The Case for Emerging Market Corporates - IndexUniverse.com
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The Case for Emerging Market Corporates - IndexUniverse.com
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<strong>The</strong> <strong>Case</strong> <strong>for</strong> <strong>Emerging</strong> <strong>Market</strong> <strong>Corporates</strong><br />
William Perry<br />
Individual Country or Broad-<strong>Market</strong> Exposure?<br />
Christopher Philips, Roger Aliaga-Díaz, Joseph Davis and Francis Kinniry<br />
Inflation-Linked Index Products<br />
Brian Upbin, Anand Venkataraman and Scott Harman<br />
Inflationary Quandaries: A Roundtable<br />
Luis Viceira, Michael Ashton, Michael Pond and more<br />
Plus Arnott and Kuo on selection bias, and Blitzer, Krein and Prestbo offering index-provider perspectives
www.journalofindexes.<strong>com</strong><br />
Vol. 14 No. 5<br />
features<br />
<strong>The</strong> <strong>Case</strong> For <strong>Emerging</strong> <strong>Market</strong> <strong>Corporates</strong><br />
By William Perry....................................10<br />
An asset class grows up.<br />
Individual Country Or Broad-<strong>Market</strong> Exposure?<br />
By Christopher Philips, Roger Aliaga-Díaz,<br />
Joseph Davis and Francis Kinniry . . . . . . . . . . . . . . . . . . . . 18<br />
Getting perspective on emerging markets.<br />
Inflation-Linked Index Products: An Overview<br />
By Brian Upbin, Anand Venkataraman<br />
and Scott Harman ..................................22<br />
A guide to some tools <strong>for</strong> hedging inflation.<br />
Inflationary Quandaries: A Roundtable<br />
Luis Viceira, Michael Ashton,<br />
Michael Pond and more.............................28<br />
Experts weigh in on an uncertain topic.<br />
10<br />
Selection Bias<br />
By Robert Arnott and Li-Lan Kuo . . . . . . . . . . . . . . . . . . . . 36<br />
An exploration of matters of choice.<br />
Considerations For <strong>The</strong> Index Shopper<br />
By David Krein and John Prestbo . . . . . . . . . . . . . . . . . . . . 46<br />
Different types of investors make different choices.<br />
From A Provider’s Perspective<br />
By David Blitzer ....................................48<br />
Some insights on a unique business relationship.<br />
Inflation Consternation ..........................64<br />
A little fun to alleviate our readers’ anxiety.<br />
news<br />
MSCI Says Korea, Taiwan Still <strong>Emerging</strong> . . . . . . . . . . . . . . . 50<br />
Russell Rebalances ...................................50<br />
FTSE Acquires DJI’s Share In ICB . . . . . . . . . . . . . . . . . . . . . . 50<br />
<strong>Case</strong>-Shiller Benchmarks Move Higher. . . . . . . . . . . . . . . . . 50<br />
Indexing Developments...............................51<br />
Around <strong>The</strong> World Of ETFs............................54<br />
From <strong>The</strong> Exchanges .................................55<br />
Back To <strong>The</strong> Futures..................................56<br />
Know Your Options ..................................56<br />
On <strong>The</strong> Move ........................................56<br />
data<br />
Selected Major Indexes .............................58<br />
Returns Of Largest U.S. Index Mutual Funds . . . . . . . . . . 60<br />
U.S. <strong>Market</strong> Overview In Style . . . . . . . . . . . . . . . . . . . . . . . 61<br />
U.S. Industry Review ................................62<br />
Exchange-Traded Funds Corner . . . . . . . . . . . . . . . . . . . . . 63<br />
22<br />
36<br />
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www.journalofindexes.<strong>com</strong><br />
September / October 2011<br />
1
Contributors<br />
Roger Aliaga-Díaz<br />
Roger Aliaga-Díaz is a senior economist with the investment strategy group<br />
at Vanguard. Be<strong>for</strong>e joining Vanguard in 2007, he was a visiting professor of<br />
macroeconomics at Drexel University’s LeBow College of Business. Aliaga-<br />
Díaz has presented his research to various groups, including the board of<br />
governors of the Federal Reserve System. He earned his Ph.D. in economics<br />
from North Carolina State University and his B.A. in economics from<br />
Universidad Nacional de Córdoba, Argentina.<br />
Robert Arnott<br />
Robert Arnott is chairman and founder of asset management firm Research<br />
Affiliates LLC. He is also the <strong>for</strong>mer chairman of First Quadrant LP and<br />
has served as a global equity strategist at Salomon Brothers (now part of<br />
Citigroup) and as the president of TSA Capital Management (now part of<br />
Analytic Investors LLC). Arnott was editor-in-chief of the Financial Analysts<br />
Journal from 2002 through 2006. He graduated summa cum laude from the<br />
University of Cali<strong>for</strong>nia, Santa Barbara.<br />
David Blitzer<br />
David Blitzer is managing director and chairman of the Standard & Poor’s<br />
Index Committee. He has overall responsibility <strong>for</strong> security selection <strong>for</strong> S&P’s<br />
indexes and index analysis and management. Blitzer previously served as chief<br />
economist <strong>for</strong> S&P and corporate economist at <strong>The</strong> McGraw-Hill Companies,<br />
S&P’s parent corporation. A graduate of Cornell University with a B.S. in<br />
engineering, he received his M.A. in economics from George Washington<br />
University and his Ph.D. in economics from Columbia University.<br />
David Krein<br />
David Krein is senior director of institutional markets <strong>for</strong> Dow Jones Indexes,<br />
where he serves as a liaison to the institutional investment <strong>com</strong>munity globally,<br />
and guides the research and development of new and enhanced index benchmarks.<br />
Prior to joining DJI, Krein was president of DTB Capital, a firm he founded<br />
in 2006 to develop indexes and structured investment products. Krein holds an<br />
MBA with honors from the University of Chicago Graduate School of Business.<br />
William Perry<br />
William Perry is an executive director <strong>for</strong> Morgan Stanley’s emerging<br />
markets debt team. He joined the firm in 2010 after 16 years at J.P. Morgan,<br />
where he was the head of the Latin American team in the global special<br />
opportunities group. Perry had previously been the credit deputy to the<br />
global head of emerging markets and co-head of EM Corporate research<br />
at J.P. Morgan. He received his MBA in finance from Columbia Business<br />
School and his B.A. from Colgate University in international relations.<br />
Christopher Philips<br />
Christopher Philips, CFA, is a senior investment analyst <strong>for</strong> Vanguard<br />
Investment Strategy Group. This group is responsible <strong>for</strong> capital markets<br />
research, the asset allocations used in solutions <strong>for</strong> Vanguard’s funds-of-funds,<br />
and maintaining and enhancing the investment methodology used <strong>for</strong> advicebased<br />
relationships with high-net-worth and institutional clients. Philips has<br />
authored several research papers on topics of concern to institutional and highnet-worth<br />
audiences. He holds a B.A. from Franklin & Marshall College.<br />
Brian Upbin<br />
Brian Upbin, CFA, CAIA, is a director and head of Index Research in the Barclays<br />
Capital Index, Portfolio and Risk Solutions group. His research is regularly published<br />
in Barclays Capital’s publications, as well as in independent periodicals.<br />
Upbin joined Barclays Capital in September 2008 from Lehman Brothers, where<br />
he was the head of the US Fixed In<strong>com</strong>e Index Strategies team. He received his<br />
B.A. from the University of Pennsylvania and his MBA from Yale University.<br />
2 September / October 2011
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Jim Wiandt<br />
Editor<br />
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Editorial Board<br />
Rolf Agather: Russell Investments<br />
David Blitzer: Standard & Poor’s<br />
Lisa Dallmer: NYSE Euronext<br />
Henry Fernandez: MSCI<br />
Deborah Fuhr<br />
Gary Gastineau: ETF Consultants<br />
Joanne Hill: ProShare and ProFund Advisors LLC<br />
John Jacobs: <strong>The</strong> Nasdaq Stock <strong>Market</strong><br />
Mark Makepeace: FTSE<br />
Kathleen Moriarty: Katten Muchin Rosenman<br />
Don Phillips: Morningstar<br />
John Prestbo: Dow Jones Indexes<br />
James Ross: State Street Global Advisors<br />
Gus Sauter: <strong>The</strong> Vanguard Group<br />
Steven Schoenfeld: Global Index Strategies<br />
Cliff Weber: NYSE Euronext<br />
Review Board<br />
Jan Altmann, Sanjay Arya, Jay Baker, William<br />
Bernstein, Herb Blank, Srikant Dash, Fred<br />
Delva, Gary Eisenreich, Richard Evans,<br />
Gus Fleites, Bill Fouse, Christian Gast,<br />
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September / October 2011
What’s really in your ETF index?<br />
<strong>Market</strong> Vectors Index Methodology<br />
For <strong>Emerging</strong> <strong>Market</strong>s ETF Investors.<br />
➤ Liquid.<br />
Each stock must meet minimum requirements <strong>for</strong> market capitalization and daily trading volume. 1<br />
Improves ability to track index.<br />
➤ Inclusive.<br />
Includes publicly traded <strong>com</strong>panies deriving at least 50% of their revenues from a country, even if the<br />
<strong>com</strong>pany is listed, domiciled or headquartered elsewhere. Many emerging market <strong>com</strong>panies list in<br />
New York, Hong Kong, London and Toronto.<br />
➤ Diversified.<br />
Stock weightings are capped at 8%, often resulting in greater diversification by holding and by sector.<br />
➤ Transparent.<br />
Constituents and weights are updated and published daily, and are accessible <strong>for</strong> free at vaneck.<strong>com</strong>.<br />
<strong>Market</strong> Vectors Indonesia Index ETF (IDX) 2<br />
Based on the <strong>Market</strong> Vectors Indonesia Index (MVIDXTR) 3<br />
➤ Inclusive and diversified Indonesia exposure.<br />
➤ Constituents must meet minimum liquidity requirements.<br />
➤ See the latest fund per<strong>for</strong>mance and get the full<br />
list of index constituents and weights, updated<br />
daily, at vaneck.<strong>com</strong>/idx.<br />
1<br />
To be “liquid,” a stock must have: a market cap over USD $150 million, a three-month average daily trading volume over USD $1 million, and traded<br />
at least 250,000 shares per month over the last six months.<br />
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Factors identified refer to the index.<br />
<strong>The</strong> Fund is subject to elevated risks, including those associated with investing in <strong>for</strong>eign securities, in particular in Indonesian<br />
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Investors should be willing to accept a high degree of volatility and the potential of significant loss. <strong>The</strong> Fund may loan its securities, which may<br />
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Editor’s Note<br />
Dueling Topics<br />
Jim Wiandt<br />
Editor<br />
Setting aside the debt ceiling debacle <strong>for</strong> a moment, two interlinked topics have<br />
been at the top of investors’ thoughts over the past several months: emerging<br />
markets and inflation.<br />
<strong>Emerging</strong> markets, of course, have been on a tear—at least <strong>com</strong>pared with developed<br />
economies—<strong>for</strong> the past few years. We kick off the issue with a <strong>com</strong>prehensive<br />
article from William Perry of Morgan Stanley, who unrolls a wealth of data to support<br />
his argument that emerging market corporate bonds have grown up into an asset<br />
class worthy of attention. Christopher Philips—with Roger Aliaga-Díaz, Joseph Davis<br />
and Francis Kinniry Jr.—follows with a succinct argument <strong>for</strong> taking a broad-based<br />
approach when investing in emerging markets.<br />
Next, we shift gears somewhat to examine the range of available inflation-linked<br />
products, including those providing opportunities in emerging markets, with an offering<br />
from Barclays Capital’s Brian Upbin, Anand Venkataraman and Scott Harman.<br />
Inflation is, of course, on everyone’s mind, not just EM investors, so we’ve gathered<br />
a panel of people in the know to offer their insights on the topic in our latest<br />
roundtable, including Luis Viceira of Harvard Business School, Michael Ashton of<br />
Enduring Investments, Michael Pond of Barclays Capital, WisdomTree’s Rick Harper,<br />
Christopher Whalen of Institutional Risk Analytics, and IndexIQ’s Adam Patti.<br />
<strong>The</strong>n, Rob Arnott takes us off-theme on a detailed <strong>com</strong>parison of the Fortune 500 and<br />
the S&P 500 that focuses on the impact of selection bias. It’s sure to pique the interest of<br />
any index nerd. David Blitzer weighs in with a meditation on the working relationship<br />
between index providers and fund managers, from the index provider’s perspective. And<br />
David Krein and John Prestbo offer some guidelines <strong>for</strong> the index end user.<br />
We wrap up the issue with a brain teaser of our own, an inflation-focused crossword<br />
puzzle. Whether the macro-economy is in an inflationary or deflationary environment<br />
and your country is good <strong>for</strong> its debts or not, we send you best wishes <strong>for</strong> a healthy<br />
investment portfolio heading into the fall.<br />
Jim Wiandt<br />
Editor<br />
8<br />
September / October 2011
VEU<br />
Vanguard FTSE All-World ex-U.S. ETF<br />
VEU has 3 times more index coverage than the<br />
industry average.*<br />
Every client’s portfolio could use some Vanguarding. ®<br />
Broader coverage can mean more accurate tracking. That’s why you should take a closer<br />
look at the Vanguard FTSE All-World ex-U.S. ETF. With 3 times more coverage than the<br />
industry average, it can help your clients build a more solid portfolio.<br />
Take a closer look at advisors.vanguard.<strong>com</strong>/ VEU<br />
800-523-1145<br />
All investments are subject to risk. Vanguard funds are not insured or guaranteed.<br />
To buy or sell Vanguard ETF Shares, contact your financial advisor. Usual <strong>com</strong>missions apply. Not redeemable.<br />
<strong>Market</strong> price may be more or less than NAV.<br />
For more in<strong>for</strong>mation about Vanguard ETF Shares, visit advisors.vanguard.<strong>com</strong>/VEU, call 800-523-1145, or contact<br />
your broker to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important in<strong>for</strong>mation<br />
are contained in the prospectus; read and consider it carefully be<strong>for</strong>e investing.<br />
Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of <strong>com</strong>panies in<br />
emerging markets are generally more risky than stocks of <strong>com</strong>panies in developed countries.<br />
*Source: Morningstar as of 05/01/2011. Based on 2011 industry average holdings of 672 <strong>for</strong> international/global ETFs<br />
and Vanguard VEU holdings of 2,297.<br />
© 2011 <strong>The</strong> Vanguard Group, Inc. All rights reserved. U.S. Pat. No. 6,879,964 B2; 7,337,138. Vanguard <strong>Market</strong>ing Corporation, Distributor.
