-cap, actively
traded companies that are of greatest interest to the investing
community. It has rules for profitability and domicile
(which are infrequently waived for particularly important
or popular companies), but it is studiously not formulaic in
its stock selection, in order to prevent advance gaming of
changes in its component list.
The two lists of companies offer similar cap-weighted
returns, with a 21 bps difference over a 53½-year span.
Given that both indexes are cap weighted, that modest
difference must be attributable to selection bias, or
rather, the different selection criteria used to construct
the Fortune 500 and the S&P 500.
In fact, the closer we look at the nonoverlap holdings,
the more significant the difference seems. The companies
that are in the Fortune 500 but not the S&P 500, weighted
by Fortune’s revenue metric, 1 outperform the companies
that are in the S&P 500 but not the Fortune 500, weighted
by S&P’s market capitalization metric, by 303 bps per
annum over a span of more than 50 years.
If the S&P 500 and the Fortune 500 are equally
weighted, which magnifies the importance of the small
nonoverlapping names, the 21 bps performance gap
widens to 57 bps per annum. To be sure, there is substantial
volatility around this mean, but it does achieve
statistical significance. And it highlights the importance
of selection rules—even in an index.
Past Studies Of Selection Bias
Empirical cross-sectional differences in the equity
risk premium have been explored extensively in the
finance literature and point in the direction of a number
of possible explanations for this substantial performance
gap. Banz (1981) found that firms with small market values
have higher risk-adjusted returns than firms with
larger market values. Portfolios formed by low P/E or
P/B ratios earn superior average returns to portfolios
based on high ratios (Basu [1977]; Rosenberg, Reid and
Lanstein [1985]; and Fama and French [1992]). Pástor
and Stambaugh (2003) show that less liquid stocks are
more sensitive to aggregate liquidity and have significantly
higher expected returns. Dozens of other articles
explore various explanations for these anomalies.
The companies that the S&P committee is likely to add
to the index have higher market caps and higher volumes
than the stocks that are dropped. They often carry high valuation
multiples. However, these are characteristics that
have empirically presaged underperformance. Recently,
academia has embraced the notion of cross-sectional differences
in equity premium, suggesting that popular companies—exhibiting
high multiples, high market cap or high
trading volume—are also likely to offer a lower equity risk
premium. Quite simply, they are perceived as less risky, so
they should offer a lower risk premium.
Reciprocally, the new entrants to the Fortune 500 may
have high or low valuation multiples, high or low trading
volume and high or low popularity. The key singular
quality they have in common is a large revenue base. Even
the market capitalization can be high or low, 2 because the
selection methodology for the Fortune 500 is valuationindifferent.
Treynor (2005) points out that a valuationindifferent
selection method—which studiously avoids
taking price into consideration—should mean a larger
risk premium, and a higher return, than a valuationlinked
index. It’s an easy extension of Treynor’s logic to
note that valuation-indifferent stock selection should
beat high-valuation-seeking stock selection.
The efficiency of cap-weighted portfolios, or lack of
same, has been widely explored. Haugen and Baker
(1991), for example, assert that cap-weighted stock index
portfolios are not an optimal strategy in the presence
of investors’ differing opinions about risk and expected
www.journalofindexes.com September / October 2011 37

eturns, short-sell constraints, tax exposure of investment
income, and foreign investors in the domestic market.
Furthermore, Hsu (2006) and Arnott and Hsu (2008) have
shown that if stock prices are inefficient, the cap-weighted
portfolio underperforms a valuation-indifferent portfolio
because the cap-weighted portfolio would overweight
overpriced stocks and underweight underpriced stocks,
relative to their eventual business prospects. 3
Even if the cap-weighted portfolio is optimal, why
should we rely on market cap to select stocks? The capweight
selection rule excludes the smaller-cap companies,
which imposes suboptimality on our portfolio. And
there are many studies suggesting statistically significant—even
highly significant—market inefficiencies. As
one of many examples, Anderson and Smith (2006) chose
America’s most admired companies identified annually
by Fortune magazine to form a portfolio, which substantially
and consistently has outpaced the S&P 500. Their
study demonstrates that some portfolio strategies offer
better performance than cap-weighted portfolios.
The S&P committee selects S&P 500 constituents
based in part on stock prices; rising prices lead to a
higher market cap and often mean higher popularity,
both of which should improve odds for inclusion
in the index. This means that a fluctuation in stock
price significantly influences the final selection. The
problem is that stock prices cannot be fully justified by
the fundamental values of firms. For instance, Shiller
(1981) used a simple model to show that observed
price movements can’t be fully justified by subsequent
changes in dividends. Factors such as psychological
traps could also lead investors to behave irrationally
and overreact to unexpected news or events.
De Bondt and Thaler (1985, 1987) showed that the stock
market does overreact. Assuming this kind of inefficiency,
when stock prices chaotically deviate from their fair market
value, a capitalization-weighting scheme could provide
an automatic mechanism to increase the number of
overpriced stocks (by adding new stocks that have become
undeservedly large-cap) while decreasing the number of
underpriced stocks (by trimming stocks that have become
undeservedly small-cap). This arguably occurred during
the tech bubble of the late 1990s. When the pricing errors
correct, the cap-weighted portfolio might experience a significant
price drop, as it did in 2000 and 2001, even as the
median stock lofted to additional new highs.
Many case studies illustrate the underperformance
of the S&P 500 portfolio relative to other perspectives
on the investors’ opportunity set, such as equal weight
or fundamental weight. 4 Does this underperformance
stem from the construction of the original index that
led to deterioration of the whole portfolio afterward? Or
is it possible that subsequent inclusion and deletion of
constituents did not improve performance?
Siegel and Schwartz (2006) found that a buy-andhold
portfolio composed of the original S&P 500 companies
outperformed the active updated S&P 500 with
lower risk. They offered three reasons for this observation:
(1) temporary overvaluation pushes stock prices
too high; overpriced stocks face the downward pressure
in the future; (2) price pressure comes from indexers
who must buy the stock when a new company is
admitted to the index; and (3) the original stocks are
often ignored by investors and result in low prices relative
to fundamentals. We think a simpler explanation is
that stocks are added when (indeed, because) they are
expensive and popular, and are dropped when they
either disappear or fall deeply out of favor.
Carty and Blank (2003) tried to identify whether the
Fortune 500 or the S&P 500 would be the better proxy for
large U.S. stocks based on precise criteria of consistency
and objectivity, composition, sector diversification, market
capitalization and performance. They concluded that
the Fortune 500 Index is a better benchmark for U.S. largecap
stocks because it shows higher returns, lower volatility
and less subjectivity bias than the S&P 500. At the end of
their report, they attributed the superior performance to
the selection process used in picking Fortune 500 stocks. 5
Defining The Data And Portfolios
Our study compares the Fortune 500 companies and
the S&P 500 companies, with particular attention to the
nonoverlapping companies. We didn’t use the published
Fortune 500 Index introduced in 1999. Instead, we used
the Fortune 500 roster year-by-year from its launch in
1955 to simulate the Fortune 500 portfolio, using a June
30 end-of-quarter reconstitution date each year, to reflect
the April/May publishing month for the Fortune 500.
Moreover, we extended our analysis to explore the two
indexes’ overlap and nonoverlap holdings, and simulated
all of these portfolios using three different weighting
schemes: cap weight, equal weight and revenue weight.
This gives us five indexes (S&P 500, Fortune 500, overlaps—companies
on both lists—and two nonoverlap portfolios:
S&P not Fortune, and Fortune not S&P) and three
weighting schemes, for a total of 15 portfolio histories.
An average of 280 companies are on both the Fortune
500 and the S&P 500 lists—the “overlaps” portfolio. The
overlapping companies were, unsurprisingly, the largest
U.S. companies in both revenues and market cap. We also
require that they be publicly traded companies. Some of
the companies on the Fortune 500 list are not publicly
traded, so we had to exclude them from this analysis.
The nonoverlapping companies fall into two categories:
(1) “Fortune not S&P,” comprising those companies
that are on the Fortune 500 list but not the S&P 500 list;
and (2) “S&P not Fortune,” those on the S&P 500 list but
not on the Fortune 500 list. The publicly traded companies
that are members of the “Fortune not S&P” list will
typically be relatively large companies that have market
cap and trading volume that are too low to capture the
attention of the S&P committee. These will typically be
deep value companies. The companies in the “S&P not
Fortune” list will typically be companies with relatively
modest revenue, and yet trading at a high enough market
cap and/or trading volume to garner the attention of the
38
September / October 2011

Figure 1
Composition Of The Portfolios, July 1957–December 2010, Including The Overlap And Nonoverlap Holdings
Portfolios
# Of
Names
Avg. Size By
Market Cap,
% Of
Overlap
Avg. Size By
Revenues,
% Of
Overlap
Market Cap,
% Of
Fortune
500
Revenues,
% Of
Fortune
500
Market Cap,
% Of
Matched
S&P 500
Revenues,
% Of
Matched
S&P 500
Fortune 500 429 71.0 75.2 100.0 100.0 84.3 88.0
S&P 500 499 74.2 74.2 123.2 116.9 102.1 100.0
Matched S&P 468 77.8 79.4 120.7 116.9 100.0 100.0
Overlaps 280 100.0 100.0 91.7 86.7 77.4 76.2
Fortune not S&P 149 16.4 29.9 8.3 13.3 6.8 11.8
S&P not Fortune 188 42.7 45.7 28.9 30.2 22.6 23.8
Source: Research Affiliates, LLC
S&P committee. These are mostly small companies trading
at lofty multiples.
The characteristics of the companies on these five
lists are summarized in Figure 1. As the data shows, all
of the lists average less than 500 names. We used the
Compustat/CRSP database as our database; for companies
that were members of the Fortune 500, we used
revenue data from Fortune’s database; for the rest, we
used Compustat revenues. Some companies in the early
years lack market-cap data, revenues data or subsequent
one-year returns. We eliminate these companies in order
to make a fair comparison between the different weighting
metrics. This problem cropped up occasionally before
1973 and frequently before 1964. We’ll shortly see that
most of these “problem companies” are too small to
make much of a difference.
The Fortune 500 list was limited to publicly traded companies
for which investment performance can be measured,
averaging 429 names. None of the publicly traded Fortune
500 companies lacked price information in our database.
The S&P 500 list averages 468 names. Why not 500?
The difference is mostly due to lack of historical revenue
data, typically for some of the smaller companies, which
would prevent revenue-weighting for these names. The
Compustat/CRSP database does not have fundamental
data—notably revenues, because we’re comparing with the
Fortune 500—for some of the stocks in the S&P 500 prior to
1973. For any of these stocks that were also in the Fortune
500, we used revenue data from Fortune’s database, which
filled in for the missing revenues in Compustat.
Naturally, there have been far more than 500 companies
that have been in each portfolio over the past half-century.
Because the S&P 500 is not selected solely by market cap,
they can be a bit patient with additions and deletions.
Companies that barely make the top 500 by market cap are
not likely to be selected for addition to the list; likewise,
stocks that rank 501 by market cap are not likely to be
targeted for removal. This keeps the rotation in the roster
of names down; little companies that briefly make the top-
500 list, by market cap, never make the cut. So, from mid-
1957 to end-2010, there have been 1,431 companies that
were on the S&P 500 at one time or another. Because the
Fortune 500 is more mechanistic (they will briefly include
companies that reach No. 499 by revenues and then fade),
there are 1,685 companies that have been on the Fortune
500 list at some time in the last half-century.
As a robustness check, we compare results for the
published S&P 500 Index with the performance of the
“Matched S&P 500,” the companies for which both
fundamental and performance data is available. Given
that the missing names were smaller-cap companies,
which collectively comprised an average of less than 2
percent of the S&P 500 portfolio, the returns and risk of
the published S&P 500 and the “Matched S&P 500” are
almost identical. Less than 1 bp separates the average
annual return and the average annual volatility of the
S&P 500 and the “Matched S&P 500” (which we might
more reasonably have called the S&P 468!). This gives
us some confidence that even the early data are deep
enough to offer meaningful results.
It’s interesting to note that the average market cap of the
companies in the Fortune 500 is only 71 percent as large
as the average market cap of the 280 overlapping names,
meaning that the nonoverlap companies (members of
the Fortune 500, but not the S&P 500) have much smaller
market cap than the overlap companies. Meanwhile, the
average market cap of the “Matched S&P 500” companies
is 77.8 percent as large as the overlapping names. The
gap on average revenues is much the same. In short, the
overlap companies are the biggest companies on both lists,
considerably larger than the average company in either the
full Fortune 500 or the “Matched S&P 500,” on both of our
size measures (market cap and revenues).
There were surprisingly many nonoverlapping names.
An average of nearly 150 companies were on the “Fortune
not S&P” list, and just about 190, on average, were on
the “S&P not Fortune” list. The former are (unsurprisingly)
mostly small-cap. The nonoverlapping names in
the “Fortune not S&P” roster were, on average, just 16.4
percent as large as the overlapping companies by market
cap and 29.9 percent as large by revenues. 6 They collectively
average a scant 6.8 percent of the market cap of the
www.journalofindexes.com September / October 2011 39

