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or allocating more of our risk budget to passive management and away from active management. Shifting assets from active to passive management is a popular choice for many reasons, including lower total costs and the empirical evidence that most—but assuredly not all!—active managers fail to add value. A more subtle reason for de-risking, which can be observed but not measured, is public anger at a perception of “Wall Street greed.” The low costs of cap weight, and its new quasiindex brethren, mean that more of the return of the holdings flows to the investors, and less to the managers, brokers, custodians and other intermediaries. This pleases many customers! For all of these investors, the noncap-weighted “index” strategies are important additions to the investment tool kit. If these strategies offer higher return and/or lower volatility on average over time, as history would suggest, at a fraction of the cost of fully active strategies, then investors can choose to reach for more return at the same portfolio risk or they can choose to reduce equity market exposure without necessarily reducing the return. Index Alternatives Of the alternatives, we have chosen to explore—and combine—the four approaches that are garnering the most attention as alternative core equity strategies. As we delve into their characteristics, let’s also examine the principles and tacit core assumptions that lay a foundation for each. Some of the key attributes for the four index strategies are summarized in Figure 1. For purposes of evaluating global results, across all four types of strategies, currencies were hedged by using interest-rate differentials to approximate the impact of continuous hedging; this did not include the impact of actual hedge costs (Lazard, 2009). Cap Weight Market capitalization remains immensely popular as the incumbent and theoretically efficient choice, despite doubts about whether its core theoretical underpinnings—the efficient market hypothesis (EMH) and CAPM—are precisely correct. Cap weight tacitly assumes that share-price-implied consensus expectations, regarding the net present value of each company’s future growth prospects, are an unbiased view of the future. Furthermore, cap weight offers very low turnover, trading costs and tax consequences, which the newer alternatives can’t quite match. As EMH and CAPM gained traction in academia, the theoretical result—that a single portfolio could be optimal—was revolutionary. The theoretical purity of cap weight, along with the difficulties faced by the average active manager, in time gave rise to passive investing. The growth in “index funds” was fueled by the historical fact that the average active manager has had a hard time beating cap-weighted indexes, after taking account of fees and transaction costs. No student of the capital markets should find this the least bit surprising. After all, if we divide the market into the passive, cap-weighted indexes and the combined holdings of all active, noncap-weighted portfolios—including individual investors—the former matches the market in both holdings and performance, which means that the latter must also match the market, before costs. So, net of costs, the noncap-weighted active managers must collectively lag cap weight. None of this requires market efficiency, nor is it necessary to believe that we cannot “beat the market.” We need only admit that winning active managers must have losing managers on the other side of their trades! Even as indexing gained traction, a growing body of empirical evidence suggested that patient investors could achieve above-market performance, with statistical significance, most notably with a value tilt. If EMH and CAPM are mere approximations of the real world, then the assured dominance of cap weight, on a riskadjusted basis, evaporates. Suppose we believe that markets are inefficient, and that investors are subject to errors that result in share prices that deviate from their fair valuations. When investors construct portfolios that weight companies proportional to capitalization, they inherently overweight the overpriced stocks and underweight the underpriced stocks. This truism has been acknowledged by many in the indexing community, and dismissed because of the equally relevant truism that we cannot know which companies are over- or undervalued. But, if we can sever the link between over- or undervaluation and portfolio weight, perhaps we can improve upon cap weight. Or so the “fundamentalists” suggest. Figure 1 Portfolio Construction Comparison Portfolio/Index Relative Size Determination Required Forecasts Turnover and Trading Costs Cap Weight Market Cap None a Minimal Economic Scale Fundamental size None Somewhat higher (economic footprint) than market cap Global Equal Weight Equal None b High Equal Weight Cap 1000 Equal None b High Equal Weight Econ 1000 Equal None b High Minimum Variance Risk contribution Volatility and correlations Somewhat higher (equal marginal change in risk) than market cap a The weight tacitly reflects a market consensus forecast for future risk-adjusted shareholder distributions. b There is a selection bias issue explored in the text: Which stocks do we select for our equal weighting? Sources: Research Affiliates, LLC, and Lazard Asset Management 18 January/February 2010