<strong>The</strong> <strong>Case</strong> For<br />
<strong>Emerging</strong> <strong>Market</strong> <strong>Corporates</strong><br />
An asset class emerges<br />
By William Perry<br />
10<br />
September / October 2011
Over the last decade, emerging market (EM) economies<br />
have benefited greatly from macroeconomic<br />
stabilization and the liberalization of trade and<br />
financial markets. Most of these countries have enjoyed<br />
robust gross domestic product (GDP) growth both on an<br />
absolute basis and relative to more developed economies.<br />
As a result, they have experienced dramatic economic<br />
trans<strong>for</strong>mations and accelerated public sector deleveraging.<br />
Gradually, local regulators have improved bankruptcy<br />
regimes, market transparency and investor rights. This<br />
has resulted in higher levels of <strong>for</strong>eign direct investment<br />
and capital markets activity, which has greatly benefited<br />
the growth of local corporations.<br />
Given this positive macro backdrop, improved legal<br />
environment and supportive demographics, <strong>com</strong>panies<br />
from many of these EM countries have been able to<br />
increase their access to the international markets <strong>for</strong> both<br />
debt and equity, broaden their investor base and extend<br />
their maturity profiles. In several instances, EM corporates<br />
have grown into global leaders in their respective sectors.<br />
Since early 2000, EM corporate debt has evolved from<br />
a marginal market with $20 billion in annual issuance<br />
volume (mostly from Latin American issuers) to a global<br />
market with average annual issuance in excess of $100<br />
billion with representation from all four major regions<br />
(Asia, Latin America, Central and Eastern Europe, and<br />
the Middle East/Africa). 1 EM corporate fixed in<strong>com</strong>e has<br />
effectively be<strong>com</strong>e an asset class in its own right, with<br />
projections that outstanding corporate debt will exceed<br />
$1 trillion in the next several years.<br />
As valuations <strong>for</strong> EM external sovereign debt reach alltime<br />
highs, fueled by record inflows and reduced sovereign<br />
issuance, traditional EM investors are selectively increasing<br />
their allocations to EM corporate debt. Furthermore,<br />
global high-yield and investment-grade fixed-in<strong>com</strong>e<br />
investors—or “crossover” investors—are also be<strong>com</strong>ing<br />
more actively involved in the asset class. An additional catalyst<br />
to interest in the sector is the recent development of<br />
the Corporate <strong>Emerging</strong> <strong>Market</strong>s Bond Index, 2 or CEMBI,<br />
<strong>for</strong> external hard-currency debt obligations. Today there<br />
are approximately $10 billion in assets under management<br />
benchmarked against various CEMBI indexes, with expectations<br />
that this will double by the end of 2011.<br />
We believe that an allocation to EM corporate debt<br />
could be an attractive option <strong>for</strong> investors seeking an<br />
opportunity to diversify away from other traditional<br />
fixed-in<strong>com</strong>e asset classes and add potential excess riskadjusted<br />
returns. In most instances, EM corporate debt<br />
investments still offer a positive basis over both sovereign<br />
benchmark bonds and <strong>com</strong>parable developed-market<br />
high-yield and investment-grade corporate fixedin<strong>com</strong>e<br />
securities—which is particularly <strong>com</strong>pelling in<br />
the current low-interest-rate U.S. Treasury environment.<br />
When <strong>com</strong>paring potential returns—taking into account<br />
historical default levels of high-yield EM corporates versus<br />
those of U.S. high-yield indexes—the argument <strong>for</strong><br />
allocating assets to EM corporates be<strong>com</strong>es, in our view,<br />
even more <strong>com</strong>pelling.<br />
An Asset Class Emerges<br />
<strong>The</strong> per<strong>for</strong>mance of emerging economies over the past<br />
decade has been notable, both on an absolute basis and relative<br />
to developed markets. Given both prudent economic<br />
policies and supportive external conditions, EM economic<br />
growth has been strong and remained positive throughout<br />
the global recession of 2008-09 (Figure 1). Today the underlying<br />
macroeconomic fundamentals of emerging markets<br />
are, in many instances, superior to those of the developed<br />
world—most emerging economies have lower debt levels,<br />
healthier fiscal balances and stronger debt positions than<br />
their developed counterparts (Figure 2).<br />
Developing governments have also made significant<br />
progress in other areas, such as strengthening property<br />
rights, rein<strong>for</strong>cing legal frameworks and improving creditor<br />
rights. This has resulted in greater investment flows,<br />
burgeoning local equity markets and increasing international<br />
capital-raising activity. Foreign direct investment<br />
flows to emerging markets, <strong>for</strong> example, have grown<br />
steadily from $139 billion in 1997 to a projected $251 billion<br />
<strong>for</strong> 2011. 3<br />
EM countries are also further diversifying their sources<br />
of economic growth by gradually shifting their export<br />
bases from developed countries to more intra-EM trade.<br />
Intra-EM exports grew from less than $24 billion in 1999<br />
to nearly $37 billion in 2009; at the same time, exports to<br />
developed economies fell from nearly $74 billion in 1999<br />
to less than $61 billion in 2009. 4<br />
EM countries have further enjoyed more attractive<br />
demographic trends (population growth, emergence of<br />
middle-class consumers 5 ) and larger labor <strong>for</strong>ces, which<br />
will continue to drive domestic demand and economic<br />
output. <strong>The</strong>se new markets provide an important source<br />
of diversification that continues to support emerging market<br />
growth in spite of weak external demand. Geographic<br />
and product diversification has reduced contagion risks<br />
through lower exposures to one particular region or mar-<br />
Figure 1<br />
10%<br />
8%<br />
6%<br />
4%<br />
2%<br />
0%<br />
-2%<br />
-4%<br />
<strong>Emerging</strong> <strong>Market</strong> Growth Exceeds<br />
Developed <strong>Market</strong> Growth*<br />
‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09E ‘10F ‘11F<br />
N Developed<br />
N <strong>Emerging</strong> <strong>Market</strong>s<br />
* Weighted average of 40 emerging economies.<br />
Forecasts/estimates are based on current market conditions, subject to<br />
change, and may not necessarily <strong>com</strong>e to pass.<br />
Source: MSIM, Official Source. Data as of August 2010.<br />
www.journalofindexes.<strong>com</strong> September / October 2011<br />
11
Figure 2<br />
GDP (%)<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
0<br />
-50<br />
-100<br />
Fundamentals In <strong>Emerging</strong> <strong>Market</strong>s<br />
Are More Robust Than In Developed Countries<br />
Japan<br />
U.S.<br />
Europe<br />
Greece<br />
Portugal<br />
Spain<br />
N Fiscal Deficit/GDP 2011 N Public Gross Debt/GDP 2010 (lhs)<br />
L Real GDP Growth 2011<br />
ket, opening up new markets <strong>for</strong> the corporate sector.<br />
In this environment, we expect greater <strong>for</strong>eign direct<br />
investment (FDI) allocations to EM countries, more global<br />
M&A activity, local industry consolidation and greater<br />
private equity involvement—all of which should be positive<br />
catalysts <strong>for</strong> corporate credit. As the global economic<br />
backdrop continues to improve and EM growth continues<br />
to outpace other markets, we expect EM corporate credits<br />
to be the major beneficiaries.<br />
Poland<br />
Brazil<br />
Source: MSIM, Official Source. Data as of August 2010.<br />
Figure 3<br />
Spread (bps)<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
0<br />
Dec<br />
2001<br />
Turkey<br />
Mexico<br />
S. Africa<br />
Indonesia<br />
<strong>Corporates</strong> Are <strong>The</strong> Fast-Growing Sector<br />
Of <strong>The</strong> <strong>Emerging</strong> <strong>Market</strong> Asset Class*<br />
Dec<br />
2002<br />
Dec<br />
2003<br />
Dec<br />
2004<br />
Dec<br />
2005<br />
Dec<br />
2006<br />
Dec<br />
2007<br />
N CEMBI Broad Div. 6 N GBI Global 7 N EMBIG 8<br />
China<br />
Dec<br />
2008<br />
Russia<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
-4<br />
Dec<br />
2009<br />
* Calculated as market capitalization of the index “deflated” by index per<strong>for</strong>mance.<br />
Source: MSIM based on JP Morgan index data. Data as of August 2010.<br />
(%)<br />
Corporate Issuance Growing<br />
Today corporate issuers <strong>com</strong>prise a growing <strong>com</strong>ponent<br />
of the outstanding debt stock of EM fixed in<strong>com</strong>e,<br />
and now represent the fastest-growing sector of the EM<br />
asset class (Figure 3). As of August 2010, outstanding corporate<br />
issuance stands at more than $600 billion (Figure<br />
4), or approximately 45 percent of the size of the outstanding<br />
EM external debt market and more than 60 percent of<br />
the U.S. high-yield market, with estimates that it will grow<br />
to in excess of $1 trillion in the next several years.<br />
<strong>The</strong> asset class has evolved into a diverse cross section<br />
of geographies, with the four major regions—Asia, Latin<br />
America and CEEMEA (Central and Eastern Europe, the<br />
Middle East/Africa)—each representing about one-third<br />
of the exposure with diversity across all major industries<br />
(Figure 5). Interestingly, the majority of outstanding debt<br />
is rated investment grade, particularly in Asia, where<br />
more than 80 percent of the corporate debt is investment<br />
grade (Figure 6).<br />
Since early 2000, EM corporates have evolved from<br />
a marginal market with $20 billion in annual issuance<br />
volumes (mostly from Latin American issuers) to a global<br />
market with average annual issuance volumes in excess<br />
of $100 billion (Figure 7), with representation from all<br />
four major regions. Several factors have contributed to<br />
this increase in corporate issuance: 1) the maturity of the<br />
major EM sovereign markets and their rapid evolution to<br />
investment-grade status; 2) a concurrent reduction in sovereign<br />
issuance; 3) accessibility to longer-term financing<br />
than available in local markets; and 4) historically attractive<br />
long-term funding rates.<br />
With increased globalization and cross-border M&A, 9<br />
many industries across the sector are undergoing greater<br />
consolidation—whether expanding domestically or internationally—or<br />
are being acquired by larger global players,<br />
resulting in an even greater need <strong>for</strong> financing.<br />
Credit Trends And Technical Support<br />
In the current environment, EM corporates have been<br />
on an improving trajectory, as measured by recent ratings<br />
agency actions. Credit improvement can be seen in<br />
the upgrades/downgrades ratio, 10 which fell to a cumulative<br />
level of 1.3 year-to-date in mid-July from a monthly<br />
high of 2.5 in April (Figure 8). On average, EM corporates<br />
have better credit metrics than similarly rated U.S. and<br />
Figure 4<br />
USD $billion<br />
5,000<br />
4,500<br />
4,000<br />
3,500<br />
3,000<br />
2,500<br />
2,000<br />
1,500<br />
1,000<br />
500<br />
0<br />