Figure 2
Comparative Returns For Fortune 500 Versus S&P 500 Including The Overlap And Nonoverlap Holdings,
Based On Three Weighting Schemes, July 1957–December 2010
Average
Standard
Deviation
Sharpe
Ratio
Best
Month
Worst
Month
Best
Year
Worst
Year
Panel A: Performance Of The Various Portfolios
Portfolio Returns
US 1-Month Treasury Bill 5.09% 0.85% 0.00 1.4% 0.0% 15.2% 0.0%
Fortune (Cap Weight) 10.10% 15.70% 0.32 17.2% -22.8% 58.8% -42.2%
S&P 500 (Cap Weight) 9.89% 15.54% 0.31 16.8% -21.5% 61.0% -42.2%
Matched S&P (Cap Weight) 9.88% 15.55% 0.31 16.7% -21.5% 61.0% -42.2%
Fortune (Equal Weight) 12.84% 18.44% 0.42 19.9% -28.2% 81.0% -46.7%
S&P 500 (Equal Weight) 12.30% 17.64% 0.41 20.5% -25.7% 76.5% -44.9%
Matched S&P (Equal Weight) 12.33% 17.57% 0.41 20.4% -25.7% 77.1% -44.8%
Fortune (Revenue Weight) 11.42% 16.77% 0.38 17.1% -24.3% 68.1% -47.1%
Matched S&P (Revenue Weight) 11.22% 16.28% 0.38 18.2% -23.1% 69.5% -46.4%
Overlaps (Cap Weight) 9.95% 15.57% 0.31 17.1% -22.4% 57.8% -41.7%
Fortune Not S&P (Cap Weight) 12.04% 18.74% 0.37 18.6% -27.7% 74.2% -52.0%
S&P Not Fortune (Cap Weight) 9.64% 17.16% 0.26 15.7% -19.9% 69.3% -45.2%
Overlaps (Equal Weight) 12.31% 17.71% 0.41 18.4% -27.3% 72.7% -44.9%
Fortune Not S&P (Equal Weight) 13.67% 20.74% 0.41 23.6% -29.8% 113.5% -52.0%
S&P Not Fortune (Equal Weight) 12.13% 18.08% 0.39 22.8% -23.7% 82.7% -44.6%
Overlaps (Revenue Weight) 11.08% 16.41% 0.37 16.5% -23.8% 66.9% -46.4%
Fortune Not S&P (Revenue Weight) 13.03% 20.49% 0.39 22.4% -27.8% 112.5% -52.6%
S&P Not Fortune (Revenue Weight) 11.69% 17.31% 0.38 23.3% -21.9% 78.1% -46.1%
Panel B: Excess Returns, For The Differenced Long-Short Portfolios
Differences In Returns
Fortune (CW) vs S&P (CW) 0.21% 1.55% 0.13 1.5% -1.9% 9.2% -7.6%
Fortune (EW) vs S&P (EW) 0.57% 2.85% 0.20 3.1% -2.9% 11.4% -8.9%
Fortune (RW) vs S&P (RW) 0.23% 1.99% 0.12 2.2% -2.1% 11.0% -7.6%
Fortune (RW) vs S&P (CW) 1.46% 4.66% 0.31 6.8% -5.1% 29.0% -14.1%
Non-Overlap Holdings Differences
Fortune x-S&P (RW) vs S&P x-Fortune (RW) 1.26% 9.70% 0.13 8.8% -9.1% 39.0% -32.8%
Fortune x-S&P (EW) vs S&P x-Fortune (EW) 1.50% 8.02% 0.19 8.8% -9.2% 39.9% -32.4%
Fortune x-S&P (CW) vs S&P x-Fortune (CW) 1.98% 9.44% 0.21 12.7% -9.6% 46.6% -30.5%
Fortune not S&P (RW) vs S&P not Fortune (CW) 3.03% 11.03% 0.27 15.8% -10.1% 60.8% -48.2%
Fortune not S&P (EW) vs S&P not Fortune (CW) 3.65% 10.97% 0.33 15.7% -9.9% 58.7% -44.7%
Source: Research Affiliates, LLC
S&P 500. The overlap companies—members of both the
Fortune 500 and the S&P 500—comprised 91.7 percent of
the aggregate market cap of the full Fortune 500 list.
The same cannot be said of the “S&P not Fortune” list,
which includes some companies that are pretty large, in
both market cap and revenues. Among all the companies
in the S&P 500, 77.4 percent of the total market cap of these
companies is also in the Fortune 500, with 22.6 percent of
the S&P 500 falling into the “S&P not Fortune” list. Fortune
excludes some large-cap names that are not domiciled in the
United States; Schlumberger is the largest current example.
These are big companies, both by revenues and by market
cap; S&P includes them, while Fortune does not.
How Much Selection Bias?
At first blush, the results in Figure 2 would seem to suggest
that the “selection bias” between the Fortune 500 and
the S&P 500 is a nonevent. The Fortune “500” beats the S&P
40
September / October

“500” by 21 bps. The risk is also a touch higher for the capweighted
Fortune 500; at only 15 bps higher standard deviation,
the Sharpe ratio of the Fortune “500” is slightly better.
The results are a bit more interesting when we look at
weighting schemes other than cap weight, and even more
so when we compare the overlapping and nonoverlapping
holdings. In particular, equal-weighting magnifies
the impact of the nonoverlapping names. Consider that
the Fortune 500 consists of the “overlap” portfolio and
the “Fortune not S&P” portfolio. The “Fortune not S&P”
list comprises over 35 percent of the Fortune 500, equally
weighted, 7 but only 8.3 percent of the market cap of the
Fortune 500. Clearly, equal-weighting increases the importance
of these nonoverlap names fourfold. There’s a similar,
albeit less pronounced, effect on the “S&P not Fortune”
list as a share of the “Matched S&P 500” portfolio. The
return difference between the S&P 500 and the Fortune
500, equal-weighting both, is magnified accordingly: We
find a 57 bps annual difference in returns instead of the 21
bps difference on the cap-weighted indexes.
The importance of selection rules in our portfolios is more
evident when we look at the nonoverlapping-name portfolios.
The returns for companies in the “Fortune not S&P”
portfolio are dramatically higher than for any of the alternative
portfolios: the S&P 500, the Fortune 500, the overlapping
holdings, and the “S&P not Fortune” portfolio. The margin
of victory is anywhere from 102 bps per year to 198 bps per
year, if we stick to apples-and-apples weighting schemes. 8
If we cherry-pick the best and worst weighting scheme, we
find that the best-performing portfolio is “Fortune not S&P,”
weighted equally, and the worst-performing portfolio is
“S&P not Fortune,” weighted by market cap. The gap here is
enormous: 365 bps per year … for over 50 years!
In Figure 2, Panel B, we explore the excess returns
earned by an array of “differenced portfolios.” 9 With
53½ years of data, anything above a Sharpe ratio of 0.25
will have statistical significance at the 5 percent level (a
p-value of 0.05). Focusing on the nonoverlap portfolios,
we note that the “Fortune not S&P” beats the “S&P not
Fortune” list with varying statistical significance, by anything
from 126 bps per year to 365 bps per year.
Does this mean that the S&P committee has made
huge errors in their selections of stocks for their index?
Not at all. Their goal is for the S&P 500 to measure the performance
of the overall stock market, not to pick winners
of a performance derby. When a stock disappears through
corporate action (e.g., merger or acquisition), it must be
replaced. When a company flounders, so that its stock has
a shadow of its past market cap and trading volume, it fails
to make the cut as one of the 500 most important stocks in
the U.S. market and must be replaced. In either event, the
S&P committee will sensibly replace it with a company
that commands more interest (volume and market cap),
and often commands a premium valuation multiple, in
order to conform to their basic goal. This is wholly consonant
with their goal of capturing the 500 stocks that are
the most important in the U.S. stock market.
The Fortune 500 is much more mechanistic. If a
company’s revenues no longer rank in the top 500, it’s
dropped in favor of a newcomer that does make the list.
The difference in selection mechanism clearly drives
the performance difference, as indeed it must, with
reasonable statistical significance.
To explore the sources of value-add, we apply the classic
CAPM analytics to these results. As Figure 3, Panel A shows,
many of the portfolios exhibit noteworthy statistical significance
in the alpha, measured against the S&P 500. Without
exception, the statistically significant beta-adjusted alphas
are for noncap-weight indexes, providing added support for
the valuation-indifferent index community. When we shift
to equal-weighting or revenue-weighting, statistical significance
becomes the norm for the beta-adjusted alpha.
Given the historical evidence of the dominance of
valuation-indifferent indexes, over long time spans, these
results are unsurprising, except perhaps in their magnitude.
For instance (cherry-picking the best result on the
table), the equal-weighted Fortune 500 beats the capweighted
S&P 500 by 290 bps per year for over 50 years.
It’s worthwhile to pause and reflect on how vast this
increment is. Over the entire time span, the S&P 500 has
given us a 9.9 percent annual return, sufficient to give us
155 times our starting wealth (assuming, of course, that
we never needed to spend any of it along the way, pay no
taxes and incur no trading costs or fees). Impressive! But,
the equal-weighted Fortune 500 leaves us four times as
wealthy, with 642 times our starting wealth!
In Figure 3, we can see how much of this is due to
selection bias, how much to beta and how much to equalweighting
vs. cap-weighting. The equal-weight S&P 500
beats the same portfolio cap weighted by 236 bps per year.
On the more relevant apples-to-apples comparison, the
equal-weighted Fortune 500 beats the equal-weighted S&P
500 by 57 bps per year. That’s much better than the skinny
21 bps margin for the cap-weighted comparison. The
weighting method matters more than the selection bias.
Again, the nonoverlap portfolios are where we find
the “real action.” If we cherry-pick the best- and worstperforming
portfolios, we find that the equal-weighted
“Fortune not S&P” list beats the cap-weighted “S&P not
Fortune” list by 365 bps per year over 53½ years. Over the
full span, the cap-weighted “S&P not Fortune” has provided
us a very respectable 9.64 percent annual return,
sufficient to give us 137 times our starting wealth under
the assumption of no additional costs or fees. However,
the equal-weighted “Fortune not S&P” remarkably leaves
us with nearly 1,000 times our starting wealth! 10
Once again, we break the 365 bps added value down to
see how much of this is due to selection bias, how much
to beta and how much to our weighting scheme. In Figure
3, the 365 bps can be partitioned into 150 bps for different
composition (the equal-weighted “Fortune not S&P”
versus equal-weighted “S&P not Fortune”) plus 228 bps
from a different weighting scheme (the equal-weighted
“S&P not Fortune” versus the cap-weighted “S&P not
Fortune”). Some of this last 228 bps difference is due to
beta (about 36 bps), but the substantial majority is not. 11
www.journalofindexes.com September / October 2011 41