One-Stop Shopping for Global Commodity Equities Market Vectors RVE Hard Assets Producers ETF (HAP) Based on The Rogers TM –Van Eck Hard Assets Producers Index (RVEI), viewed by many as the definitive global benchmark for commodity equities. ➤ Comprehensive: 35+ countries–6 sectors–270+ companies ➤ Includes water and renewable energy (solar and wind) ➤ Balanced exposure with consumption-weighted sectors Sector Weights: As of September 30, 2009 Agriculture Industrial Metals Energy Paper/Forest Products Precious Metals Water/Renewable Energy 30.7% 13.4% 40.9% 3.8% 7.2% 4.0% JIM ROGERS 1.888.MKT.VCTR vaneck.com/HAPetf Van Eck Securities Corporation, Distributor | 335 Madison Avenue | New York, NY 10017 The Fund is subject to various risks associated with making investments in companies engaged in producing and distributing hard assets and related products and services, such as commodity price volatility, government policy and technological change, competitive pressures, resource depletion, labor issues, foreign investment risks, high volatility and potentially significant loss. The Fund may loan its securities, which may subject it to additional credit and counterparty risk. ➤ Fund shares are not individually redeemable and will be issued and redeemed at their NAV only through certain authorized broker-dealers in large, specified blocks of shares called “creation units” and otherwise can be bought and sold only through exchange trading. Creation units are issued and redeemed principally in kind. Shares may trade at a premium or discount to their NAV in the secondary market. ➤ An investor should consider investment objectives, risks, charges and expenses of the investment company carefully before investing. To obtain a prospectus, which contains this and other information, call 1.888.MKT.VCTR or visit vaneck.com/HAPetf. Please read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. An investor cannot invest directly in an index. The RVEI data presented is not necessarily indicative of the Fund. No representation is being made that an investment will achieve performance similar to that shown. ➤ RVEI is published by S-Network Global Indexes, LLC, which neither sponsors nor endorses HAP. ➤ “Jim Rogers,” “James Beeland Rogers, Jr.,” and “Rogers,” are trademarks, service marks and/or registered trademarks of Beeland Interests, Inc. (“Beeland Interests”), which is owned and controlled by James Beeland Rogers, Jr., and are used subject to license. The personal names and likeness of Jim Rogers/James Beeland Rogers, Jr. are owned and licensed by James Beeland Rogers, Jr. ➤ HAP is not sponsored, endorsed, sold or promoted by Beeland Interests or James Beeland Rogers, Jr. Neither Beeland Interests nor James Beeland Rogers, Jr. makes any representation or warranty, express or implied, nor accepts any responsibility, regarding the accuracy or completeness of this material, or the advisability of investing in securities or commodities generally, or in HAP or in futures particularly. ➤ BEELAND INTERESTS AND ITS AFFILIATES AND VAN ECK AND ITS AFFILIATES SHALL NOT HAVE ANY LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS, AND MAKES NO WARRANTY, EXPRESS OR IMPLIED, AS TO RESULTS TO BE OBTAINED BY OWNERS OF HAP, OR ANY OTHER PERSON OR ENTITY FROM THE USE OF RVEI. WITHOUT LIMITING ANY OF THE FOREGOING, IN NO EVENT SHALL BEELAND INTERESTS OR VAN ECK OR ANY OF THEIR RESPECTIVE AFFILIATES HAVE ANY LIABILITY FOR ANY LOST PROFITS OR INDIRECT, PUNITIVE, SPECIAL OR CONSEQUENTIAL DAMAGES OR LOSSES, EVEN IF NOTIFIED OF THE POSSIBILITY THEREOF. ➤ The definition of the index can be found at vaneck.com/hap on the Index Overview tab. MUTUAL FUNDS | ETFs | ETNs | INSURANCE FUNDS | SEPARATE ACCOUNTS | ALTERNATIVE INVESTMENTS
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Page 3 and 4: Contributors Rob Arnott Rob Arnott
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Page 7 and 8: David Smith Publisher dsmith@fa-mag
Page 9 and 10: Editor’s Note Was 2008 A Last Gas
Page 11 and 12: Record-High Correlations Pose Chall
Page 13 and 14: Figure 4 Correlations Of Weekly Ret
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Page 45 and 46: Figure 1 Passive-Passive: Buy-And-H
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Page 49 and 50: Apparent Value Added By Fund Manage
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