Estimated Corporate Debt Stock<br />
At Year End 2009<br />
4,500<br />
975<br />
Source: JP Morgan. Data as of August 2010.<br />
605<br />
140<br />
US IG US HY EM Euro HY<br />
12<br />
September / October 2011
international peers. Interestingly, many of the high-yield<br />
ratings in the asset class are due to sovereign ratings constraints,<br />
rather than to any underlying structural or legal<br />
subordination more typically associated with traditional<br />
high-yield issuers. 11 Consequently, as the underlying<br />
sovereign ratings are reviewed, we would expect concurrent<br />
upgrades to the respective sovereigns.<br />
On the technical side, there are three <strong>for</strong>ces at work that,<br />
in our view, should all positively affect the per<strong>for</strong>mance of<br />
EM corporate debt: 1) strong inflows into the entire EM<br />
fixed-in<strong>com</strong>e asset class; 2) increasing corporate allocations<br />
by both EM sovereign and crossover investors; and<br />
3) a shortage of developed-market credit product.<br />
Data from various market sources including <strong>Emerging</strong><br />
Portfolio Fund Research, Bloomberg and J.P. Morgan<br />
suggest that inflows into EM <strong>for</strong> full-year 2010 should be<br />
in the range of $70 billion to $75 billion. Inflows through<br />
July suggest that we have already seen $50 billion to $55<br />
billion <strong>com</strong>e into the market, or $7 billion per month <strong>for</strong><br />
the first seven months of 2010, <strong>com</strong>pared with $3.9 billion<br />
per month in 2009. This includes inflows from strategic,<br />
mutual fund and Japanese investment trust sources, with<br />
mutual funds being the most significant contributors.<br />
On the EM side, a recent investor survey by J.P.<br />
Morgan suggests that traditional EM external sovereign<br />
managers have increased their EM corporate allocations<br />
on average by 500 basis points over 2009 levels, from 19<br />
percent to 24 percent of assets under management.<br />
As Figure 9 highlights, there has also been a decline<br />
of approximately $1.3 trillion in developed-market credit<br />
product since 2007, particularly following the disruption<br />
in the structured product markets. We would expect this<br />
to induce crossover investors to further consider EM corporate<br />
debt as an alternative.<br />
Development Of <strong>The</strong> CEMBI<br />
An additional catalyst <strong>for</strong> the sector is the recent<br />
development of the Corporate <strong>Emerging</strong> <strong>Market</strong>s Bond<br />
Index, or CEMBI. Introduced in 2007, the CEMBI consists<br />
of U.S.-denominated EM corporate bonds and was<br />
created in response to investor demand <strong>for</strong> a representative<br />
benchmark. CEMBI (Figure 10) is categorized by a<br />
traditional market-weighted approach. Another index,<br />
the CEMBI Diversified, was created to limit the weights of<br />
index countries with larger corporate debt stocks.<br />
Most EM corporate mandates (85 percent) are<br />
benchmarked to the CEMBI Broad Diversified, given<br />
the broader geographic <strong>com</strong>position, permitted investments<br />
and limit on geographic concentration. 12 As of<br />
mid-2010, there is already an estimated $8 billion to<br />
$10 billion in assets benchmarked against the various<br />
CEMBI indexes, with expectations <strong>for</strong> that to double by<br />
the end of 2011. 13<br />
<strong>The</strong> CEMBI utilizes a broad regional classification <strong>for</strong><br />
inclusion: countries in Asia ex Japan, Eastern Europe,<br />
Middle East/Africa and Latin America, resulting in a<br />
broader list of countries than in traditional indexes such<br />
as the J.P. Morgan <strong>Emerging</strong> <strong>Market</strong>s Bond Index Global<br />
Figure 5<br />
100%<br />
50%<br />
0%<br />
Asia<br />
82%<br />
18%<br />
Asia, Latin America And<br />
CEEMEA Diversity Across Industries<br />
Metals<br />
6.50%<br />
Industrials<br />
21.22%<br />
Tele<strong>com</strong><br />
13.24%<br />
Retail<br />
3.19%<br />
47%<br />
53%<br />
<strong>Emerging</strong><br />
Europe<br />
Investment Grade<br />
Oil<br />
13.84%<br />
Banks<br />
31.24%<br />
High Rates Of Investment-Grade Debt In<br />
Asia, Latin America And CEEMEA<br />
(EMBIG) or MSCI <strong>Emerging</strong> <strong>Market</strong>s Index 14 (Figure 11).<br />
Portfolios, however, can be constructed to eliminate more<br />
developed-country exposure <strong>for</strong> those investors looking<br />
59%<br />
41%<br />
Latin<br />
America<br />
High Yield<br />
Utilities<br />
10.78%<br />
Source: MSIM based on JP Morgan index data. Data as of August 2010.<br />
Figure 6<br />
Source: MSIM based on JP Morgan index data. Data as of August 2010.<br />
Figure 7<br />
USD billion<br />
140<br />
120<br />
100<br />
80<br />
60<br />
40<br />
20<br />
0<br />
<strong>The</strong> Evolution Of <strong>Emerging</strong> <strong>Market</strong><br />
Corporate Issuance<br />
88%<br />
12%<br />
ME &<br />
Africa<br />
‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 YTD<br />
Source: Bond Radar. Data as of August 2010.<br />
www.journalofindexes.<strong>com</strong> September / October 2011<br />
13
Figure 8<br />
Historical <strong>Emerging</strong> <strong>Market</strong> Corporate Improvement<br />
As Displayed By Issuer Rating Upgrades And Downgrades<br />
Number of upgrades/downgrades<br />
45<br />
40<br />
35<br />
30<br />
25<br />
20<br />
15<br />
10<br />
Source: JP Morgan. Data as of August 2010.<br />
Figure 9<br />
$921<br />
2004<br />
5<br />
0<br />
1/10 2/10 3/10 4/10 5/10 6/10 7/10 8/10<br />
Upgrades Downgrades<br />
— Cum. upgrades to downgrades ratio (rhs)<br />
Decline In Developed-<strong>Market</strong> Credit Issuance:<br />
An Opportunity For EM <strong>Corporates</strong><br />
$1,226<br />
2005<br />
$1,565<br />
2006<br />
$1,515<br />
2007<br />
$242<br />
2008<br />
-$1.3tn decline<br />
$345<br />
2009<br />
-$20<br />
F2010<br />
$292<br />
F2011<br />
HG HY Non-agency MBS EM <strong>Corporates</strong> BABs<br />
Agency MBS CMBS ABS CLOs<br />
Note: For EM corporates, about 46% are currently investment-grade corporates.<br />
ABS includes Autos, credit cards and student loans.<br />
Source: JP Morgan. Data as of June 2010.<br />
to more closely approximate true EM exposure.<br />
Given the broader geographic representation, the<br />
CEMBI Broad is, in fact, predominantly investment grade,<br />
with close to a 70 percent weighting. With continued<br />
global issuance, the CEMBI Broad is now also sufficiently<br />
diverse, with no major geographic concentrations and<br />
wide-ranging representation across all major industry<br />
sectors. At the time this article was written, Asia represented<br />
nearly 41 percent of the index, followed by emerging<br />
Europe at 12.4 percent, Latin America at 28.47 percent<br />
and Middle East/Africa at 18.25 percent.<br />
Lower Default Expectations<br />
And Higher Risk Premia<br />
From a peak of 11.5 percent in 2009, market strategists<br />
expect default rates to <strong>com</strong>e in below 2 percent <strong>for</strong> 2010,<br />
which is in line with expectations <strong>for</strong> the U.S. high-yield<br />
1.4<br />
1.3<br />
1.2<br />
1.1<br />
1.0<br />
0.9<br />
0.8<br />
0.7<br />
0.6<br />
0.5<br />
Upgrades/downgrades ratio<br />
$389<br />
F2012<br />
market. 15 In the context of recent historical returns <strong>for</strong><br />
EM corporates, the securities have delivered higher risk<br />
premia over the default and business-cycle risk than are<br />
typically found in other asset classes.<br />
Over the last decade, the average EM corporate<br />
default rate was actually lower than the average U.S.<br />
corporate default rate, and has only exceeded U.S.<br />
default levels in three of the last 10 years. 16 If the <strong>com</strong>pensation-to-default<br />
risk is priced equally <strong>for</strong> all asset<br />
classes, then EM corporate spreads should be around<br />
the same level as U.S. corporate spreads, after accounting<br />
<strong>for</strong> business-cycle risk.<br />
To calculate the business-cycle risk, we take a capital<br />
asset pricing model (CAPM) approach. 17 Using four<br />
fixed-in<strong>com</strong>e asset classes—EM corporates, U.S. credit,<br />
U.S. high yield and EM sovereigns—we regress monthly<br />
excess returns since January 2003 on the historical excess<br />
return of the S&P 500. We then calculate the required<br />
risk premium associated with business-cycle risk from<br />
this CAPM regression and subtract it from the prevailing<br />
option-adjusted spread in each asset class. Figure<br />
12 plots the evolution of spreads adjusted <strong>for</strong> businesscycle<br />
risk <strong>for</strong> the four fixed-in<strong>com</strong>e asset classes.<br />
As the chart illustrates, the risk premium from EM<br />
corporate over business-cycle risk is higher than that of<br />
U.S. investment-grade credit and EM sovereigns, and<br />
is consistent with the level of premium found in U.S.<br />
high yield. However, U.S. high yield should have higher<br />
default realizations than those we showed earlier <strong>for</strong><br />
U.S. and EM corporates. <strong>The</strong>re<strong>for</strong>e, the effective premium<br />
above default and business cycle <strong>com</strong>ing from<br />
EM corporates is unique and higher than those found in<br />
other <strong>com</strong>mon fixed-in<strong>com</strong>e asset classes.<br />
Economic And Diversification Rationale<br />
<strong>The</strong> two principal reasons to consider incorporating an<br />
EM corporate bond allocation to a global bond portfolio are<br />
return enhancement and diversification from core markets.<br />
For the last several years, EM corporate bonds have<br />
Figure 10<br />
CEMBI Characteristics Compared To Other Asset Classes*<br />
CEMBI<br />
Broad<br />
Div<br />
CEMBI<br />
Broad<br />
Div<br />
Only<br />
EM<br />
EMBI<br />
Global<br />
Barcap<br />
U.S.<br />
Corp 18<br />
Barcap<br />
U.S.<br />
High<br />
Yield 19<br />
Mkt Cap (USD bn) 114.7 71.6 381.2 2,716.7 830.3<br />
Avg. Life (years) 7.8 8.1 11.8 10.3 6.8<br />
Duration (years) 5.0 5.3 7.2 6.6 4.3<br />
YTM (%) 5.9 6.8 5.4 4.1 8.7<br />
Spread (bps) 395 457 289 182 687<br />
Speed Duration (%) 5.2 5.2 6.8 6.4 4.2<br />
Avg. Rating BBB BB+ BB+ A- B+<br />
* Calculated using simple weighting. Data as of August 2010. Past per<strong>for</strong>mance is<br />
no guarantee of future results.<br />
Source: MSIM based on JPMorgan and Barclays index data.<br />
14<br />
September / October 2011
Figure 11<br />
Country Weights Of <strong>The</strong> CEMBI<br />
7<br />
6<br />
6.7<br />
6.6 6.6<br />
6.4<br />
6.3<br />
6.0<br />
5.8 5.8 5.7<br />
5.0<br />
5<br />
Weight (%)<br />
4<br />
3<br />
2<br />
3.6<br />
3.1 3.0 2.9 2.8<br />
2.6<br />
2.4<br />
2.2 2.2 2.2<br />
1.7<br />
1.4 1.4 1.2<br />
0.9 0.9 0.9<br />
1<br />
0<br />
Hong Kong<br />
Brazil<br />
Russia<br />
Korea<br />
Mexico<br />
UAE<br />
India<br />
Qatar<br />
Singapore<br />
China<br />
Colombia<br />
Malaysia<br />
Chile<br />
Kazakhstan<br />
Indonesia<br />
Jamaica<br />
Thailand<br />
Peru<br />
S. Africa<br />
Ukraine<br />
Israel<br />
Argentine<br />
Philippines<br />
Turkey<br />
Saudi Arabia<br />
Kuwait<br />
Egypt<br />
Taiwan<br />
Barbados<br />
Bahrain<br />
Macau<br />
Venezuela<br />
Nigeria<br />
Lebanon<br />
Panama<br />
El Salvador<br />
0.7 0.6 0.5 0.5<br />
0.3 0.3 0.3 0.3 0.2<br />
Source: MSIM based on JP Morgan. Data as of August 2010.<br />