Figure 3
Comparative Characteristics For Fortune 500 Versus S&P 500, Including The Overlap And Nonoverlap Holdings,
Based On Three Weighting Schemes, July 1957–December 2010
Beta
Alpha
Value
Added
Tracking
Error
Info
Ratio
Alpha
t-St
Panel A: Performance Of The Various Portfolios
Portfolio Characteristics
US 1-Month Treasury Bill 0.00 0.00% N.A. N.A. N.A. -0.03
Fortune (Cap Weight) 1.01 0.19% 0.21% 1.55% 0.13 0.86
S&P 500 (Cap Weight) 1.00 0.00% 0.00% 0.00% 0.00 0.00
Matched S&P (Cap Weight) 1.00 0.00% 0.00% 0.00% 0.00 0.00
Fortune (Equal Weight) 1.10 2.49% 2.90% 6.72% 0.43 2.59
S&P 500 (Equal Weight) 1.08 2.04% 2.36% 5.37% 0.44 2.67
Matched S&P (Equal Weight) 1.07 2.09% 2.38% 5.25% 0.45 2.79
Fortune (Revenue Weight) 1.03 1.38% 1.46% 4.66% 0.31 2.06
Matched S&P (Revenue Weight) 1.01 1.26% 1.24% 3.83% 0.32 2.29
Overlaps (Cap Weight) 1.00 0.08% 0.05% 1.57% 0.03 0.34
Fortune Not S&P (Cap Weight) 1.08 1.75% 2.13% 7.86% 0.27 1.55
S&P Not Fortune (Cap Weight) 1.04 -0.45% -0.14% 5.48% -0.03 -0.58
Overlaps (Equal Weight) 1.08 2.04% 2.37% 5.49% 0.43 2.61
Fortune Not S&P (Equal Weight) 1.14 3.10% 3.75% 10.24% 0.37 2.11
S&P Not Fortune (Equal Weight) 1.08 1.88% 2.21% 6.59% 0.33 2.00
Overlaps (Revenue Weight) 1.01 1.13% 1.12% 4.34% 0.26 1.81
Fortune Not S&P (Revenue Weight) 1.13 2.52% 3.14% 10.09% 0.31 1.74
S&P Not Fortune (Revenue Weight) 1.04 1.62% 1.71% 6.02% 0.28 1.87
Panel B: Excess Returns, For The Differenced Long-Short Portfolios
Differences In Returns
Fortune (CW) vs S&P (CW) 0.00 0.19% 0.21% 1.55% 0.13 0.89
Fortune (EW) vs S&P (EW) 0.02 0.49% 0.57% 2.85% 0.20 1.26
Fortune (RW) vs S&P (RW) 0.02 0.16% 0.23% 1.99% 0.12 0.59
Fortune (RW) vs S&P (CW) 0.02 1.35% 1.46% 4.66% 0.31 2.13
Nonoverlap Holdings Differences
Fortune x-S&P (RW) vs S&P x-Fortune (RW) 0.08 0.90% 1.26% 9.70% 0.13 0.68
Fortune x-S&P (EW) vs S&P x-Fortune (EW) 0.06 1.22% 1.50% 8.02% 0.19 1.12
Fortune x-S&P (CW) vs S&P x-Fortune (CW) 0.03 2.20% 1.98% 9.44% 0.21 1.71
Fortune not S&P (RW) vs S&P not Fortune (CW) 0.07 2.70% 3.03% 11.03% 0.27 1.80
Fortune not S&P (EW) vs S&P not Fortune (CW) 0.08 3.29% 3.65% 10.97% 0.33 2.21
Source: Research Affiliates, LLC
In Figures 4-6, we show the cumulative growth of $100
invested in mid-1957 following the launch of the S&P 500
Index and the publication of the 1957 Fortune 500 list of
America’s largest businesses through year-end 2010. As
with any sensible long-term performance graph, these are
shown on a log scale.
The very-worst-performing strategy on the list (“S&P not
Fortune,” cap-weighted) still gives us 137 times our money
in a bit over a half-century. The very best (companies
that are in the Fortune 500, but not the S&P 500, equally
weighted) delivers 948 times our starting wealth. Of course,
with all of these results unimpeded by trading costs, taxes
or spending in the intervening half-century, we see ratification
of Einstein’s whimsical observation that “the most
powerful force in the universe is compound interest”!
These performance graphs reveal consistent patterns of
42
September / October 2011

Figure 4
Figure 5
Performance Of Various Indexes,
Cap-Weight, 1957–2010
Performance Of Various Indexes,
Equal-Weight, 1957–2010
$100,000
$10,000
Growth of $100, from various
cap-weighted indexes
$100,000
$10,000
Growth of $100, from various
equal-weighted indexes
$1,000
$1,000
$100
$100
Source: Research Affiliates, LLC
Figure 6
$0
Jun
’57
Jun
’62
Jun
’67
Jun
’72
Jun
’77
Jun
’82
Jun
’87
Jun
’92
Jun
’97
Jun
’02
N Fortune Not S&P (Cap Weighted) N Fortune 500 (Cap Weighted)
N Overlaps (Cap Weighted) N S&P 500 (Cap Weighted)
N S&P Not Fortune (Cap Weighted) N US 1-Month Treasury Bill
Performance Of Various Indexes,
Revenue-Weight, 1957–2010
Jun
’07
Figure 7
$0
Jun
’57
Jun
’62
Jun
’67
Source: Research Affiliates, LLC
Jun
’72
Jun
’77
Jun
’82
Jun
’87
Jun
’92
Jun
’97
Jun
’02
N Fortune Not S&P (Equal Weighted) N Fortune 500 (Equal Weighted)
N Overlaps (Equal Weighted) N S&P 500 (Equal Weighted)
N S&P Not Fortune (Equal Weighted) N US 1-Month Treasury Bill
Relative Performance Of Various
Equal-Weight Indexes, 1957–2010
Jun
’07
$100,000
$10,000
Growth of $100, from various
revenue-weighted indexes
$100,000
$10,000
Relative returns, for
various index comparisons
$1,000
$1,000
$100
$100
$0
Jun
’57
Jun
’62
Jun
’67
Source: Research Affiliates, LLC
Jun
’72
Jun
’77
Jun
’82
Jun
’87
Jun
’92
Jun
’97
Jun
’02
Jun
’07
N Fortune Not S&P (Revenue Weighted) N Fortune 500 (Revenue Weighted)
N Overlaps (Revenue Weighted) N Matched S&P (Revenue Weighted)
N S&P Not Fortune (Revenue Weighted) N US 1-Month Treasury Bill
$0
Jun
’57
Jun
’62
Jun
’67
Source: Research Affiliates, LLC
Jun
’72
Jun
’77
Jun
’82
Jun
’87
Jun
’92
Jun
’97
Jun
’02
Jun
’07
N Fortune Not S&P (Equal Weighted) N Fortune 500 (Equal Weighted)
N Overlaps (Equal Weighted) N S&P 500 (Equal Weighted)
N S&P Not Fortune (Equal Weighted) N Fortune x-S&P (EW) vs. S&P x-Fortune (CW)
return. The Fortune 500 beats the S&P 500 over the entire
time span using any of the three weighting metrics, by
anywhere from 21 to 57 bps per year. It then follows that
the “Fortune not S&P” portfolio must beat the “S&P not
Fortune” portfolio, using any of the three weighting metrics.
It does so, by anywhere from 126 to 198 bps per year.
By comparing Figures 4, 5 and 6, we find the equalweighting
scheme shows the highest returns for any of
the portfolios, whereas the cap-weighting scheme is the
lowest for any of the portfolios, with no exceptions. This
also is not a surprise: As with revenue-weighting, equalweighting
results in a valuation-indifferent index; but,
equal-weighting has the added benefit of introducing
a substantial small size effect, while revenue-weighting
still maintains a large-company (hence, in most cases,
large-cap) bias. Conversely, the cap-weighting scheme
tends to concentrate our investments in the most popular
and expensive companies: the growth stocks and the
safe havens. It seems unsurprising—to those of us outside
of the die-hard efficient markets crowd—that this
should deliver a lower risk premium to investors than
the other two weighting schemes.
We can also note that the “Fortune not S&P” portfolio
is the top performer over the entire time span, using any
of the three weighting metrics. The “S&P not Fortune”
is the worst performer for two of the three weighting
schemes, with the “overlap” portfolio bringing up the rear
on revenue-weighting. The performance gap between
the “Fortune not S&P” and the “S&P not Fortune” largely
reflects the superior stock selection that stems from
choosing stocks on fundamental size of the business (revenues)
vs. popularity (market cap and trading volume).
www.journalofindexes.com September / October 2011 43