enjoyed high returns in both absolute and relative terms.<br />
<strong>The</strong> potential return enhancement of an EM corporate<br />
portfolio is demonstrated in Figure 13, which provides<br />
cumulative returns <strong>for</strong> various fixed-in<strong>com</strong>e asset classes<br />
going back to 2002. To better understand the drivers of the<br />
CEMBI, we have further reclassified the returns to reflect<br />
both high-yield and investment-grade sub<strong>com</strong>ponents<br />
and created a “CEMBI-EM only” category to remove the<br />
dilutive effect of returns from the more developed markets<br />
included in the broader index.<br />
As the chart illustrates, on an aggregate basis, the<br />
CEMBI Broad high-yield sub<strong>com</strong>ponent has outper<strong>for</strong>med<br />
all other fixed-in<strong>com</strong>e asset classes since 2002.<br />
As such, one can make a strong case <strong>for</strong> introducing EM<br />
high-yield corporates to any of these fixed-in<strong>com</strong>e portfolios<br />
as a means of adding potential alpha—particularly<br />
so to U.S. corporate portfolios, when considering the<br />
historical default data discussed above. Furthermore,<br />
when <strong>com</strong>paring the CEMBI Broad Diversified with the<br />
J.P. Morgan U.S. Liquid Index (JULI) 20 credit portfolios,<br />
the index outper<strong>for</strong>med by an incremental 30 percent<br />
and approximately 16 percent when <strong>com</strong>paring only the<br />
investment-grade <strong>com</strong>ponent of the CEMBI to the equivalent<br />
U.S. benchmark.<br />
<strong>The</strong> 2008-09 global financial crisis and the recent sovereign<br />
debt problems in Europe have demonstrated the<br />
benefits of diversifying away from core markets. Indeed,<br />
even though all risky assets sold off during the global turmoil,<br />
EM corporate debt recovered faster due to stronger<br />
fundamentals and better growth prospects.<br />
In addition to their different risk profiles relative to<br />
the developed world, emerging market corporates are<br />
diversified among themselves across country, region,<br />
industry and credit quality. As such, an EM corporate<br />
portfolio can help reduce regional and idiosyncratic<br />
risks while also benefiting from differences in business<br />
cycles across regions.<br />
By applying modern portfolio theory, we can see that<br />
EM corporates can be additive to an underlying fixedin<strong>com</strong>e<br />
portfolio. Figure 14 shows the efficient frontier<br />
of two global portfolios including EM corporates. <strong>The</strong><br />
effects of adding EM corporates to a global fixed-in<strong>com</strong>e<br />
portfolio can be beneficial, as risk/return <strong>com</strong>binations<br />
potentially maximize the return while reducing the overall<br />
risk of the portfolios.<br />
Risk Considerations Of EM Corporate <strong>The</strong>sis<br />
An EM corporate investment strategy is not without<br />
risk. Principal issues to consider include: size and liquidity;<br />
market beta versus the underlying sovereign benchmark;<br />
potential <strong>for</strong> <strong>for</strong>eign exchange mismatches; and<br />
limited creditor en<strong>for</strong>cement rights.<br />
r #Z UIFJS OBUVSF HJWFO UIFJS TNBMMFS TDBMF BOE NPSF<br />
limited financing needs, EM corporate issues are typically<br />
www.journalofindexes.<strong>com</strong> September / October 2011<br />
15
Figure 12 Figure 14<br />
Spreads Over Business-Cycle Risk Premia For EM<br />
<strong>Corporates</strong>, U.S. Credit, U.S. High Yield And EM Sovereigns<br />
Positive Potential Risk/Return Effects From Adding EM<br />
<strong>Corporates</strong> To A Fixed In<strong>com</strong>e Portfolio<br />
1,600<br />
(bps)<br />
1,400<br />
1,200<br />
1,000<br />
800<br />
600<br />
400<br />
200<br />
0<br />
Dec<br />
2006<br />
Jun<br />
2007<br />
Dec<br />
2007<br />
Jun<br />
2008<br />
Dec<br />
2008<br />
Jun<br />
2009<br />
Dec<br />
2009<br />
EM CEMBI Barcap U.S. Credit Barcap U.S. HY EMBIG<br />
Jun<br />
2010<br />
Note: EM corporate debt is represented by the JPMorgan CEMBI Broad Diversified<br />
Index. EM sovereign debt is represented by the JPMorgan EMBIG Index. U.S.<br />
investment-grade debt is represented by the JPMorgan JULI Index.U.S. high-yield<br />
debt is represented by the JPMorgan Domestic High Yield Index. 21<br />
Source: MSIM based in JP Morgan index data. Data as of August 2010.<br />
Figure 13<br />
Annualized Return (%)<br />
12<br />
10<br />
8<br />
6<br />
7 8 9 10 11<br />
Annualized Standard Deviation (%)<br />
N EM Corps Vs Trsy Dev. ex-US<br />
N EM Corps Vs US High Yield<br />
EM <strong>Corporates</strong> Variance Minimizing Mix With:<br />
EM Corporate Debt 75%<br />
EM Corporate Debt 43%<br />
U.S. High Yield 25%<br />
Trsy Dev. ex-U.S. 57%<br />
Note: EM Corps representatives of the JP Morgan CEMBI Broad Diversified Index.<br />
Source: MSIM based on JP Morgan index data. Data as of August 2010.<br />
<br />
<br />
CEMBI Broad<br />
Div HY<br />
GBI-EM Gbl Div<br />
EMBI Global<br />
US High Yield<br />
CEMBI Broad<br />
Div Only EM<br />
CEMBI Broad Div<br />
CEMBI Broad<br />
Div IG<br />
Trsy Dev. ex-US<br />
US Corps IG<br />
US Securitized<br />
US Treasury<br />
13.9%<br />
13.7%<br />
11.8%<br />
10.1%<br />
9.8%<br />
8.8%<br />
7.7%<br />
7.4%<br />
6.4%<br />
5.4%<br />
5.1%<br />
48.9%<br />
45.8%<br />
59.7%<br />
76.0%<br />
72.1%<br />
90.0%<br />
107.3%<br />
103.4%<br />
132.7%<br />
168.1%<br />
164.0%<br />
0% 20% 40% 60% 80% 100% 120% 140% 160% 180%<br />
Annualized returns since 2002 Cumulative returns since 2002<br />
"! Treasury Developed Ex-U.S. as represented by the JPMorgan GBI Broad excluding<br />
the U.S. U.S. Corps IG is represented by the JPMorgan JULI Index. 20 U.S. High Yield is<br />
represented by the JPMorgan Domestic High Yield Index. U.S. Securitized is represented<br />
by the Barclays Capital U.S. Securitized Bond Index. 22 U.S. Treasury is represented by the<br />
JPMorgan’s GBI Broad U.S. sub index.<br />
!MSIM based on JPMorgan, Barclays and Bloomberg data. Data as of August 2010.<br />
smaller and less liquid than their sovereign counterparts,<br />
resulting in wider bid/offer spreads. <strong>The</strong> average issue<br />
size as of September 2010 among EM corporate issuers<br />
has been $450 million versus more than $1 billion <strong>for</strong><br />
EM sovereign issuers. 23 Many issuers, in fact, may only<br />
have one bond outstanding, particularly as the number<br />
of debut issuers increases. With the passage of time, however,<br />
we are seeing <strong>com</strong>panies build out more <strong>com</strong>prehensive<br />
yield curves, though this is more typical <strong>for</strong> the<br />
larger capitalized credits such as the tele<strong>com</strong>s, financials,<br />
metals and mining, and oil <strong>com</strong>panies.<br />
r )JTUPSJDBMMZ JO UJNFT PG NBSLFU WPMBUJMJUZ XF IBWF<br />
seen EM portfolio managers favor more liquid investments;<br />
there<strong>for</strong>e, they reduce their corporate exposure<br />
be<strong>for</strong>e their sovereign exposure. Thus, bonds can overshoot<br />
on the way down, and be slower to rebound during<br />
a recovery. Typically, these anomalies will correct themselves<br />
over time, but investors should be sensitive to this<br />
potential <strong>for</strong> higher associated volatility.<br />
r8IJMFNBOZJTTVFSTUSZUPUBLFBEWBOUBHFPGUIFMPOHFS<br />
BWBJMBCMFUFOPSTJOUIFJOUFSOBUJPOBMDBQJUBMNBSLFUTUIFZ<br />
can, in certain circumstances, concurrently increase the<br />
MFWFM PG UIF BTTPDJBUFE GPSFJHO FYDIBOHF SJTL JF JODVS<br />
external debt obligations while only generating local<br />
currency cash flows. While less relevant to exporters<br />
and countries with more stable <strong>for</strong>ex policies, corporate<br />
defaults have arisen specifically due to these mismatches,<br />
as was the case in Argentina in 2002-2003.<br />
r 8IJMF SFHVMBUPST JO NBOZ DPVOUSJFT IBWF SFDFOUMZ<br />
JNQSPWFEUIFJSCBOLSVQUDZDPEFTBOEBTTPDJBUFEDSFEJUPS<br />
rights, investor en<strong>for</strong>cement rights are still significantly<br />
XFBLFS UIBO JO NPSF EFWFMPQFE DPVOUSJFT 4IBSFIPMEFS<br />
reputation and character of management are, there<strong>for</strong>e,<br />
crucial factors in the investment analysis, as is an appreciation<br />
<strong>for</strong> the issuer’s desire <strong>for</strong> continued access to the<br />
JOUFSOBUJPOBMNBSLFUT<br />
All of the above are important considerations when<br />
evaluating an investment in EM corporate assets.<br />
Depending on the issuer and its payment history, one<br />
NVTU EFUFSNJOF XIFUIFS UIFSF JT BO BQQSPQSJBUF SJTL<br />
premium over the relevant sovereign and <strong>com</strong>parable<br />
EFWFMPQFENBSLFUTCFODINBSLDSFEJUT<br />
16<br />
September / October 2011
Conclusion<br />
We believe that an allocation to EM corporate debt is an<br />
attractive option <strong>for</strong> investors seeking the opportunity to add<br />
potential excess risk-adjusted returns, whether considering<br />
a CEMBI high-yield overlay to U.S. high-yield, investmentgrade<br />
or the J.P. Morgan <strong>Emerging</strong> <strong>Market</strong>s Bond Index<br />
Global (EMBIG) port-folios, or investing in a more traditional<br />
CEMBI diversified portfolio <strong>com</strong>pared with U.S. credit. <strong>The</strong><br />
fact that EM corporate default rates have been lower than<br />
U.S. levels <strong>for</strong> seven out of the last 10 years is an additional<br />
key consideration. <strong>The</strong>re is still a positive basis between EM<br />
corporates and U.S. investment-grade or high-yield indexes<br />
of between 90 and 150 basis points, which while narrower<br />
than historical levels, is in our view still <strong>com</strong>pelling in the<br />
current U.S. Treasury environment.<br />
For the many reasons discussed above, we expect the<br />
asset class to continue growing, as the various underlying<br />
<strong>com</strong>panies evolve or the credit metrics improve over time<br />
with the growth of the underlying sovereigns.<br />
A version of this story previously appeared in the Morgan<br />
Stanley Investment Management Journal, Volume 1, Issue 1.<br />
Endnotes<br />
1. Source: Bond Radar. Data as of August 2010. As of October 5, 2010, year-to-date 2010 issuance stood at $143 billion.<br />
2. <strong>The</strong> Corporate <strong>Emerging</strong> <strong>Market</strong>s Bond Index was created in December 2007 by J.P. Morgan to measure global liquid U.S.-dollar-denominated corporate EM bonds.<br />
3. Sources: MSIM, official sources<br />
4. Sources: MSIM and IMF<br />
5. For example, Banco Bradesco estimates that the middle in<strong>com</strong>e (“Class C”) sector of the Brazilian population has grown from 38.73 percent to 53.4 percent from January<br />
2004 to May 2010. Source: Banco Bradesco, October 2010.<br />
6. <strong>The</strong> J.P. Morgan CEMBI Broad Diversified Index tracks U.S.-dollar-denominated debt issued by emerging market corporations. It includes fixed, floating, amortizing and<br />
capitalizing instruments.<br />
7. <strong>The</strong> J.P. Morgan Global Government Bond Index tracks total returns <strong>for</strong> fixed-rate government debt in developed government bond markets.<br />
8. <strong>The</strong> J.P. Morgan <strong>Emerging</strong> <strong>Market</strong>s Bond Index Global tracks total returns <strong>for</strong> traded external debt instruments in the emerging markets.<br />
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<br />