These two portfolios exhibit the largest performance gap
when weighted by market cap.
In Figure 7, we examine the cumulative relative performance
of the various equal-weighted indexes, all
measured relative to the cap-weighted S&P 500 matched
list (near-identical in performance to the published S&P
500 Index). All five equal-weighted portfolios beat the
cap-weighted S&P 500 over the entire time span (though,
of course, not in every year). Although not shown in our
exhibits, all of the five revenue-weighted portfolios beat
the cap-weighted S&P 500, albeit by a lesser margin. The
consistency of these results is very interesting. 12
The top line in Figure 7 is different from the others. It
introduces an apples-with-oranges comparison, reflecting
the value added for the equal-weighted “Fortune not S&P”
portfolio relative to the cap-weighted “S&P not Fortune”
portfolio. Yes, this is cherry-picking the best-performing
index against the worst-performing index, 13 but the line
illustrates the combined effects of different stock selection
methods and different weighting schemes for two 100
percent nonoverlapping portfolios. The performance difference,
as noted previously, is 3.65 percent per annum. To
be sure, it also delivers 10.97 percent annual volatility. But,
with 53½ years of data, it achieves statistical significance.
Conclusion
To explore how selection bias affects the performance
of indexes, we compare the performance of two simple
decision rules: (1) an objective selection rule based on
relative company revenues (Fortune 500); and (2) a subjective,
cap- and growth-oriented selection approach
(S&P 500). Using portfolios of overlapping names and
nonoverlapping names, we show that selection rules
make a material difference in performance, even for
quasi-passive indexes. We also find that the weighting
rules make a difference, though that finding is secondary
to the main purpose of this research.
Our results show that the Fortune 500 outperforms the
S&P 500 in all of our weighting schemes: cap-weighting,
revenue-weighting or equal-weighting, with reasonably
impressive consistency. In addition, in the nonoverlap
portfolios, the companies that are in the Fortune 500 but
not the S&P 500 outperform the companies that are in the
S&P 500 but not the Fortune 500, with much larger return
differences, in any of these three weighting schemes. And,
in general, equal-weighting beats revenue-weighting
which beats cap-weighting for any of these indexes.
By including more large-cap, high-volume and popular
growth companies, the S&P 500 exhibits selection
bias relative to the Fortune 500, objectively based on the
companies’ revenue base. Whether the large-cap and
growth bias leads to overweighting overvalued stocks or
these “comfort” biases lead to a lower risk premium is
immaterial. Either way, the result is lower performance,
some of which is directly attributable to the selection
methodology. In contrast, the index that selects companies
by a fundamental metric, which is unrelated to
market cap, provides a simple way that investors can
capture the pricing errors and achieve returns superior
to the cap-weighted index.
Endnotes
1. A revenue-based selection of companies, which are then revenue weighted, would fall cleanly into the now-classic definition of a “Fundamental Index®” strategy. The
copyright and patent for such strategies are owned by Research Affiliates, LLC. A revenue-reweighted S&P 500—which is currently available in the marketplace from
RevenueShares—is more accurately considered a “fundamentally reweighted index.” We chose revenue weighting for this exercise, because that’s the metric that
Fortune uses in selecting the 500 stocks for the Fortune 500.
2. New entrants into the Fortune 500 will typically be at the low end of the spectrum on revenues. However, if their revenues are rising fast, they may command growth multiples
sufficient to make them reasonably large-cap. An illustrative example would be Google, which almost immediately ranked in the top 50 companies by market cap.
3. Some observers have argued that the cap-weighted market index cannot have an alpha because the market portfolio is cap weighted. They suggest that the cap-weighted index
cannot overweight the overvalued and underweight the undervalued because the index weights match the market weights. These arguments are tautological, when the portfolios
are viewed from a cap-weight-centric worldview and when the index is complete, spanning the full market. These critics are not correct when we view the market from the vantage
point of the macro economy, which may be revenue weighted or employment weighted, but which is not cap weighted. Both the market-centric and the economy-centric frames
of reference are legitimate. We would suggest that viewing the market from one frame of reference, while ignoring the other, is like driving with one eye covered.
4. Again, a tautology: Relative to the market, defined as the S&P 500, the S&P 500 cannot underperform the market. Critics often make this counterargument as if it has
intellectual rigor.
5. Carty and Blank relied on the cap-weighted Fortune 500 Index, which was introduced on a real-time basis in December 1999 but was discontinued in June 2005. It
would appear that the Fortune 500 cap-weighted index missed “first-mover advantage” by just over 40 years. By 1999, the relative merits of Fortune 500 and S&P 500
were irrelevant from a business development perspective. Never mind the resistance to an index that performs better, lest it be used as a benchmark!
6. This means that the aggregate market cap of the “Fortune not S&P” nonoverlaps was considerably smaller, about 16 percent of the market cap of the overlapping
names, in part because it’s also a shorter list of names.
7. The “Fortune not S&P” list averages 149 names out of an average of 429 for the Fortune 500. That works out to 35 percent, with equal-weighting of the names.
8. The smallest win is 102 bps per year for “Fortune not S&P” vs. “Fortune,” equal-weighted; the largest win is 198 bps per year for “Fortune not S&P” vs. “S&P not
Fortune,” cap-weighted.
9. It’s important to note that we do not recommend any of these long/short strategies. While the turnover is low, and the value added in some cases is large, the volatility is
also noteworthy, leading to a poor consistency of success. Furthermore, the biggest difference involves an equal-weighted version of the “Fortune not S&P” list. That’s
going to be a nightmare to trade and manage, especially in institutional size. These are typically illiquid small-cap names, equally weighted; and the equal-weighting
44
September / October 2011

tends to involve higher turnover than the other weighting schemes. These differenced portfolios, or long/short strategies, are merely a very interesting ratification of
the core focus of this article; namely, that selection bias matters, even in index construction.
10. This excludes implementation drag—trading costs, fees, etc.,—much the same as the broader indexes. Still …
11. Beta-adjusted alpha of the equal-weighted “Fortune not S&P” is 355 bps above alpha of the cap-weighted “S&P not Fortune.”
12. Not shown in these exhibits, the five equal-weighted portfolios and the five revenue-weighted portfolios beat the cap-weighted S&P 500 in an average of 63 percent
of the individual years. Of course, there’s overlap among the five, so it’s useful to consider the three independent indexes that do not share any names in common—
“overlap,” “Fortune not S&P” and “S&P not Fortune.” Here we find that a binomial distribution would yield this 63 percent win rate, across three nonoverlapping
portfolios, 0.03 percent of the time.
13. This is data mining of the worst kind. But, it’s too fun to ignore!
References
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Why advertise in the Journal of Indexes?
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www.journalofindexes.com September / October 2011 45

In Perspective
Considerations
For The Index Shopper
Different users have different needs
By David Krein and John Prestbo
David Krein
John Prestbo
Choosing a benchmark is not a decision to be taken
lightly. Whether you are a retail trader, pension
fiduciary, active fund manager or investment product
provider, when weighing the various pros and cons
among different indexes, it is critical to understand the key
factors that should be involved in such an evaluation.
Choosing A Provider
First, it should be acknowledged that the indexing
business is, above all, a business. As a result, choosing an
index that will underlie an investment product or serve as
a benchmark for a plan involves establishing a long-term
business relationship with another commercial enterprise—the
index provider. That introduces unique risks
and rewards that must be considered in context, and are
too often overlooked by investors.
This index provider does not pull an index from the
ether; it must, quite literally, manufacture the index.
Index manufacture requires its own widget-making process
in which certain raw materials come in one door
and certain final products go out a different door. It
brings together all kinds of market data from around
the world and a set of rules to produce an index value.
The largest and most successful index providers build
thousands of high-quality indexes across asset classes,
generating values for many of them every few seconds.
Indexes also must be reviewed and maintained regularly,
too. These are not trivial tasks.
Would-be customers looking to choose an index should
seek answers to key questions about the index provider and
its manufacturing process. How long has the index provider
been in business? What is its long-term viability in supporting
this index? Does it have the necessary distribution relationships
to create scale? Can its research and technology
incorporate necessary changes in the marketplace? What
about its maintenance and quality control processes?
Different classes of index users will weight these
(and other) questions differently depending on their
own needs and concerns. For example, a pension fiduciary
seeking to benchmark a multibillion-dollar U.S.
equity allocation may choose an index provider with
a long track record of successfully publishing indexes
for the institutional marketplace over many years or
even decades, which matches the pension’s expected
investment-decision horizon. Further, it would look for
an index provider that offers a full suite of benchmarks,
broken down by size, style and industry, in a way that
logically and comprehensively captures the investment
opportunity set for all of the pension’s asset managers.
Finally, it would ensure that the index and componentlevel
benchmark data be readily available to all of the
participants in the process (asset managers, investment
consultants and the pension itself) for performance
reporting, attribution analysis and so on.
Each of these components—track record, offering suite
and availability—reflects how a successful index provider
chooses to execute its business strategy and compete for
this market segment. Index analysis alone does not indicate
whether a specific index provider can support the
user in the aforementioned ways.
In contrast, an ETF issuer looking for a thematic index
in, say, an area like water or infrastructure, may place
a greater emphasis on other considerations such as
the providers’ quality of underlying stock research and
company-level due diligence.
On occasion, index providers attempt to leverage exist-
46
September / October 2011

ing in-house tools and data to build thematic indexes;
here, the provider usually comes with a shorter track
record in understanding the theme or segment, and has
difficult-to-verify due diligence processes and related
quality control. This approach (which is separate from
the index calculation and maintenance requirements)
may raise the overall business relationship risk with
regard to accurately and credibly capturing the theme.
Occasionally, it’s possible to get the best of both worlds,
however. In some cases, a research house or investment
firm specializing in a niche area and an index provider
will collaborate to create indexes, combining specialized
industry knowledge with a well-developed maintenance,
calculation and distribution framework.
Like the pension fund, the ETF issuer will consider
each of the different approaches to determine which will
best satisfy its business needs.
A customer’s choice of provider is a key element in
the search for a benchmark, as it is the starting point for
an important (even if not-so-obvious) risk/reward relationship.
The process of asking certain questions and
finding the answers allows the user to more thoroughly
understand how well the relationship will satisfy their
needs. Often as not, the sensible choice is likely to favor
the more established index provider.
Selecting An Index
But what of the index itself? Does the choice matter?
Of course it does.
The process may be complicated by the fact there are far
more indexes than index providers, so there is more information
to sift through before making a selection.
Continuing the pension example is useful here.
Suppose a pension fund decides to benchmark its U.S.
equity allocation to a large-cap index from one provider
and a small-cap index from a different provider. There are
more than a few funds that use the S&P 500 to benchmark
their large-cap mandates and simultaneously employ the
Russell 2000 to benchmark their small-cap mandates. For
a long time, this was the accepted standard.
Even if both of the indexes were selected because
of their popularity and broad use, the combination
introduces gaps and overlaps in the fund’s aggregate
exposure. The S&P 500 is a basket of 500 stocks that
are selected by committee. Although they are generally
large, the stocks are certainly not simply the largest 500.
(If they were, S&P wouldn’t need a committee for selection.)
Roughly speaking, the stocks are chosen subjectively
based on how well they collectively represent the
overall U.S. market, rather than strictly based on market
capitalization. As a result, the S&P 500 contains the largest
350 or so, and then a smattering of smaller securities
further down the spectrum of market capitalization.
In contrast, the Russell 2000 is a basket of stocks that
includes the 2,000 stocks that fall below the top 1,000 stocks
in the U.S. market, in terms of market capitalization. When
paired with the S&P 500, there are hundreds of stocks that
are simply not accounted for by either index—and a few
that are, that appear in both indexes.
Although perhaps convenient, the combination is not
an appropriate measure for a pension fund seeking to
benchmark the total portfolio. Gaps and overlaps tend
to create opportunities for managers to take risks and
earn additional compensation for “beating the index”
when, in fact, such risks are simply not being accounted
for properly. A more appropriate benchmark could be
created by using complementary indexes that provide
seamless exposure to, and measure of, the U.S. equity
opportunity set. In short, index selection creates unique
risks if the indexes involved are not constructed using a
consistent methodology, even if both indexes (and both
index providers) are of the highest caliber.
Not surprisingly, an ETF provider that is more concerned
with covering a specific segment of the market—as
opposed to a particular asset class within the context of a
broad-market investment scheme—is going to be focused
on a slightly different set of considerations. When scrutinizing
individual indexes that supposedly cover the same
slice of the market, the seemingly significant similarities
of purpose can obscure some of the more nuanced—but
highly relevant—design differences. For example, is the
index designed with an eye for complete coverage or
for efficient representation? How many holdings does it
have? What is the turnover? How does it weigh individual
securities? The list goes on, with the user’s choice of index
influenced by specific needs.
Users should look beyond the index itself to its governing
principles, considering how the index defines its
stated objective, how well the index addresses the user’s
investment objective, how well it adheres to that objective,
and whether it is transparent and rules-based. A
firm grasp of these facets of the index is crucial to evaluating
whether any perceived tracking error, performance
shortfall and unnecessary costs are the result of poor
index construction and maintenance or simply anomalies
in that particular market’s performance.
These are not easy questions, and truly identifiable
answers may not exist until an index is tested, as evidenced
by what occurred in the markets during the dot-com bust
and the financial crisis. During those periods, technology
indexes, homebuilder indexes and dividend indexes faced
serious and previously unanticipated challenges.
As the housing bust roiled the markets, homebuilder
indexes, for example, needed to respond to a rapid and
unprecedented decline in the number of eligible securities.
Index providers responded in different ways, with at
least one including nonhomebuilding stocks as per their
published rules in order to maintain a predetermined
number of securities. However, such shifts in portfolio
focus seriously alter risk exposure and performance characteristics
on a go-forward basis, and such minutiae may
escape investors’ notice. Even so, it should not escape the
product provider’s notice.
At around the same time the homebuilding market was
imploding, dividend indexes also experienced a period of
continued on page 49
www.journalofindexes.com September / October 2011 47

Talking Indexes
From A Provider’s
Perspective
Looking out from inside the index
By David Blitzer
In institutional money management, portfolio managers
and traders work side by side. The portfolio manager
sets investment strategy, chooses the securities
to buy and relies on the trader to handle the tactics and
execute the trades. They work as a team with continuous
communication back and forth. Institutional index investing,
on the other hand, can be quite different. Key parts of
the portfolio manager’s role—security selection and the
weighting of securities in the portfolio—are handled by
the index provider, while trading and execution remain
with the fund manager.
Communication is also different from active management
in that the index provider publicly announces portfolio
changes a few days before the change is effected in the
index. The roles of portfolio management and trader are
carried out in separate companies with different objectives.
An institutional investor’s goal is generally to seek superior
investment performance, and decades of data indicate
tracking an index is the best way to do that. While the index
provider recognizes the desire for high returns, low risks and
outstanding investment performance, the index provider’s
objective is to represent a particular market or segment of
a market with the index. Examples range from investable
equities on a global basis to developed markets to large-cap
U.S. equities to a sector or an even narrower example, such
as stocks with consistent records of paying dividends.
As the de facto portfolio manager, the index provider
publishes a methodology document for the index, similar
to a portfolio manager’s investment policy statement.
The index provider also issues announcements about any
changes to the portfolio for institutional investors tracking
the index. While the index provider determines what is in
the index, it is the institutional fund manager who ultimately
decides when to trade stocks and how closely the fund’s
holdings will match the index. When the index components
are reasonably liquid and relatively easy-to-trade stocks in
a single market, the fund’s holdings will usually match the
index closely and be able to achieve performance within
a few basis points of the index’s calculated results, after
adjusting for fees or other costs that may be involved. In
other situations, institutional investors and fund managers
may choose to hold only some of the securities in the index
and may under- or outperform the index.
Another difference from active management is that with
index funds, there may be a number of institutional investors
competing with one another while tracking the same
index. Further, those offering products, such as ETFs or
mutual funds, are required to publish their results for all to
see. The product’s success is measured against the results
calculated by the index provider giving the theoretical
returns earned by the index. Such returns are considered
“theoretical” because the index provider is not trading and
does not include such costs related to trading as commissions
or market impacts. For index products tracking the
same index, a competitive advantage comes down to basis
points of operating expense and performance compared
with their peers. In few places in the investment world can
comparisons depend so much on only costs and returns
and so little on qualitative factors.
Communication between the index provider and the
investors is public and must maintain equal access for a
level playing field. The communications are not informal
conversations. They are governed by rules established by
the index provider as well as state and federal laws and regulations.
Active, or nonindex, money managers may enjoy
some secrecy about their investing intentions, while index
48
September / October 2011

investors do not. Active investors may be concerned about
being front-run; if they execute a series of large trades, they
may try to “disguise” their intentions or spread trades over
a few days to avoid being noticed. Index investors, on the
other hand, know that any pertinent news hits the market
at the same time for everyone. However, this does not
mean that the institutional index investors are blindly waiting
for the next add or drop announcements to pop up on
the screen. The index provider’s methodology—the guidelines
and procedures used to run the index—is public.
Unlike an active manager worried about front-running, the
index fund manager has no need to “disguise” his actions
or spread out his trades. On the contrary, in some cases the
index provider prefers to be predictable.
Occasionally an investor will argue that making the index
methodology public and giving investors five days’ notice
of any change invites hedge funds or other sophisticated
investors to trade in front of, and thereby gain from, index
funds that instead time their trades to exactly match any
changes in an index. However, as shown by the Standard
& Poor’s SPIVA reports, this concern about fast trading is
misplaced. In fact, as documented in these reports, 1 over
the last several years, index funds remain very difficult to
consistently outperform. This holds true in most markets—
large-cap or small, developed or emerging—even for the
largest index funds. Published methodologies and public
announcements don’t disadvantage investors.
There are some other differences in communication for
indexes versus active managers. For index providers, communication
is largely one way, except for an occasional
clarification; and there is little opportunity to change one’s
mind after an announcement. For example, an index provider
can’t say anything more than “no comment” when an
investor—or a company CFO—calls to discuss the implications
of whether company A or B may be a better fit for a
certain index. While there may be times when an experienced
trader might have valuable information about the
likely market reaction to a particular index announcement,
an index provider can do no more than listen stone-faced
to the comments, say “thank you” and conclude the call.
Communication from an index provider is public and
broadcast to the market through the media as well as
delivered by email or FTP. There is no way to tell who
received it—and who would need to be told if it were being
changed. Once an announcement is made, investors will
begin planning and executing trades to take advantage
of pending index changes. As tempting as it might be in
unusual circumstance to revise an announcement after
it is published, it is virtually impossible unless the trades
suggested by the announcement can’t be completed.
Such rare cases might happen if a merger or a spinoff
were canceled after an announcement or if trading in
a stock is halted indefinitely. Given these constraints,
announcements sometimes omit such details as the specific
date when a stock will join an index until a second
announcement, such as when a merger is expected to
close shortly but the date is not yet known.
When thinking about how an active institutional money
manager compares with an institutional index manager, it
is easy to believe that the index investor following the index
provider’s announcements has little to do—just a few trades
now and then as suggested by an announcement. This is far
from the truth. The success of the institutional index manager
depends on how effectively and efficiently the trading
is done, on whether the trade exactly tracks the index or
when the trader anticipates other market adjustments. Such
challenges may be just as great, if not greater, for the index
manager in comparison with the active manager.
Endnote
1. See www.spiva.standardandpoors.com.
In Perspective continued from page 47
extreme stress as banks and other financial institutions
altered their dividend policies to preserve capital or as a
condition of federal support. Financial companies were of
the largest sector in virtually every dividend-focused index,
and they possessed some of the highest yields. With their
component share prices now plunging, dividend indexes
also saw their levels plummet. This was compounded
by subsequent dividend cuts or outright eliminations as
the relevant stocks plumbed their lows. Index providers
were then forced to kick most of the financials out of their
indexes, and scramble to find replacement securities.
However, the market rebound was later led by many of the
very financial stocks that had been excised from component
lists of the dividend indexes. As a result, those indexes
suffered the full brunt of the market’s collapse, but did not
fully share in the subsequent market recovery. This turned
out to be a big disappointment for investors—though they
have since returned to these indexes for reasons pertaining
to the low-yield environment.
While these nuances of index construction likely did not
seem terribly important before 2008’s market disaster, they
should be taken into account by product providers when
choosing indexes in the future.
Clearly, the process of deciding on just the right index is
quite exacting. There’s little doubt, however, that customers
who take the time to thoughtfully consider all of the
relevant factors that go into the selection of an index will
be far more satisfied than those who don’t.
www.journalofindexes.com September / October 2011 49

News
MSCI Says Korea,
Taiwan Still Emerging
South Korea and Taiwan will
retain their developing market status
in the MSCI Emerging Markets Index
because they still lack accessibility, but
they remain under review for possible
reclassification to developed status a
year from now, MSCI said.
In its June announcement of its annual
reclassification review, MSCI also said
further consideration of whether Qatar
and the United Arab Emirates ought to
be shifted to emerging market status
from their current frontier market status
will be extended until December of
this year. The indexing company noted
it needed more time to assess recent
changes to those two markets.
While MSCI will weigh in on the two
Persian Gulf countries in November
of this year, a potential reclassification
of the two to emerging market
status wouldn’t be implemented until
November 2012, at the earliest.
As it stands, both MSCI’s emerging
and frontier market indexes will
remain unchanged for now, the company
said in a press release.
MSCI, widely considered the market
leader in international benchmarks,
also said it isn’t adding any new
countries for potential reconsideration
in next year’s review. It announces
changes every June and provides the
first warning that changes to its indexes
could be coming the following June.
Remy Briand, a managing director
and the global head of index research
at MSCI, in a news conference, also
briefly touched on Egypt’s status as an
emerging market country, which MSCI
said earlier this year might come under
review because the civil unrest there
that led to the resignation of President
Hosni Mubarak had left the stock market
closed for almost 40 days.
Briand said the feedback MSCI has
received from investors suggests that
trading on Egypt’s stock exchange is
going smoothly. But he also noted that
MSCI would be continuing to monitor
the situation, though its eligibility
would not be reviewed.
Russell Rebalances
Russell Investments added 186 companies
to its broad-market Russell 3000
Index as part of its annual reconstitution
this year, of which it said 22 were initial
public offerings. Overall market capitalization
of the index meanwhile grew by
almost 25 percent in the past year.
The components of the reconstituted
Russell 3000, which reflects about
98 percent of the U.S. equities universe,
had a total market value of $16.7 trillion
as of May 31, up from $13.4 trillion a
year earlier.
The changes to U.S. companies in
Russell indexes—as well as additions
and deletions to the Russell Global
Index—were finalized on June 27.
Changes to the index are available on
the company’s website.
The process of reconstituting
benchmarks takes place annually
and revisits the inclusion of particular
companies in various indexes
through rules such as market-capitalization
rankings, the company said in
May when it announced the timing of
this year’s changes.
Russell also noted in its press release
that the median market capitalization
of the Russell 3000 was to increase by
23 percent—to $1.04 billion from $802
million in 2010.
It said its lists showed a relatively
even distribution of additions among
sectors, and included 35 firms in the
health care sector, 33 in financial services
and 31 in technology.
Russell said its research shows Exxon
Mobil and Apple remain the two largest
companies in the Russell 3000 Index,
with market values of $411.2 billion and
$321.7 billion, respectively, and that
Chevron was to re-enter the top 10 as
the fourth-largest stock in the index.
FTSE Acquires DJI’s Share In ICB
In mid-June, FTSE announced it
had acquired the 50 percent it didn’t
already own of the global sector classification
system, ICB, from Dow Jones
Indexes. Terms weren’t disclosed.
FTSE and Dow Jones developed ICB,
one of three major classification systems
that dominate global sector indexing, in
2005. ICB is the broadest classification
system available to the market, with a
universe of 80,000 stocks, and is consistently
evolving to respond to market
requirements, FTSE said.
Three major classification systems
dominate sector indexing worldwide:
r5IF41.4$*#BSSB(MPCBM
Industry Classification Standard
(GICS)
r5IF5IPNTPO3FVUFST#VTJOFTT
Classification (TRBC)
r5IF%PX+POFT'54&*OEVTUSZ
Classification Benchmark (ICB)
Although details differ, the goal of
each system is the same: to sift through
tens of thousands of available stocks
and organize them into discrete yet
comprehensive categories.
Dow Jones Indexes will continue
to maintain its own classification
system based on the ICB going forward,
FTSE said.
Case-Shiller Benchmarks
Move Higher
U.S. home prices in April inched
higher for the first time in eight months,
after falling in March to their lowest
levels since 2009, helped by warmer
weather and an uptick in buying inter-
FTU UIF MBUFTU 41$BTF 4IJMMFS )PNF
Price report said.
Housing prices are typically stronger
in the spring and summer months,
as people strive to move into their new
homes by fall when school resumes,
50
September / October 2011