billion <strong>for</strong> the full year 2009. M&A by <strong>com</strong>panies in EM now account <strong>for</strong> 30 percent of global activity. Data as of September 2010.<br />
10. <strong>The</strong> upgrades/downgrades ratio is cumulative monthly corporate ratings upgrades from Moody’s, S&P and Fitch, divided by downgrades during the same period.<br />
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<br />
generation or substantial offshore assets.<br />
12. Source: J.P. Morgan, August 2010<br />
13. <strong>The</strong> CEMBI series includes fixed-rate securities, while the CEMBI Broad includes fixed, floating, amortizing and capitalizing instruments.<br />
14. <strong>The</strong> MSCI <strong>Emerging</strong> <strong>Market</strong>s Index is a free-float-adjusted market-capitalization index designed to measure equity market per<strong>for</strong>mance of emerging markets.<br />
15. Source: J.P. Morgan, July 2010<br />
16. Source: J.P. Morgan<br />
17. See “Measuring Business-Cycle Risk In Fixed-In<strong>com</strong>e Portfolios” by David Armstrong, July 10, 2010, Morgan Stanley.<br />
18. <strong>The</strong> Barclays Capital U.S. Corporate Bond Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity,<br />
liquidity and quality requirements.<br />
19. <strong>The</strong> Barclays Capital High Yield Bond Index tracks the per<strong>for</strong>mance of below-investment-grade U.S.-dollar-denominated corporate bonds publicly issued in the U.S.<br />
domestic market.<br />
20. <strong>The</strong> J.P. Morgan GBI Index measures local-currency-denominated fixed-rate government debt issued in developed markets.<br />
21. <strong>The</strong> 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.<br />
22. <strong>The</strong> Barclays Capital U.S. Securitized Bond Index is an unmanaged <strong>com</strong>posite of asset-backed securities, collateralized mortgage-backed securities (ERISA-eligible) and<br />
fixed-rate mortgage-backed securities.<br />
23. Source: Bond Radar, J.P. Morgan, August 2010<br />
www.journalofindexes.<strong>com</strong> September / October 2011<br />
17
Individual Country Or<br />
Broad-<strong>Market</strong> Exposure?<br />
Which makes sense in emerging markets?<br />
By Christopher Philips, Roger Aliaga-Díaz,<br />
Joseph Davis and Francis Kinniry<br />
18<br />
September / October 2011
With recent events in Egypt leading to suspension<br />
of that country’s investment market activity and<br />
the closure of its stock exchange on Jan. 27, 1 the<br />
question of the risks inherent in emerging market investing<br />
is on many investors’ minds. While we do not believe recent<br />
events warrant a flight of capital from emerging markets,<br />
we do believe that the situation represents an opportunity<br />
<strong>for</strong> investors to consider the best way to access emerging<br />
market stocks. We delve into the risks of shifting an emerging<br />
market allocation away from broad, diversified coverage<br />
to a more concentrated focus. We conclude that diversifying<br />
across emerging market countries helps to minimize idiosyncratic<br />
or un<strong>com</strong>pensated risks and is analogous to diversifying<br />
across individual <strong>com</strong>panies in developed markets.<br />
Why Focus On Countries?<br />
<strong>The</strong> appeal of investing in individual countries is the<br />
potential <strong>for</strong> higher returns <strong>com</strong>pared with a more diversified<br />
investment. Figure 1 shows the range of annual<br />
returns across MSCI <strong>Emerging</strong> <strong>Market</strong> Index countries<br />
since 1988. An investor who correctly picked the topper<strong>for</strong>ming<br />
countries could have significantly outpaced<br />
the broad global market. Of course, the obvious risk in this<br />
strategy is that the investor might have instead selected the<br />
country or countries that significantly underper<strong>for</strong>med the<br />
market. And in emerging markets, the difference between<br />
the winning countries and the losing countries can be<br />
stark (much more so, <strong>for</strong> example, than when focusing on<br />
sectors within the U.S. market); this can mean significant<br />
volatility <strong>for</strong> portfolios focused on country selection.<br />
Although the spread between best and worst per<strong>for</strong>mers<br />
appears to have narrowed during the 2000s—perhaps<br />
because of persistently rising correlations across emerging<br />
market countries and regions—substantial risks still<br />
remain <strong>for</strong> investors who use a country-selection strategy.<br />
For example, investors tend to display a natural behavior to<br />
migrate toward the winning sector or country. For instance,<br />
in Russia, following strong returns through mid-2008 (largely<br />
due to a rise in oil prices), cash flows into Russian<br />
exchange-traded funds peaked that June. Subsequently,<br />
the MSCI Russia Index fell -75 percent over the 12 months<br />
ended February 2009. Cash flows bottomed in June 2009,<br />
just as the Russian market was beginning its rebound. <strong>The</strong>n,<br />
as Russian stocks accelerated in 2009 and into 2010, cash<br />
flows picked up considerably. This relationship has not<br />
been unique to the Russian stock market. Indeed, the correlation<br />
between 12-month returns and 12-month cash flows<br />
into China ETFs has been 0.61 since 2005.<br />
Challenges Of Country Selection<br />
A primary problem with attempting to predict the winning<br />
emerging market country is that when evaluated<br />
individually, countries can be much less efficient than the<br />
broad market. In other words, stocks of individual countries<br />
have generally exhibited greater volatility without<br />
<strong>com</strong>pensating investors with high enough returns. Figure<br />
2 shows that from 1993 through 2010, the MSCI <strong>Emerging</strong><br />
<strong>Market</strong>s Index delivered a <strong>com</strong>bination of risk and return<br />
that exceeded the risk-adjusted per<strong>for</strong>mance of most of the<br />
individual countries in the index over that period. Although<br />
five countries offered proportionately higher risk-adjusted<br />
returns, only one country (Chile) had volatility that was<br />
lower than that of the broad market. Of course, to have<br />
realized the lower average volatility, investors would have<br />
had to be invested in Chile <strong>for</strong> the entire period without<br />
adjusting their allocations. <strong>The</strong> question then is: Can those<br />
countries with superior risk-adjusted returns be selected<br />
in advance—and then held in a strategic allocation across<br />
both good and bad markets?<br />
Economic Per<strong>for</strong>mance<br />
Often, economic per<strong>for</strong>mance is posited as a useful<br />
metric when evaluating expected market per<strong>for</strong>mance<br />
across countries. Vanguard’s research, however, has<br />
shown no correlation between realized economic per<strong>for</strong>mance<br />
and market returns. Figure 3 illustrates this<br />
Figure 1<br />
Total Annual Return<br />
1,500%<br />
700%<br />
300%<br />
100%<br />
0%<br />
-50%<br />
-75%<br />
-87.5%<br />
<strong>The</strong> Range Of Returns For Individual <strong>Emerging</strong><br />
<strong>Market</strong> Countries Has Been Substantial<br />
1990 1994 1998 2002 2006 2010<br />
N Individual Country Returns N MSCI <strong>Emerging</strong> <strong>Market</strong>s Index Return<br />
Note: Countries represent the constitution of the MSCI <strong>Emerging</strong> <strong>Market</strong>s Index as of<br />
Jan. 31, 2011. Return data <strong>for</strong> Brazil, Chile, Indonesia, Korea, Malaysia, Mexico,<br />
Philippines, Taiwan, Thailand and Turkey start in 1988. Return data <strong>for</strong> China,<br />
Colombia, India, Peru, Poland and South Africa start in 1993. Return data <strong>for</strong> Czech<br />
Republic, Egypt, Hungary, Morocco and Russia start in 1995. Figure 1 uses a log scale<br />
to plot the returns to better represent the relative dispersion across individual<br />
countries. To convert the log scale into a returns framework, we subtracted 1 from<br />
each log value.<br />
Sources: Vanguard, MSCI and Thomson Reuters Datastream<br />
Figure 2<br />
Average Annual Total Return<br />
25%<br />
20%<br />
15%<br />
10%<br />
5%<br />
0%<br />
-5%<br />
A Broad <strong>Emerging</strong> <strong>Market</strong>s Index<br />
Offers Efficiencies In Risk And Return<br />
Relationship between returns and volatility <strong>for</strong> individual MSCI<br />
<strong>Emerging</strong> <strong>Market</strong> Index countries, 1993–2010<br />
MSCI <strong>Emerging</strong><br />
<strong>Market</strong>s Index<br />
Risk-neutral capital<br />
market line<br />
10% 20% 30% 40% 50% 60%<br />
Annual Volatility (Standard Deviation Of Returns)<br />
Note: Results are shown since 1993 to balance the number of observations<br />
(16 countries) with a long-enough period.<br />
Sources: Vanguard, MSCI and Thomson Reuters Datastream<br />
www.journalofindexes.<strong>com</strong><br />
September / October 2011<br />
19
Figure 3<br />
Annual Real GDP Per Capita Growth<br />
6%<br />
5%<br />
4%<br />
3%<br />
2%<br />
1%<br />
0%<br />
Relationship Between GDP Growth<br />
And <strong>Market</strong> Returns<br />
-1%<br />
-5% 0% 5% 10% 15% 20%<br />
Note: Sample includes the 12 emerging markets that had both economic and market<br />
return data available back to 1988. Evaluating alternative time periods (1993 or 1995,<br />
<strong>for</strong> example) would not alter the results.<br />
Sources: Vanguard, International Monetary Fund, MSCI, Thomson Reuters<br />
Datastream and the World Bank<br />
Figure 4<br />
Annual Equity <strong>Market</strong> Return<br />
20%<br />
15%<br />
10%<br />
5%<br />
0%<br />
<strong>Emerging</strong> <strong>Market</strong>s, 1988-2010<br />
Annual Real Return<br />
Relationship Between Currency<br />
And <strong>Market</strong> Returns<br />
<strong>Emerging</strong> <strong>Market</strong>s<br />
-5%<br />
-10% -8% -6% -4% -2% 0% 2% 4%<br />
Annual Change In Currency Value Relative To U.S. Dollar<br />
Note: Sample includes the 21 emerging market countries with data back to 1995. We<br />
excluded Russia and Turkey from the sample as outliers. (Including Russia and Turkey<br />
would not alter the results, but would significantly alter the scale of the graph.)<br />
Sources: Vanguard, MSCI and Thomson Reuters Datastream<br />
in striking fashion: <strong>The</strong> correlation between long-run<br />
economic growth (as measured by real gross domestic<br />
product growth per capita, a standard proxy <strong>for</strong> a country’s<br />
productivity growth) and long-run stock returns<br />
across emerging markets has been effectively zero. 2 <strong>The</strong><br />
challenge facing investors is that while economic growth<br />
is certainly important <strong>for</strong> equity investors (economic surprises<br />
and the price paid <strong>for</strong> economic growth are the true<br />
critical factors), expected economic per<strong>for</strong>mance alone<br />
has not shown a strong positive link to equity returns. In<br />
other words, investors are not <strong>com</strong>pensated <strong>for</strong> investing<br />
on the basis of economic growth that is expected and<br />
there<strong>for</strong>e priced into financial markets. And because outper<strong>for</strong>mance<br />
is more dependent on unexpected growth,<br />
in order to profit, investors must be able to accurately<br />
predict unexpected growth, a decidedly difficult task.<br />