and it appears that dynamic helped
support the 10-City and 20-City composites,
which rose marginally—less
than 1 percent—from March levels.
It was the first positive month-overmonth
performance since July 2010,
though prices in most markets remain
lower than in the same year-earlier
period, the report said.
According to an S&P spokesman,
there was no way to tell if the upturn
was a turning point or just the result of
the warm weather.
A total of 13 out of 20 cities surveyed
saw home prices inch higher in April vs.
March, and half of them posted gains of
more than 1 percent. But, again, nearly
all the cities in the indexes remained
well below year-ago levels.
The exception was Washington, D.C.,
where home prices rose 3 percent in
April compared with March, and are now
4 percent higher than a year earlier.
By contrast, housing values dropped
in seven cities in April, and six of them
even forged new lows. Charlotte,
Chicago, Detroit, Las Vegas, Miami
and Tampa each fell into deeper negative
territory in April.
Minneapolis was the only city that
posted a double-digit annual decline—
home prices there are 11 percent lower
than they were a year ago. On the same
note, Cleveland, Detroit and Las Vegas
have home prices that are now lower
than they were 11 years ago.
INDEX DEVELOPMENTS
Guggenheim To
Change SEA’s Index
Guggenheim Funds filed paperwork
with the Securities and
Exchange Commission to change the
index on its Guggenheim Shipping
ETF (NYSE Arca: SEA). The change
appears to cut U.S. weighting in the
fund by 80 percent.
The ETF, which is currently based on
the Delta Global Shipping Index, will be
organized around the Dow Jones Global
Shipping Index once the change takes
place, according to the filing. It said the
change will become effective 60 days
after the filing, “pursuant to paragraph
(A)(1) of Rule 485.” The Guggenheim
filing was dated May 27.
The proposed new Delta Global
Shipping Index weighted U.S. companies
at 36.3 percent as of March 3, while
the Dow Jones Global Shipping Index
had a U.S. weighting of 7.8 percent as of
April 30. The new benchmark index also
weights certain Asian countries more
heavily than the existing index.
The fund has almost $12 million in
assets, according to data compiled by
IndexUniverse.
10 New Russell-Axioma
Indexes Debut
In late May, Russell Investments
announced it was launching 10
more indexes through its partnership
with Axioma Inc.
The new indexes are designed to target
risk factor exposures through longonly
positions. The benchmarks are derivations
of the Russell 1000 and Russell
2000 indexes, and individually offer high
and low volatility and beta exposures.
They also offer high momentum factor
exposure for both size segments. Russell
launched 10 ETFs based on each of the
new indexes at the end of May.
The index provider first announced
its collaboration with Axioma in
December 2009, with the first resulting
indexes debuting in November 2010.
S&P Launches ‘RC 2’ Indexes
S&P said in early June that it was
launching a new series of “next-generation”
risk control indexes. The index
provider already offers a wide array of
indexes focusing on different regions
and strategies that control risk by aiming
for specific risk levels and allocating
a percentage of the theoretical
portfolio to cash accordingly.
However, the ‘RC 2’ (risk control 2)
indexes allocate part of the portfolio to
bonds instead of cash, allowing investors
to benefit from the yields offered
by fixed-income investments, a press
release said. Also, unlike S&P’s origi-
www.journalofindexes.com September / October 2011 51

News
nal risk control series, the new indexes
do not use leverage or shorting to
achieve their exposures, but they can
allocate entirely to the equity index or
the bond index components.
According to its website, S&P currently
offers RC 2 versions of the S&P
500, S&P Euro 75, S&P Asia 50 and S&P
BRIC 40 indexes that target volatility
levels of 8, 10 and 15 percent.
FTSE, TOBAM Create Maximum
Diversification Indexes
An early June announcement from
FTSE outlined a new partnership with
TOBAM, a France-based asset management
firm known for its “anti-benchmark”
strategies. The joint collaboration
will focus on the creation of a family
of alternatively weighted indexes
built on a quantitative methodology
designed to minimize concentration
risk and achieve as much diversification
as possible, the press release said.
No launch date was given.
S-Network Unveils CEFMX
S-Network Global Indexes LLC
rolled out the S-Network Municipal
Bond Closed-End Fund Index in
early June. Paul Mazzilli, previously
executive director and director of ETF
research at Morgan Stanley, helped to
create the index, a press release said.
Mazzilli was the firm’s senior closedend
fund and ETF analyst. He left
Morgan Stanley in November 2008.
According to the press release, the
index employs a modified weighting
methodology based on net assets.
Components are drawn from a universe
of roughly 130 funds. All of the
eligible funds have at least $100 million
in net assets; they must also meet
specific requirements regarding maximum
expense ratio and maximum
average trading premium levels.
The index underlies the Market
Vectors CEF Municipal Income
ETF (NYSE Arca: XMPT), which
launched in July.
New S&P Index Targets Africa
In mid-June, Standard & Poor’s
debuted the S&P Access Africa
Index, which is designed as a bluechip
benchmark.
According to the press release, the
selection universe includes the stocks listed
on the Johannesburg Stock Exchange;
all companies based in Africa but listed
on developed-market exchanges; and
developed-market companies that operate
mainly in Africa and generate their
profits there. As a general rule, eligible
companies must generate at least 50 percent
of their revenues from Africa.
The index’s methodology also
requires components have a minimum
market capitalization of $200
million and meet a minimum daily
volume requirement, the press
release said. In all, the index includes
45 stocks, the largest of which were
Tullow Oil (9.78 percent); Anglo
American Plc (9.51 percent); and
Old Mutual (6.82 percent) as of May
31, 2011. The top countries were the
United Kingdom (35 percent); South
Africa (30.8 percent); and Canada
(20.1 percent).
S&P has also launched a series of
risk-controlled indexes based on the
S&P Access Africa Index, the press
release said.
Stoxx Rolls Out ‘World’ Index
Stoxx Limited launched the blue-chip
iStoxx World Select Index in early July,
the company said in a press release.
The index targets some of the
world’s most followed developed markets,
rolling the narrow-based Euro
Stoxx 50, Stoxx 50 and Stoxx Japan
50 up into one 150-stock benchmark.
Interestingly, the benchmark equalweights
its three component indexes,
which according to Stoxx, means that
the outsized influence usually wielded
by the U.S. in any developed-market
index is significantly reduced. The
components index themselves, follow
similar methodologies and are
weighted by free-float market capitalization,
the press release notes.
The component indexes are rebalanced
quarterly, and the broader
index resets their equal weightings on
a quarterly basis as well, according to
the press release.
Stoxx Launches Minimum
Variance Index
Stoxx Ltd. rolled out the iStoxx Europe
Minimum Variance Index in late June,
the company said in a press release.
The new index is derived from
the free-float capitalization-weighted
Stoxx Europe 600 Index. Using an
algorithm, it selects its components
from its parent index and reweights
them to create a benchmark that is
designed to exhibit minimal expected
variance, the press release said. The
index’s design is based on the principles
of modern portfolio theory.
With caps on sector and individual
component weightings, in
addition to diversification requirements,
the iStoxx Europe Minimum
Variance Index typically has a component
list of about 80 stocks, the
press release said.
Ossiam, which assisted in the development
of the index, has signed a
licensing agreement that will allow it to
use the index as the basis for an ETF.
DJ Global Commodity
Equity 100 Index Debuts
In late June, Dow Jones Indexes
rolled out of the Dow Jones Global
Commodity Equity 100 Index.
According to a press release, the
index covers companies operating in
the commodities industry, including
in the areas of “agriculture, energy,
metals, precious metals and water.”
The index’s launch included the
debut of four subindexes. Two cover
agriculture and energy, respectively,
while a third—the Dow Jones Global
Equity Scarcity Index—covers nonrenewable
resources. The fourth
subindex is the Dow Jones Islamic
Market Global Equity Commodity
Index, which screens out the components
in the parent index that are
not permissible investments under
Shariah law, the press release said.
According to a DJI fact sheet,
the U.S. is the largest country in
the main index, with a weighting
of 30.5 percent, followed by the
United Kingdom (20.37 percent) and
Canada (13.16 percent).
52
September / October 2011

Thomson Reuters Designs
Islamic Indexes
A July 4 announcement from
Thomson Reuters indicates it is
the latest index provider to offer its
own lineup of Shariah-compliant
indexes. The company teamed up
with IdealRatings, a firm that offers
Shariah-compliant funds and evaluation
research, to create the Thomson
Reuters IdealRatings Islamic Indices.
The component companies are
monitored on an ongoing basis via
quarterly reviews conducted by computers
using algorithms and human
researchers, the press release said;
the index methodology keeps track of
more than 30 different types of revenue
sources that require scrutiny under
Shariah law, it added.
The indexes draw their components
from more than 60 countries,
using Thomson Reuters’ universe of
71,000 companies. Currently the index
family has nine regional benchmarks,
including subindexes covering the Gulf
Cooperation Council and the Middle
East and North Africa region, the
announcement said.
The press release noted that the
indexes were designed to meet the
standards set forth by the Accounting
and Auditing Organisation for
Islamic Financial Institutions, a nonprofit
that establishes ethical and
accounting standards for the Islamic
financial community.
S&P Consults On
Country Classifications
Standard & Poor’s launched a consultation
document in June seeking
feedback from market participants on its
country classification system. Responses
were requested by Aug. 26, 2011.
The index provider’s queries targeted
seven countries in particular, asking
survey participants if they thought each
country’s development status should be
reclassified. S&P is considering whether
it should promote the Czech Republic
from emerging to developed status, and
whether it should downgrade Greece
from developed to emerging status. The
index provider is also reviewing whether
Jordan, Kuwait, Oman, Qatar and the
United Arab Emirates should be promoted
from frontier to emerging status.
The consultation paper also asks
participants if they think that companies
trading in renminbi on the
Hong Kong Stock Exchange should be
included in the S&P indexes.
In a separate release in early June,
S&P also announced that Colombia, a
frontier market, would be promoted to
emerging market status as of the S&P
indexes’ September 2011 reconstitution.
DJI Unveils European
Titans Indexes
In June, Dow Jones Indexes said
it had launched a pair of indexes targeting
European blue-chip stocks; the
indexes are its latest additions to the
Dow Jones “Titans” index family.
The Dow Jones Eurozone Titans 80
Index and the Dow Jones Europe Titans
80 Index each have 80 components
chosen based on float-adjusted market
capitalization, revenues and net profits,
according to the press release. While
the Eurozone index selects its components
from the markets of Austria,
Belgium, Finland, France, Germany,
Greece, Ireland, Italy, the Netherlands,
Portugal and Spain, the more broadly
focused DJ Europe Titans 80 Index canvasses
those countries and Denmark,
Iceland, Norway, Sweden, Switzerland
and the U.K., the press release said.
UniCredit has licensed the indexes
to underlie structured products that will
be offered in Germany and Austria.
MSCI Adds To ESG Index Family
MSCI announced in late June the
addition of 25 indexes to its family
of environmental sustainability governance
(ESG) indexes.
Nine of the indexes screen out
“controversial weapons” such as land
mines, biological weapons and depleted
uranium weapons, according to a
press release. They were largely created
to respond to demand from the
institutional sector and have already
been licensed to BlackRock to underlie
index funds. The group of indexes
includes screened versions of the MSCI
ACWI, MSCI World, MSCI USA and
MSCI Emerging markets indexes.
MSCI also debuted the MSCI World
Socially Responsible Index and four
subindexes, the press release said. The
stocks included in the main benchmark
have the highest ESG scores out
of the companies in MSCI’s universe,
and also have been screened to exclude
companies with operations in the areas
of tobacco, nuclear energy and genetically
modified products.
The remaining 11 indexes mentioned
in the announcement cover
different regions and countries as
well as the companies with the highest
ESG scores in each of MSCI’s 10
sectors, with an eye to achieving a
close correlation to their corresponding
standard MSCI indexes.
Markit Debuts European ABS Index
In June, Markit rolled out the
Markit iBoxx European ABS Index,
which targets the European assetbacked
securities. The new index
includes floating-rate ABS denominated
in euros, British pounds or U.S.
dollars, an announcement said.
The index can be broken down into
eight subindexes, including ones that
target the various parts of Europe’s
www.journalofindexes.com September / October 2011 53

News
commercial and residential ABS markets,
respectively, AAA-rated ABS and
ABS in different countries.
In the press release, Markit said
that the index could be used for
benchmarking purposes or to underlie
investment products.
AROUND THE WORLD OF ETFs
Barclays Redeems VZZ
Due To Price Drop
Barclays Bank automatically
redeemed its iPath Long Enhanced
S&P 500 Mid-Term Futures ETN (NYSE
Arca: VZZ) on July 1 because the price
of the notes fell just below the $10 per
share redemption barrier.
VZZ, which had $12.8 million in
assets as of June 30, was halted by Arca,
the New York Stock Exchange’s electronic
trading platform, after the ETN
fell to $9.98 a share. That was $1.82
lower on the day.
VZZ’s 15 percent slide could have
been related to the looming possibility
of the automatic redemption,
as its nonleveraged counterpart—the
iPath S&P 500 VIX Mid-Term Futures
ETN (NYSE Arca: VXZ)—was down
just about 4 percent at the time Arca
halted trade in VZZ.
First Trust Debuts
Cloud Computing ETF
First Trust rolled out in July the
First Trust ISE Cloud Computing Index
Fund (Nasdaq GM: SKYY). The ETF
is based on the ISE Cloud Computing
Index and includes companies actively
involved in the cloud computing industry,
according to a filing the company
made with the SEC on April 20.
Cloud computing refers to computer
users accessing many different servers
to meet their needs, as opposed to
using centralized computing resources.
Companies such as Amazon with
immense computing resources that
go beyond internal demands have
become big players in the expanding
world of cloud computing.
SKYY comes with an annual expense
ratio of 0.60 percent.
Pimco Launches
Short-Dated Corp. Junk ETF
On June 17, Pimco rolled out a highyield
corporate bond index ETF focused
on the short end of the yield curve. The
Pimco 0-5 Year High Yield Corporate
Bond Index Fund (NYSE Arca: HYS)
tracks the BofA Merrill Lynch 0-5 Year
US High Yield Constrained Index and
costs 0.55 percent after a fee waiver, the
company said on its website.
Noninvestment-grade debt offers a
way to obtain extra yield at a time when
benchmark short-term interest rates
remain near zero. The noninvestmentgrade
debt in the new Pimco fund must
be dollar denominated and issued in
the U.S. It must have fewer than five
years’ remaining term to final maturity,
a fixed coupon schedule and a
minimum amount outstanding of $100
million, issued publicly, the company
said. Also, allocations to an individual
issuer will not exceed 2 percent.
Emerging Global
Unveils Sector ETFs
Emerging Global Advisors launched
a first-of-its-kind suite of sector funds
on June 23, canvassing the developing
markets that are tied to the Dow
Jones Emerging Market Titans Index
series. The new funds are marketed
as the Global Emerging Market Sector
ETFs, or “GEMS.” The family is the
first to represent a complete lineup
of sector ETFs drawing their components
entirely from emerging markets.
The ETFs, which all have net expense
ratios of 0.85 percent, are:
• EGShares Basic Materials GEMS
ETF (NYSE Arca: LGEM)
• EGShares Consumer Goods
GEMS ETF (NYSE Arca: GGEM)
• EGShares Health Care GEMS ETF
(NYSE Arca: HGEM)
• EGShares Industrials GEMS ETF
(NYSE Arca: IGEM)
• EGShares Technology GEMS ETF
(NYSE Arca: QGEM)
• EGShares Telecom GEMS ETF
(NYSE Arca: TGEM)
• EGShares Utilities GEMS ETF
(NYSE Arca: UGEM)
• EGShares Consumer Services
GEMS ETF (NYSE Arca: VGEM)
IndexIQ Rolls Out
Small-Cap REIT ETF
In June, IndexIQ launched a
small-cap ETF focused on REITs,
providing investors with what the
company called an opportunity to
earn higher dividends than on REIT
ETFs focused on bigger firms.
The IQ US Real Estate Small
Cap Index ETF (NYSE Arca: ROOF)
comes with a 0.69 percent annual
expense ratio, and is based on
the IQ US Real Estate Small Cap
Index—a float-adjusted, marketcap-weighted
benchmark focused
squarely on small-capitalization
U.S. real estate companies.
IndexIQ said ROOF’s dividend of
about 5 percent is as much as 200
basis points higher than those on
many large-cap ETFs.
The index that ROOF is built on
includes the bottom 10 percent of
U.S. REITs by market capitalization.
IndexIQ also said that small-cap REITs
have significantly outperformed largecap
REITs over most time frames.
54 September / October 2011

iShares Joins
Floating-Rate ETF Party
iShares rolled out a new ETF in
June to help investors weather fluctuations
in interest rates. The iShares
Floating Rate Note Fund (NYSE Arca:
FLOT) invests in dollar-denominated,
investment-grade floating-rate
bonds. By having adjustable interest
rates, the bonds fluctuate less in
value when interest rates are changing
than fixed-yield bonds.
FLOT’s launch follows both the
Market Vectors Investment Grade
Floating Rate ETF (NYSE Arca: FLTR),
which also invests in high-quality
notes; and the Invesco PowerShares’
Senior Loan Portfolio (NYSE Arca:
BKLN), which holds noninvestmentgrade
bank loans.
Floating-rate bonds are often
linked to highly leveraged borrowers,
as they are issued for recapitalization
needs and acquisitions, such
as leveraged buyouts.
The new iShares ETF comes with
an annual expense ratio of 0.20 percent,
the company said on its website.
By contrast, BKLN costs 0.83
percent including acquired fund fees,
while FLTR has a net expense ratio of
0.19 percent.
New UBS ETNs
Hone In On Contango
In June, UBS added to its family of
“ETRACS” ETNs with the rollout of
two first-to-market securities that try
to profit from contango in the crude
oil and natural gas futures markets.
The ETNs, which UBS marketing
materials said both come with annual
expense ratios of 0.85 percent, are:
r&53"$4/BUVSBM(BT'VUVSFT
Contango ETN (NYSE Arca: GASZ)
r&53"$40JM'VUVSFT$POUBOHP
ETN (NYSE Arca: OILZ)
GASZ is designed to achieve its
objective by going short the frontmonth
contract, and going long an
equivalent amount that’s divided into
three equal investments in the 12th-,
13th- and 14th-month contracts on
the futures curve. OILZ is meanwhile
designed to achieve its objective by
going short the front-month contract
and simultaneously establishing a
long position that’s worth 150 percent
of the short position. The long
position is divided into three equal
investments in the sixth-, seventhand
eighth-month contracts on the
crude oil futures curve.
Deutsche Debuts
Leveraged Dollar Index ETNs
Deutsche Bank and Invesco
PowerShares rolled out in late May
the first-ever U.S. dollar index leveraged
ETNs that provide triple-long
and triple-short exposure to futures
contracts on the currency benchmark
that measures the value of the
greenback compared with six of the
world’s most-traded currencies.
The PowerShares DB 3x Long US
Dollar Index Futures ETN (NYSE Arca:
UUPT) and the PowerShares DB 3x
Short US Dollar Index Futures ETN
(NYSE Arca: UDNT) each charge an
annual expense ratio of 0.95 percent.
They are designed to replicate
the performance of the dollar relative
to a basket of six currencies: the
euro, Japanese yen, British pound,
Canadian dollar, Swedish krona
and Swiss franc.
The ETNs are rebalanced monthly.
Global X Debuts
Fertilizer, Farming ETFs
Global X Funds launched two ETFs
in May that focus on global fertilizer
producers and farming equities.
The Global X Fertilizers/Potash
ETF (NYSE Arca: SOIL), which tracks
the Solactive Global Fertilizers/
Potash Index, owns the largest and
most liquid global names involved
in various aspects of the fertilizer
industry. SOIL comes with a 0.69
percent price tag.
The Global X Farming ETF (NYSE
Arca: BARN), on the other hand,
will likely face stiff competition from
the likes of the $5.25 billion Market
Vectors Agribusiness ETF (NYSE Arca:
MOO). Still, BARN claims to be more
narrowly focused than its competitors,
as it only includes companies in
the agricultural products, livestock
operations and farming equipment
manufacturing segments.
BARN tracks the Solactive Global
Farming Index from Germany-based
Structured Solutions AG. The benchmark
comprises 50 securities screens for
liquidity, and weights securities based
on free-float market capitalization.
FROM THE EXCHANGES
Shareholders Approve NYSE,
Deutsche Boerse Combo
In July, NYSE Euronext announced
that its shareholders and the shareholders
of Deutsche Boerse had
approved the latter exchange’s acquisition
of the former.
The proposed deal involves
Deutsche Boerse acquiring the
NYSE Euronext for $9.5 billion via
an all-stock transaction. A fact sheet
about the combination said shares in
Deutsche Boerse could be exchanged
for one share of the new company
and shares of NYSE Euronext could
be exchanged for 0.47 share.
According to press releases from
NYSE Euronext, more than 96 percent
of NYSE Euronext shareholders voted to
approve the deal in a “special meeting,”
and a few days later, on July 13, more
than 82 percent of Deutsche Boerse
shareholders had tendered their shares
for shares in the new company, exceeding
the 75 percent approval needed.
The fact sheet states that the deal
is expected to be finalized by the
close of 2011; however, it must still
be approved by regulatory agencies
in both the U.S. and Europe.
CME Launches Corn,
Soybean Volatility Indexes
In early June, CME Group unveiled
two new volatility indexes tied to
CBOT corn and soybean contracts.
The CBOE/NYMEX WTI Crude
Oil Volatility Index and the CBOE/
COMEX Gold Volatility Index are
constructed using the Chicago Board
Options Exchange’s VIX methodology.
The indexes are based on the
CBOT options contracts for corn and
soybeans, and are designed to mea-
www.journalofindexes.com September / October 2011
55

News
sure the underlying contracts’ implied
volatility for the next 30 days, the press
release said.
According to the CME, corn and
soybean volatility has increased as
global demand for those commodities
has increased.
BACK TO THE FUTURES
CME Volumes Rise
Year-Over-Year
CME Group said in a press release
that its volumes for June had increased
by 22 percent from the prior year; the
daily average for the month was 14.9
million contracts.
Despite the overall increase, the
average monthly volumes for equity
index futures were down 3 percent
year-over-year. The monthly volume
for the e-mini S&P 500 futures contract,
the CME’s most actively traded
index contract, was down 3.4 percent
from the prior year to just under 60
million contracts, while the e-mini
Nasdaq-100 futures contract’s volume
was down 15.8 percent to 6.8
million contracts. At the same time,
the e-mini S&P 500 options contract
saw its monthly volume increase by
nearly 80 percent to more than 3
million contracts.
KNOW YOUR OPTIONS
CBOE Options See Increase
The CBOE reported a 4 percent
increase in its average daily volume
for June to 4.3 million options contracts,
up from 4.1 million in June of
the prior year.
According to the press release,
index options in particular saw an
outsized increase in ADV to 1.3 million
contracts, a 28 percent yearover-year
increase. Meanwhile, ETF
options also came in with an ADV
of 1.3 million contracts, a 10 percent
increase from June 2010.
Of the index and ETF options traded
on the CBOE, the most active contracts
in June were those tied to the S&P
500 Index, the SPDR S&P 500 ETF, the
CBOE VIX, the iShares Russell 2000
Index Fund (NYSE Arca: IWM) and
the PowerShares QQQ (Nasdaq GM:
QQQ). In particular, the VIX contracts
saw a year-over-year ADV increase of
96 percent, while the S&P 500 contracts
saw an ADV increase of 18 percent.
ON THE MOVE
Fuhr Leaves BlackRock
Deborah Fuhr, head of BlackRock’s
ETF research and implementation
strategy unit, is leaving the firm, the
world’s largest issuer of exchange-traded
funds said in a July press release.
Fuhr joined BlackRock in 2008
after leaving Morgan Stanley, where
she was a managing director. She had
been based in London.
BlackRock plans to centralize
all its ETF-related research in
a new unit, called the BlackRock
Investment Institute, the firm said in
the prepared statement.
Russ Koesterich, the chief investment
strategist for iShares, will help
define ETF research at the institute,
which will be led by Lee Kempler,
the company said. Koesterich will be
supported by Joe Linhares in Europe,
the Middle East and Africa; Jennifer
Grancio in the U.S. and Canada; Daniel
Gamba in Latin America; and Nick
Good in the Asia-Pacific region.
BlackRock declined to say whether
Fuhr had been dismissed or if she
had resigned, citing company policy
regarding personnel matters.
Russell Names New
CEO/President …
Russell Investments said in a mid-
July press release that it had named
Len Brennan as its new chief executive
officer and president.
Brennan held a variety of management
roles at Russell from 1985 until
2005, when he left the company to
become the president and CEO of
Rainier Investment Management. He
returned just this year to become the
chief executive of Russell’s EMEA operations,
before taking over the leadership
of the company. Not only will Brennan
continue to head the EMEA operations,
but he will also join the company’s
board as a director, the press release
said. It noted that he would divide his
time between the company’s Seattle
and London offices.
Brennan replaces Andrew Doman,
who has held the CEO and president
posts for 2½ years. Doman had succeeded
Kelly Haughton after the latter’s
retirement. He will replace Ed
Zore as chairman of Russell’s board,
while Zore stays on as a director.
… And Adds New
Sales Director For Indexes
Russell also named a new sales
director in its index business division.
Shelton Unger is to head up
domestic sales of the firm’s indexes
to plan sponsors.
Unger joins Russell after 25 years
with the Vanguard Group. There, she
was involved in multiple facets of the
company’s business operations targeting
the institutional retirement
area, a press release said.
Unger reports to the managing
director overseeing Russell’s index
sales, Kevin Lohman.
VelocityShares Adds
iShares’ Parsons To Board
VelocityShares, the new ETN company
known for its volatility-linked
products, in May named to its board
J. Parsons, who was previously global
head of iShares sales while it was part
of Barclays Global Investors.
VelocityShares first entered the
ETP market with the launch of six
VIX-based ETNs in November 2010,
among them the VelocityShares Daily
2X VIX Short-Term ETN (NYSE Arca:
TVIX). The company said its family of
ETNs has since amassed about $180
million in assets.
Parsons, who led iShares’ global
business development from its inception
through its sale to BlackRock,
said he is “thrilled” to help the company
continue to grow.
VelocityShares’ lineup of VIX-linked
ETNs includes leveraged as well as
inverse strategies. It said TVIX now
trades more than 1 million shares a
day, and is one of the most liquid ETPs
launched in the last six months.
Parsons left BlackRock in 2010.
56 September / October 2011