Foreign Currency Appreciation<br />
A second metric often used to make the case <strong>for</strong> overweighting<br />
a particular country concerns expectations of<br />
Figure 5<br />
Subsequent Annualized<br />
10-Year Return<br />
50%<br />
40%<br />
30%<br />
20%<br />
10%<br />
0%<br />
-10%<br />
-20%<br />
Do Low P/E Countries Offer Higher Returns?<br />
Relationship Between Initial Valuations And Returns<br />
0 10 20 30 40<br />
50<br />
Initial P/E Ratio<br />
Note: All countries in the MSCI <strong>Emerging</strong> <strong>Market</strong>s Index are represented that had at<br />
least 13 years of reported P/Es and returns (to supply at least 36 ten-year return<br />
observations <strong>for</strong> each country) as of January 31, 2011. P/Es as of 1/31/2001; ten-year<br />
returns as of 1/31/2011. <strong>The</strong> data represent 21 countries, accounting <strong>for</strong> 1,646<br />
observations. For presentation, we truncated the x-axis <strong>for</strong> observations less than 0 or<br />
greater than 50. Those outliers accounted <strong>for</strong> 10% of the observations. By removing<br />
the outliers from the analysis, the theoretical relationship between initial valuations<br />
and subsequent returns appears, albeit to a lesser extent than observed in the United<br />
States. Returns denominated in U.S. dollars.<br />
Sources: Vanguard, MSCI and Thomson Reuters Datastream<br />
<strong>for</strong>eign currency appreciation (and subsequent depreciation<br />
of the U.S. dollar), perhaps due to differences in a<br />
country’s fiscal standing, national balance sheets and/or<br />
economic growth. Again, however, while seemingly theoretically<br />
sound, the historical data do not support this relationship.<br />
Figure 4 <strong>com</strong>pares currency return with market<br />
return across emerging markets. <strong>The</strong> regression trend line<br />
indicates that differences in currency values may largely<br />
be priced into equity prices. If investors were able to benefit<br />
from currency, we would expect a positive relationship.<br />
However, just as with economic per<strong>for</strong>mance, investors<br />
have not been rewarded <strong>for</strong> expected currency movements.<br />
And as with unexpected economic per<strong>for</strong>mance, accurately<br />
predicting unexpected currency movements is no easy task.<br />
Valuations<br />
Finally, we turn to a third metric, valuations, which<br />
have been found to be the critical factor in explaining<br />
relative per<strong>for</strong>mance. For example, in the United States,<br />
low initial price/earnings ratios have historically led to<br />
higher subsequent returns. This relationship has been<br />
shown to be particularly valid during periods of extreme<br />
valuations (Davis, Aliaga-Díaz, and Ren, 2009; Philips<br />
and Kinniry, 2010). Based on this relationship, we conducted<br />
a similar analysis with emerging market countries.<br />
Un<strong>for</strong>tunately, however, Figure 5 demonstrates<br />
that the relationship between initial P/E ratios and subsequent<br />
returns breaks down when we extend it to individual<br />
emerging markets. 3 We clearly see that low initial<br />
P/E ratios have not signified higher subsequent returns,<br />
nor have high initial P/E ratios led to low subsequent<br />
returns. <strong>The</strong> trend line overlaid on the chart reveals the<br />
lack of any relationship.<br />
Although Figure 5’s results are in<strong>for</strong>mative, it’s important<br />
to note that the absolute relationship between valuations<br />
and returns may obscure relative relationships.<br />
20<br />
September / October 2011
Indeed, sovereign risk, varied economic growth rates, or<br />
idiosyncratic economic uncertainty can lead to systematically<br />
different valuation levels from country to country. We<br />
there<strong>for</strong>e replicated Figure 5 using normalized P/E ratios,<br />
or a ratio of a country’s P/E in any given period relative to its<br />
average historical P/E. It is interesting that the results using<br />
normalized P/Es were nearly identical to those shown in<br />
Figure 5. While several countries displayed the traditional<br />
markets (as with individual stocks), valuation ratios<br />
could be low not just because prices are depressed but<br />
possibly because of expectations of slower future earnings<br />
growth. Indeed, in the case of Venezuela, geopolitical<br />
risks prevailed, and Venezuela was removed from the<br />
public investment space as private assets and <strong>for</strong>eign<br />
capital were seized by the government, thus making the<br />
potentially attractive P/E multiple meaningless.<br />
<strong>The</strong> key difference among individual emerging markets<br />
in terms of the relationship between valuations and<br />
return is idiosyncratic, or country-specific, risk.<br />
relationship between valuations and subsequent returns, a<br />
significant majority did not.<br />
We also replicated this analysis with local returns, using<br />
the hypothesis that the volatility of currencies has overwhelmed<br />
the underlying relationship between valuations<br />
and returns <strong>for</strong> local investors. However, the results were<br />
again identical to those shown in Figure 5.<br />
<strong>The</strong> key difference among individual emerging markets<br />
in terms of the relationship between valuations and<br />
return is idiosyncratic, or country-specific, risk. A case<br />
in point is Venezuela. From December 2004 through<br />
October 2006, the Venezuela stock market was valued at<br />
less than 10x earnings. Historically speaking, if a diversified,<br />
developed market such as the U.S. stock market<br />
were so valued, this would be a strong indicator of aboveaverage<br />
future per<strong>for</strong>mance. However, <strong>for</strong> concentrated<br />
Conclusion<br />
<strong>The</strong> evidence presented here suggests that accurately<br />
selecting an emerging market country that will outper<strong>for</strong>m<br />
is difficult, at best. At worst, an investor or advisor<br />
can experience significant volatility and underper<strong>for</strong>mance,<br />
not to mention the potential <strong>for</strong> nonmarket risks.<br />
Although individual emerging markets have outper<strong>for</strong>med<br />
the broad emerging markets index over both the short and<br />
long term, selecting them in advance is extremely difficult<br />
and fraught with risk. Indeed, as with most concentrated<br />
and volatile asset classes or strategies, the risk of getting<br />
it wrong can far outweigh the gains from getting it right.<br />
<strong>The</strong> message, then, is simple: When investing in emerging<br />
markets, diversification is key. For a greater chance of<br />
success, investors have found broad-market vehicles to<br />
be their most reliable tool.<br />
Endnotes<br />
1. It has since reopened.<br />
2. <strong>The</strong> 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<br />
Staunton, of the London Business School (Princeton University Press, 2002). See also Davis et al. (2010) <strong>for</strong> an in-depth analysis of this result.<br />
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<br />
and subsequent returns has been shown to exist <strong>for</strong> the MSCI <strong>Emerging</strong> <strong>Market</strong>s Index. Similarly, Davis et al. (2010) showed that the relative spread between valuations in<br />
developed vs. emerging markets has been a significant reason <strong>for</strong> the outper<strong>for</strong>mance of emerging markets since 2000.<br />
References<br />
Davis, Joseph H., Roger Aliaga-Díaz, C. William Cole, and Julieann Shanahan, 2010. “Investing in <strong>Emerging</strong> <strong>Market</strong>s: Evaluating the Allure of Rapid Economic Growth.”<br />
Valley Forge, Pa.: <strong>The</strong> Vanguard Group.<br />
Davis, Joseph H., Roger Aliaga-Díaz, and Liqian Ren, 2009. “What Does the Crisis of 2008 Imply <strong>for</strong> 2009 and Beyond?” Valley Forge, Pa.: <strong>The</strong> Vanguard Group.<br />
Philips, Christopher B., and Francis M. Kinniry Jr., 2010. “2009: A Return to Risk-Taking.” Valley Forge, Pa.: <strong>The</strong> Vanguard Group.<br />
Disclosure<br />
All investments are subject to risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty. Stocks of <strong>com</strong>panies in emerging markets are<br />
generally riskier than stocks of <strong>com</strong>panies in developed countries. Past per<strong>for</strong>mance is no guarantee of future returns. <strong>The</strong> per<strong>for</strong>mance of an index is not an exact representation of<br />
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.<br />
www.journalofindexes.<strong>com</strong> September / October 2011<br />
21
Inflation-Linked Index Products:<br />
An Overview<br />
Considerations <strong>for</strong> fixed-in<strong>com</strong>e investors<br />
By Brian Upbin, Anand Venkataraman and Scott Harman<br />
22<br />
September / October 2011
Inflation is an important risk factor <strong>for</strong> investors concerned<br />
about the purchasing power of future cash<br />
flows to be received or future liabilities to be paid.<br />
This is true <strong>for</strong> traditional debt investors seeking a positive<br />
real return on assets; <strong>for</strong> pension plans; and <strong>for</strong> other<br />
asset owners with future cash flow obligations that must<br />
be funded by their investment portfolios. It is also the case<br />
<strong>for</strong> bond issuers who must <strong>com</strong>pensate <strong>for</strong> inflation risk<br />
in the interest rate they are required to pay.<br />
To address these risks, bond investors may seek high<br />
positive real returns with traditional fixed-in<strong>com</strong>e assets<br />
or tap into a large and growing <strong>com</strong>ponent of the fixedin<strong>com</strong>e/OTC<br />
derivative universe that is directly linked to<br />
inflation. <strong>The</strong>se inflation-linked bond and swap instruments<br />
offer returns or payoffs that are linked to inflation,<br />
but have also created an opportunity to express directional<br />
market views on expected inflation by <strong>com</strong>paring<br />
the valuations of inflation-linked and nominal assets.<br />
Inflation-Linked Bonds: Though not eligible <strong>for</strong> broadbased<br />
bond benchmarks, inflation-linked bonds (or “linkers”)<br />
have be<strong>com</strong>e a relevant part of many traditional<br />
fixed-in<strong>com</strong>e portfolios because of the growth in and<br />
increased liquidity of the asset class. Some investors will<br />
treat inflation-linked debt as a <strong>com</strong>ponent of their existing<br />
government bond allocations, as a separate inflation-linked<br />
allocation in their overall fixed-in<strong>com</strong>e mix, or as a tactical<br />
out-of-index investment to generate portfolio alpha.<br />
Regardless of the treatment of inflation-linked bonds in a<br />
bond portfolio allocation, debt investors still need objective<br />
and rules-based indexes to measure this inflation-linked<br />
asset class. Barclays Capital publishes a family of developed<br />
market and emerging markets inflation-linked bond<br />
indexes <strong>for</strong> investors, offering both an explicit per<strong>for</strong>mance<br />
target <strong>for</strong> these assets and an in<strong>for</strong>mational measure on the<br />
risk and return characteristics of the market.<br />
Inflation Swaps: Inflation swaps are an important index<br />
tool used by a different set of fixed-in<strong>com</strong>e investors<br />
seeking liability-driven investment (LDI) benchmarks<br />
to measure future cash flow obligations and there<strong>for</strong>e<br />
the per<strong>for</strong>mance hurdle required to fund such obligations<br />
properly. Barclays Capital also offers a rules-based<br />
family of inflation swaps indexes that can be used in<br />
isolation or blended with other debt and nominal swaps<br />
indexes as benchmarks <strong>for</strong> LDI portfolios.<br />
This article discusses the landscape <strong>for</strong> both inflation-linked<br />
bonds and inflation swaps, covering the<br />
basic mechanics of these instruments and details on<br />
the structure and growth of the overall market. We also<br />
discuss other inflation-linked index products that are<br />
used by market participants when accessing, evaluating<br />
and managing inflation.<br />
Inflation-Linked Bond Mechanics<br />
In simple terms, inflation-linked bonds are securities<br />
where the promised cash flows (coupon and principal)<br />
are linked throughout the life of the security to<br />
changes in a specified price index (most <strong>com</strong>monly a<br />
consumer price index, or CPI). 1<br />
<strong>The</strong> inflation “earned” is generally captured by an “index<br />
ratio,” which measures the growth of the price index from a<br />
base reference level. This index ratio is used periodically to<br />
“inflate” the par amount of the security and determine how<br />
much principal is owed and on what denominator actual<br />
coupon cash flows will be paid. Price index data are usually<br />
available with a monthly frequency. In practice, a reference<br />
index value typically needs to be derived <strong>for</strong> each trade<br />
settlement date using the monthly series, with the base<br />
reference level being the calculated reference index <strong>for</strong> the<br />
date from which inflation is accrued on the security.<br />
<strong>The</strong> stated coupon will remain constant as a percentage<br />
of principal owned, 2 but investors will receive larger<br />
cash flows throughout the life of the bond <strong>for</strong> increases in<br />
notional due to inflation. Cash flows on an inflation-linked<br />
bond tend to be more back-ended <strong>com</strong>pared with a nominal<br />
bond; later coupons will be bigger than initial ones and<br />
the principal repayment at maturity will usually be above<br />
the initial par value when it was purchased. For a particular<br />
issuer and maturity, this back-ended nature of cash flows<br />
can be interpreted as a bigger credit risk in holding an<br />
inflation-linked bond <strong>com</strong>pared with a nominal bond.<br />
Example Of Inflation-Linked Bond Mechanics<br />
For a nominal bond paying an annual coupon of 5<br />
percent, the final payment at maturity would be $100<br />
plus the $5 coupon, with a fixed 5 percent coupon each<br />
year during the life of the bond. For an inflation-linked<br />
bond, the principal and coupon are fixed in real, not<br />
nominal, terms. So, if the price index rose by 25 percent<br />
over the life of the bond, the index ratio would be 1.25<br />
and the principal repayment at maturity would be $100 x<br />
125 percent = $125. Similarly, the final coupon payments<br />
would also be adjusted in nominal terms to reflect the<br />
changes in the price index, so instead of receiving $5, the<br />
investor would receive $6.25 (5 percent of the adjusted<br />
principal) and would there<strong>for</strong>e be protected against<br />
inflation. Interim coupon payments will also take into<br />
account the growth of the price index. Typically, if the<br />
price index level is lower than the base reference level,<br />
coupon payments will also be adjusted lower. In other<br />
words, while the principal of many inflation-linked<br />
bonds is protected against deflation by the maintenance<br />
of a floor of 100—the par value—coupon payments may<br />
fall to below the level at issuance.<br />
Inflation data is typically calculated and published by<br />
the relevant government authorities and often takes several<br />
weeks to gather. <strong>The</strong>re<strong>for</strong>e, the price index referenced<br />
in any inflation-linked bond will usually be calculated<br />
with a lag of a few months to allow <strong>for</strong> the delay. <strong>The</strong> index<br />
ratio incorporates this lag by a daily interpolation of the<br />
reference price index, lagged by two to three months, or<br />
alternatively by simply referencing the price index with,<br />
<strong>for</strong> example, a lag of a month. <strong>The</strong> <strong>for</strong>mer methodology<br />
is the most widely followed in inflation-linked bond markets,<br />
and is usually referred to as the Canadian model. 3<br />
www.journalofindexes.<strong>com</strong> September / October 2011 23
Inflation-Linked Government Bond <strong>Market</strong><br />
Inflation-linked government bonds 4 are the most <strong>com</strong>mon<br />
type of inflation-linked bond, with an increasing number<br />
of sovereign issuers maintaining or initiating inflationlinked<br />
bond programs. Currently, 13 of the 20 largest countries<br />
in the world by GDP (including all G7 countries) have at<br />
least one government inflation-linked bond outstanding.<br />
Why Issue Inflation-Linked Bonds?<br />
A government will generally issue inflation-linked<br />
debt if it makes economic sense to do so and if there is<br />
sufficient demand from investors <strong>for</strong> such a product.<br />
r'PSBHPWFSONFOUUIBUFYQFSJFODFTIJHIJOGMBUJPOUIF<br />
issuance of inflation-linked debt may attract more investors<br />
to its debt and thereby lower its effective borrowing costs.<br />
r #Z JTTVJOH JOGMBUJPOMJOLFE EFCU B HPWFSONFOU DBO<br />
also signal strength to the market in the institutional<br />
arrangements it has put in place to maintain an antiinflationary<br />
bias.<br />
r(PWFSONFOUTUIBUIBWFFGGFDUJWFMZCSPVHIUEPXOMPOH<br />
term inflation may also issue inflation-linked bonds while<br />
JOGMBUJPO FYQFDUBUJPOT SFNBJO IJHI JO PSEFS UP TBWF UIF<br />
JOGMBUJPOSJTLQSFNJVNTUJMMFNCFEEFEJOGJYFESBUFEFCU<br />
r (PWFSONFOUT NBZ GBDF MBSHF EFNBOE GSPN MPDBM<br />
investors with inflation-linked liabilities. <strong>The</strong>se investors<br />
may prefer inflation-linked to nominal government<br />
bonds <strong>for</strong> liability matching.<br />
r 'JOBMMZ JTTVJOH JOGMBUJPOMJOLFE EFCU NBZ QSPWJEF B<br />
method of diversifying a government’s debt portfolio and<br />
matching its future debt-servicing costs with its revenues.<br />
While there are many reasons to issue inflation-linked<br />
EFCUUIFSFBSFTPNFESBXCBDLT#ZGBSUIFCJHHFTUDSJUJcism<br />
of inflation-linked bonds is that these securities<br />
tend to be less liquid and trade with larger bid/ask<br />
TQSFBETUIBOUIFJSGJYFESBUFFRVJWBMFOUT4VDIJMMJRVJE-<br />
JUZNBZCFFYBDFSCBUFEEVSJOHNBSLFUEJTMPDBUJPOTTVDI<br />
as those that occurred in 2008 and 2009.<br />
Developed Inflation-Linked Bond <strong>Market</strong>s<br />
<strong>The</strong> first government inflation-linked bond was issued<br />
CZ 'JOMBOE JO CVU UIF GJSTU JOGMBUJPOMJOLFE 6, HPWernment<br />
bond (“gilt”), issued in 1981, is widely considered<br />
BTIBWJOHHJWFOCJSUIUPUIJTBTTFUDMBTT5IF6,TMFBEXBT<br />
Figure 1<br />
$ Trillion<br />
Aggregate WGILB Inflation-Linked Debt Gross Issuance<br />
250<br />
200<br />
150<br />
100<br />
50<br />
0<br />
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010<br />
Source: Barclays Capital<br />
N Linker Issuance<br />
followed by other developed economies such as Australia,<br />
$BOBEB BOE 4XFEFO BMM PG XIJDI FOUFSFE UIF NBSLFU CZ<br />
UIFFBSMZT5IF645SFBTVSZCFHBOJTTVJOHJOGMBUJPO<br />
MJOLFE CPOET NPTU DPNNPOMZ LOPXO BT 5*14 5SFBTVSZ<br />
inflation-protected securities), in 1997, while the European<br />
NBSLFUHBJOFEBEEJUJPOBMJNQFUVTXJUI'SBODFTGJSTU$1*FY<br />
UPCBDDPJOEFYMJOLFETFDVSJUZJOBOEUIF&VSP)*$1Y<br />
JOEFYMJOLFECPOEJO(SFFDF*UBMZBOE(FSNBOZIBWF<br />
since followed, with Italy now the largest issuer in the euro<br />
&.6)*$1MJOLFETFDUPS*O"TJBUIF+BQBOFTFNJOJTUSZPG<br />
GJOBODF .P' IBT CFFO JTTVJOH JOGMBUJPOMJOLFE +BQBOFTF<br />
HPWFSONFOUCPOET +(#JTTJODF.BSDI<br />
Developed market government inflation-linked bonds<br />
BSF SFQSFTFOUFE CZ UIF GMBHTIJQ #BSDMBZT $BQJUBM 8PSME<br />
(PWFSONFOU *OGMBUJPO-JOLFE #POE 8(*-# *OEFY UIF<br />
measure of the asset class most widely used by global debt<br />
investors. <strong>The</strong> largest and most liquid markets within the<br />
8(*-# *OEFY BSF JO PSEFS PG NBSLFU DBQJUBMJ[BUJPO 64<br />
QFSDFOU6, QFSDFOUBOEFVSP QFSDFOU<br />
which, taken together, constitute 91 percent of the market<br />
WBMVFPGUIFJOEFY5IFFVSPDPNQPOFOUJODMVEFTJTTVBODF<br />
GSPN 'SBODF (FSNBOZ BOE *UBMZ XJUI UIF NBSLFU TIBSF<br />
split 14 percent, 4 percent and 9 percent, respectively. <br />
+(#JTPODFSFQSFTFOUFEPWFSQFSDFOUPGUIF8(*-#IPX-<br />
FWFSTJODF0DUPCFSUIF+BQBOFTF.P'CFHBOUPBDDFM-<br />
FSBUFSFQVSDIBTFTPG+(#JTBOEDFBTFEBVDUJPOBDUJWJUZ#Z<br />
UIFFOEPG+VOFUIFXFJHIUJOHPG+(#JTJOUIF8(*-#<br />
JOEFYIBEGBMMFOUPKVTUPWFSQFSDFOU<br />
Inflation-Linked Bonds In <strong>Emerging</strong> <strong>Market</strong>s<br />
Inflation-linked bonds are not confined to developed<br />
markets. Many emerging market economies, including<br />
*TSBFM$IJMFBOE#SB[JMIBWFCFFOJTTVJOHUIFTFTFDVSJUJFT<br />
TJODFUIFT0WFSUIFDPVSTFPGUIFQBTUEFDBEFNBOZ<br />
more EM governments have chosen to issue inflation-<br />
MJOLFEEFCUXJUI5VSLFZ1PMBOE4PVUI"GSJDBBOE4PVUI<br />
,PSFBBMMJNQMFNFOUJOHQSPHSBNTJOSFDFOUZFBST4PNF<br />
of this growth can be attributed to changes in the investment<br />
mandates of institutional investors in the EM world.<br />
"OPUIFSSFBTPOJTUIFHSPXUIJOTJ[FBOETPQIJTUJDBUJPOPG<br />
the local institutional investor base.<br />
In many emerging markets with higher levels of inflation,<br />
inflation-linked bond issuance represents a higher<br />
portion of government debt than in developed markets.<br />
'PS TPNF NBSLFUT TVDI BT #SB[JM BOE $IJMF UIF UPUBM<br />
JOGMBUJPOMJOLFE EFCU PVUTUBOEJOH BDUVBMMZ FYDFFET UIF<br />
value of nominal debt outstanding, and the inflationlinked<br />
yield curve tends to cover a greater range of matur-<br />
JUJFT 'PS FYBNQMF QFSDFOU PG PVUTUBOEJOH $IJMFBO<br />
JOEFYFMJHJCMFHPWFSONFOUEFCUJTJOGMBUJPOMJOLFE <br />
EM government inflation-linked bonds are measured<br />
CZ UIF #BSDMBZT $BQJUBM &NFSHJOH .BSLFUT *OGMBUJPO<br />
-JOLFE #POE &.(*-# *OEFY XIJDI XBT MBVODIFE JO<br />
0DUPCFS"TPG+VOFUIF&.(*-#DPWFSFE<br />
&.HPWFSONFOUJTTVFSTBOEIBEBNBSLFUDBQJUBMJ[BUJPO<br />
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#SB[JMBMPOFBDDPVOUJOHGPSPWFSQFSDFOUPGUIFJOEFYT<br />
24<br />
September / October 2011
Figure 2<br />
Barclays Capital World Government Inflation-Linked Bond (WGILB) Index Characteristics<br />
June 30, 2011<br />
<strong>Market</strong><br />
Cap<br />
Local Bn<br />
<strong>Market</strong><br />
Cap<br />
$ Bn<br />
Weight %<br />
WGILB<br />
Number<br />
Of<br />
Bonds<br />
Real Yield<br />
(%)<br />
Mod<br />
Duration<br />
$<br />
Unhedged<br />
Returns<br />
YTD (%)<br />
Local<br />
Returns<br />
YTD (%)<br />
Index<br />
Rating<br />
WGILB<br />
US<br />
UK<br />
Euro Government<br />
France<br />
Germany<br />
Italy<br />
Canada<br />
Japan<br />
Sweden<br />
Australia<br />
1-5 year<br />
5-10 year<br />
>10 year<br />
1,820.3 106 0.91 10.06 7.69 4.60<br />
By Country/Region<br />
715.9 715.9 39.3% 31 0.86 8.05 5.84 AAA<br />
272.4 437.4 24.0% 17 0.47 16.02 7.02 4.37 AAA<br />
343.0 497.3 27.3% 27 1.74 7.73 3.08<br />