Rydex Equal Weight Sector ETFs.
Invest in an entire sector, equally.
Rydex Equal Weight Sector ETFs (unlike traditional cap-weighted funds) give investors exposure to every stock in a sector
index. This takes risk and spreads it across all stocks in the index. Investing in energy? Get all the energy stocks. Not
just the big ones. Same for tech. Health Care. Financials. All nine of RydexShares’
Equal Weight Sector ETFs. Find out why equal weight might be a more intelligent
way to invest in sectors. Call 800.820.0888 or go to rydex-sgi.com
The intelligent pursuit of wealth.
RYE
S&P 500 ®
Energy
RYF
S&P 500 ®
Financials
RYH
S&P 500 ®
Health Care
RGI
S&P 500 ®
Industrials
RTM
S&P 500 ®
Materials
RYT
S&P 500 ®
Technology
RYU
S&P 500 ®
Utilities
RHS
S&P 500 ®
Consumer
Staples
RCD
S&P 500 ®
Consumer
Discretionary
For more complete information regarding RydexShares, ® call 800.820.0888 or visit www.rydex-sgi.com for a prospectus and a summary prospectus
(if available). Investors should carefully consider the investment objectives, risks, charges and expenses of a fund before investing. The fund’s
prospectus and its summary prospectus (if available) contain this and other information about the fund. Please read the prospectus and summary
prospectus (if available) carefully before you invest or send money.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Rydex Equal Weight ETFs may not be suitable for all investors. • Investment returns and principal value will fluctuate so that when shares are redeemed, they
may be worth more or less than original cost. Most investors will also incur customary brokerage commissions when buying or selling shares of an ETF. • Investments
in securities are subject to market risks that may cause their prices to fluctuate over time. • ETF Shares may trade below their net asset value (“NAV”). The NAV
of shares will fluctuate with changes in the market value of an ETF’s holdings. In addition, there can be no assurance that an active trading market for shares
Scan with phone to
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will develop or be maintained. Sector funds may not be suitable for all investors. Investing in sector funds is more volatile than investing in broadly diversified funds, as there is
a greater risk due to the concentration of the fund’s holdings in issuers of the same or similar offerings. • Please review a prospectus carefully for more information of the risks
associated with each ETF.
“Standard & Poor’s®,” “S&P®” and “S&P 500®,” are trademarks of Standard and Poor’s Financial Services, LLC and have been licensed for use by Rydex Investments and its affiliates. Rydex S&P ETFs are not sponsored,
endorsed, sold nor promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of investing in Rydex S&P ETFs.
Rydex|SGI funds are distributed by Rydex Distributors, LLC (RDL). Security Investors, LLC (SI) is a registered investment advisor, and does business as Security Global Investors® and Rydex Investments. SI and RDL are affiliates
and are subsidiaries of Security Benefit Corporation, which is wholly owned by Guggenheim SBC Holdings, LLC, a special purpose entity managed by an affiliate of Guggenheim Partners, LLC, a diversified financial services firm with
more than $100 billion in assets under supervision.

Global Index Data
58
September / October 2011

STOXX LIMITED
INNOVATIVE GLOBAL
INDICES
Innovation means, literally, “the introduction of something better” – a definition STOXX has always lived up to,
first and foremost with the EURO STOXX 50®, Europe’s leading blue-chip index. But STOXX has more to offer
than that: a truly global index family, ranging from blue-chip indices to broader benchmarks for virtually every
country and region. And because innovation is part of our DNA, STOXX offers advanced index concepts such
as Risk Control, Global ESG Leaders, and enhanced infrastructure indices – all applying a transparent, purely rulesbased
methodology. Besides being one of the financial world’s most renowned index brands, STOXX Ltd. also
markets and distributes the complete portfolio of DAX® and SMI Indices®, the leading brands from Deutsche
Börse AG and SIX Swiss Exchange AG. While innovation is our driver for product development, established
values such as trustworthiness and responsiveness are what matters most to us in client relationships. A successful
combination, as the figures clearly show: in 2010, approx. 185,000 structured products were issued on STOXX®,
DAX®, and SMI® indices, and our indices are the fourth-largest underlying for ETFs worldwide. More about the
index innovators on www.stoxx.com
STOXX is part of Deutsche Börse and SIX Group
STOXX®, EURO STOXX 50®, DAX®, and SMI® indices are protected through intellectual
property rights. The use of these indices for fi nancial products or for other purposes
requires a license from STOXX Ltd. (“STOXX”), Deutsche Börse AG (“DBAG”), and/or
SIX Swiss Exchange AG (“SIX”). STOXX, DBAG, and SIX do not make any warranties or
representations, express or implied, with respect to the timeliness, sequence, accuracy,
completeness, currentness, merchantability, quality, or fi tness for any particular purpose
of their indices and index data. STOXX, DBAG, and SIX are not providing investment
advice through the publication of the STOXX®, DAX®, and SMI® indices or in connection
therewith. In particular, the inclusion of a company in an index, its weighting, or the
exclusion of a company from an index, does not in any way refl ect an opinion of STOXX,
DBAG, or SIX on the merits of that company or qualifi es as an investment advice.
Contacts
Zurich, Headquarters: +41 58 399 5300 stoxx@stoxx.com

Index Funds
60
September / October 2011

Morningstar U.S. Style Overview Jan. 1 - June 30, 2011
Source: Morningstar. Data as of June 30, 2011
Source: Morningstar. Data as of 2/29/08
www.journalofindexes.com
September / October 2011
61

Dow Jones U.S. Industry Review
62
September / October 2011

Exchange-Traded Funds Corner
www.journalofindexes.com September / October 2011
63

Test Your Skills
Inflation Consternation
Having fun
with a distinctly
“un-fun” subject
ACROSS
7 U.S. president whose
1971 counter-inflation
measures were a “Shock”
8 Russian leader’s title
until 1917
9 Allowance for the
difference in value of
two currencies
11 U.S. president
during the creation of
the Federal Reserve
12 French revolutionary
paper money, backed by
confiscated lands
13 What France enjoyed
between 1718–1720
as a result of 18D’s
new concept
15 Slang term for diamonds
16 Black ____, European
disaster of which one
consequence was
massive inflation
19 First name of the king
responsible for 24D’s
financial crisis in 1716
20 German emergency
money of the 1920s
23 ____ and desist!
25 ____-Margret, Elvis
Presley’s “Viva Las
Vegas” co-star
26 To change periodically,
as 28A can
28 ____ Rates, often raised
to counter inflation
30 Continent whose countries’
currencies include
kwanza, dalasi and naira
32 Share index of 100 U.K.
companies
1
2 3 4 5
7 8 9
10
11 12
13 14 15 16
19
23
28 29
24
27
32 33
33 David ____, economist who
suggested that oversupply of
banknotes led to depreciation
34 James ____, proponent of a
tax on currency trading
DOWN
1 Nickname given to the New
Zealand dollar
2 The annual percentage
change of this price index is
used as a measure of inflation
3 Family of ETFs managed by
BlackRock
4 Financial collapse, which
often follows 13A!
5 Bargain or argue over a price
6 Former currency of Vatican City
10 Indexes in England
22
25
20
18
30
34
21
26
14 Red ____, pigment once used
as commodity money in
Swaziland
17 Silver coin, used in Europe for
400 years
18 Scotsman, known as the
father of paper money
21 Mervyn King’s position
in relation to the Bank of
England
22 Hobby, such as numismatics
24 Country whose currency was
the riksdaler throughout the
18th century
27 New ____, capital city where
rupees are spent
29 A dollar bill, for example
31 Metal money, often clipped
by Henry VIII, leading to
devaluation
6
17
31
Solution
ACROSS: 7. Nixon; 8. Tsar; 9. Agio; 11. Wilson; 12. Assignat; 13. Boom; 15. Ice; 16. Death; 19. Charles;
20. Notgeld; 23. Cease; 25. Ann; 26. Vary; 28. Interest; 30. Africa; 32. FTSE; 33. Hume; 34. Tobin.
DOWN: 1. Kiwi; 2. Consumer; 3. iShares; 4. Crash; 5. Haggle; 6. Lira; 10. Indices; 14. Ochre; 17. Taler;
18. John Law; 21. Governor; 22. Pastime; 24. Sweden; 27. Delhi; 29. Note; 31. Coin.
64
September / October 2011

INDICES CLEARLY FOCUSED
ON YOUR WORLD.
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BND
Vanguard Total Bond Market ETF
BND has 12 times more index coverage than the industry average.*
Are you Vanguarding ® your clients’ portfolios?
Broader coverage can mean more accurate tracking. When you take a closer look at BND,
you’ll see that it has 4,907 holdings versus the industry average of 424 holdings, and that can
have a real impact on your clients’ portfolios.
Take a closer look at advisors.vanguard.com/ BND
800-523-0664
All investments are subject to risk. Vanguard funds are not insured or guaranteed. Investments in bond funds are subject to
interest rate, credit, and inflation risk.
To buy or sell Vanguard ETFs, contact your financial advisor. Usual commissions apply. Not redeemable. Market price may be
more or less than NAV.
For more information about Vanguard ETF Shares, visit advisors.vanguard.com/BND, call 800-523-0664, or contact your
broker to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are
contained in the prospectus; read and consider it carefully before investing.
*Source: Morningstar as of 05/01/2011. Based on 2011 industry average bond ETF holdings of 424 and BND holdings of 4,907.
© 2011 The Vanguard Group, Inc. All rights reserved. U.S. Pat. No. 6,879,964 B2; 7,337,138. Vanguard Marketing Corporation, Distributor.

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