177.4 257.2 14.1% 13 1.21 8.03 11.13 2.83 AAA<br />
50.3 72.9 4.0% 4 0.71 5.23 10.41 2.17 AAA<br />
115.3 167.2 9.2% 10 2.79 8.35 12.26 3.87 A<br />
54.8 56.8 3.1% 6 0.97 16.28 7.61 4.52 AAA<br />
4,450.4 55.1 3.0% 16 0.67 5.32 3.52 3.08 AA<br />
232.3 36.8 2.0% 5 0.92 8.40 11.36 4.52 AAA<br />
19.6 21.0 1.2% 4 2.38 8.34 10.08 5.40 AAA<br />
WGILB By Maturity<br />
484.3 484.3 26.6% 30 -0.24 2.82 3.27<br />
570.2 570.2 31.3% 33 0.62 6.81 5.19<br />
765.8 765.8 42.1% 43 1.12 17.07 4.98<br />
Source: Barclays Capital; data as of June 30, 2011.<br />
Figure 3<br />
Barclays Capital <strong>Emerging</strong> <strong>Market</strong> Government Inflation-Linked Bond (EMGILB) Index Characteristics<br />
June 30, 2011<br />
<strong>Market</strong><br />
Cap<br />
$ Bn<br />
Weight (%)<br />
EMGILB<br />
Number<br />
Of<br />
Bonds<br />
Real Yield<br />
(%)<br />
Mod<br />
Duration<br />
$<br />
Unhedged<br />
Returns<br />
YTD (%)<br />
Local<br />
Returns<br />
YTD (%)<br />
Index<br />
Rating<br />
EMGILB<br />
LATAM<br />
Argentina<br />
Brazil<br />
Chile<br />
Colombia<br />
Mexico<br />
EEMEA<br />
Poland<br />
South Africa<br />
Turkey<br />
Israel<br />
ASIA<br />
South Korea<br />
1-5 year<br />
5-10 year<br />
>10 year<br />
469.1 80 4.92 6.86 5.66 1.96<br />
By Country/Region<br />
343.7 73.3% 52 5.78 6.93 7.39 1.93<br />
16.4 3.5% 5 10.19 5.93 -15.21 -12.40 B<br />
264.1 56.3% 13 6.24 6.69 9.95 3.48 BBB<br />
10.8 2.3% 20 2.92 5.31 1.07 1.20 AA<br />
2.6 0.6% 4 3.52 4.77 12.25 3.65 BBB<br />
49.7 10.6% 10 3.35 8.98 6.28 1.05 BBB<br />
121.4 25.9% 26 2.49 6.68 1.13 1.97<br />
6.7 1.4% 2 2.71 6.61 13.23 5.21 A<br />
31.3 6.7% 6 2.51 9.41 2.49 5.02 A<br />
41.9 8.9% 8 2.28 4.08 -3.92 1.38 BB<br />
41.6 8.9% 10 2.54 7.26 4.18 0.09 A<br />
3.9 0.8% 2 1.48 6.58 11.25 4.66<br />
3.9 0.8% 2 1.48 6.58 11.25 4.66 A<br />
EMGILB By Maturity<br />
195.5 41.7% 34 4.78 2.40 6.94 3.71<br />
99.9 21.3% 21 4.59 5.80 4.93 1.25<br />
173.7 37.0% 25 5.04 12.50 4.59 0.32<br />
Source: Barclays Capital; data as of June 30, 2011.<br />
www.journalofindexes.<strong>com</strong><br />
September / October 2011 25
Figure 4<br />
Universal Government Inflation-Linked Bond (UGILB) Index Composition<br />
Universal Government Inflation-Linked Bond Index<br />
World Government <strong>Emerging</strong> <strong>Market</strong>s Government Other<br />
Australia<br />
0.91%<br />
Canada<br />
2.47%<br />
France<br />
11.07%<br />
Italy<br />
7.21%<br />
Germany<br />
3.17%<br />
Sweden<br />
1.65%<br />
UK<br />
19.51%<br />
US<br />
30.93%<br />
Japan<br />
2.45%<br />
Argentina<br />
0.72%<br />
Brazil<br />
11.05%<br />
Chile<br />
0.43%<br />
Colombia<br />
0.11%<br />
Mexico<br />
2.38%<br />
Poland<br />
0.29%<br />
South<br />
Africa<br />
1.34%<br />
Turkey<br />
1.85%<br />
South<br />
Korea<br />
0.17%<br />
Israel<br />
1.81%<br />
Greece<br />
0.47%<br />
Source: Barclays Capital; data as of June 30, 2011.<br />
Figure 5<br />
Universal Government Inflation-Linked Bond (UGILB) Index Characteristics<br />
June 30, 2011<br />
<strong>Market</strong><br />
Cap<br />
$ Bn<br />
Weight (%)<br />
In UGILB<br />
Number<br />
Of<br />
Bonds<br />
Real Yield (%)<br />
Mod<br />
Duration<br />
$<br />
Unhedged<br />
Returns<br />
YTD (%)<br />
UGILB<br />
WGILB<br />
EMGILB<br />
Others (Greece)<br />
2,300.0 188 1.57 9.41 7.23<br />
1,820.3 79.1% 106 0.91 10.06 7.69<br />
469.1 20.4% 80 4.92 6.86 5.66<br />
10.6 0.5% 2 9.83 10.41 -2.51<br />
Source: Barclays Capital; data as of June 30, 2011.<br />
debt outstanding. Due to the large concentration of Brazil<br />
in the market-value-weighted EMGILB, the more popular<br />
choices among fund managers are constrained versions<br />
of the EMGILB Index that cap an individual country’s<br />
exposure at 25 percent of the benchmark. Other popular<br />
variants are the EMGILB Constrained ex-Colombia<br />
ex-Argentina 7 Index, which excludes the two named<br />
markets, and the EM Tradable Inflation Linked Index<br />
(EMTIL), which measures a narrower universe of more<br />
liquid EM inflation-linked bonds. 8<br />
Blended Developed And <strong>Emerging</strong> <strong>Market</strong>s IL Debt (UGILB)<br />
<strong>The</strong> Universal Government Inflation-Linked Bond<br />
(UGILB) Index is Barclays Capital’s broadest measure<br />
of the government inflation-linked bond universe. <strong>The</strong><br />
UGILB presently has a market capitalization of around<br />
$2.3 trillion and <strong>com</strong>bines the country coverage of the<br />
WGILB and EMGILB. 9 WGILB represents 79.1 percent<br />
of the universe by market value, with EM inflationlinked<br />
bonds representing 20.4 percent.<br />
Breakeven Inflation Indexes<br />
<strong>The</strong> growth of inflation-linked products has also created<br />
the opportunity <strong>for</strong> fixed-in<strong>com</strong>e investors to express<br />
directional views on inflation expectations and real rates.<br />
Breakeven inflation, which can be defined as the rate of<br />
inflation that will equate the returns on an inflation-linked<br />
bond and a “<strong>com</strong>parator” nominal bond of equal term, is<br />
central to most derivations of inflation expectations from<br />
market prices. <strong>The</strong> Fisher equation estimates the relationship<br />
between interest rates and inflation as follows:<br />
(1 + Nominal Interest Rate) = (1 + Real Interest Rate)<br />
x (1 + Inflation Rate)<br />
Breakeven inflation indexes, which measure returns<br />
of long inflation-linked bonds/bond indexes and short<br />
nominal <strong>com</strong>parator bonds/bond indexes, can be used as<br />
benchmarks <strong>for</strong> passive as well as active managers.<br />
Inflation Swap Indexes<br />
<strong>The</strong> growth of the international inflation-linked government<br />
bond market has also facilitated the growth of the inflation<br />
derivatives market. Inflation swaps enable one party to<br />
pay or receive inflation from another and are a <strong>com</strong>mon<br />
instrument used by the LDI <strong>com</strong>munity both to measure risk<br />
and to set per<strong>for</strong>mance targets <strong>for</strong> future obligations.<br />
<strong>The</strong> Barclays Capital inflation swap indexes are designed<br />
to replicate the per<strong>for</strong>mance of a portfolio investing in two<br />
different types of inflation swap: zero-coupon inflation<br />
swaps and real rate swaps. <strong>The</strong> <strong>for</strong>mer is an exchange of<br />
an inflation-linked cash flow and a fixed cash flow at maturity<br />
with no interim payments, whereas the real rate swap<br />
involves an exchange of Libor-based payments with a fixed<br />
real payment, plus payments <strong>for</strong> realized inflation.<br />
Inflation swap indexes can be created <strong>for</strong> almost any<br />
26<br />
September / October
Figure 6<br />
Figure 7<br />
A Zero-Coupon Inflation Swap Transaction<br />
Fixed Breakeven Rate<br />
A Real Rate Inflation Swap Transaction<br />
Libor<br />
Counterparty<br />
Bank<br />
Fixed<br />
Breakeven<br />
Rate<br />
Counterparty<br />
Bank<br />
Actual Inflation<br />
Fixed Nominal<br />
Swap Rate<br />
Source: Barclays Capital<br />
tenor and offer fund managers a tool to match the specific<br />
cash flows and weights of their pension liabilities more<br />
accurately than inflation-linked bonds. Mismatches in<br />
maturity, index, profile and size between assets and<br />
liabilities can be bridged by the use of such swap indexes,<br />
and also preclude the need to continuously reinvest the<br />
coupon payments and principal redemptions that are<br />
inherent within a bond portfolio.<br />
Conclusion<br />
Inflationary pressures and low growth rates in the developed<br />
world are among a number of new challenges faced<br />
by fixed-in<strong>com</strong>e portfolio managers. <strong>The</strong>se factors have led<br />
Source: Barclays Capital<br />
Bank<br />
Actual Inflation<br />
many investors who have not naturally been drawn to the<br />
inflation-linked asset class to consider it as an alternative.<br />
In the EM world, this trend has been most notable, with<br />
an increasing number of EM credit managers evaluating<br />
EM inflation-linked bonds. With recent research suggesting<br />
that EM inflation-protected bonds have the potential<br />
to enhance the risk/return profile of an international EM<br />
investor, it is likely that this trend will continue. 10<br />
Endnotes<br />
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<br />
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<br />
bought an inflation “floor” at maturity.<br />
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<br />
the same maturity.<br />
3. A number of EM inflation-linked bonds are also issued in a <strong>for</strong>mat similar to Canadian-style bonds; however, the inflation adjustment calculation can be very different.<br />
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<br />
increase between the known published values.<br />
4. <strong>The</strong>re are two main types of categories of inflation-linked (“linker”) debt: government inflation bonds and nongovernment bonds. <strong>The</strong> market <strong>for</strong> government bonds<br />
is substantially larger and more liquid than the market <strong>for</strong> corporate or other nongovernment bonds, and will be the focus of this market overview.<br />
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-,<br />
the minimum rating requirement <strong>for</strong> the WGILB and EGILB indexes.<br />
6. Data as of 2010 year-end. Note: Chilean Central Bank inflation-linked issuance is not index eligible, and there<strong>for</strong>e the total amount of inflation-linked government<br />
debt excludes such issuance.<br />
7. Key reasons why portfolio managers may choose to avoid these markets in their benchmarks are the unfavorable taxation treatment of Colombian inflation-linked<br />
bonds <strong>for</strong> international investors and the unreliability of CPI reporting in Argentina, notwithstanding relatively poor liquidity in these markets.<br />
8. <strong>The</strong> EMTIL Index also rebalances on an annual basis, <strong>com</strong>pared with more standard benchmarks, which rebalance monthly.<br />
9. Greece was excluded from the WGILB in December 2009, due to a ratings downgrade, but remains eligible <strong>for</strong> the UGILB.<br />
10. See “<strong>Emerging</strong> <strong>Market</strong>s Inflation-Linked Bonds” by Laurens Swinkels <strong>for</strong> a recent study of the diversification benefits of EM inflation-linked bonds.<br />
References<br />
Barclays Capital Research, 2010. “Global Inflation-Linked Products – A Users Guide.”<br />
Brière, M., and Signori, O., 2009. “Do inflation-linked bonds still diversify?,” European Financial Management 15(2), pp. 279-297.<br />
Deacon, M., Derry, A. and Mirfendereski, D., 2004. “Inflation-Indexed Securities: Bonds, Swaps and Other Derivatives,” 2nd edition, John Wiley and Sons.<br />
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.<br />
Swinkels, L., 2011. <strong>Emerging</strong> <strong>Market</strong>s Inflation-Linked Bonds, Robeco Quantitative Strategies, working paper series.<br />
www.journalofindexes.<strong>com</strong> September / October 2011 27
Inflationary Quandaries:<br />
A Roundtable<br />
Do investors need to worry?<br />
28<br />
September / October 2011
With inflation and deflation both looming possibilities, and<br />
theories being tossed around like beach balls in July, the<br />
Journal of Indexes staff decided to check in with some inflation<br />
experts to get some perspective on what’s really going on<br />
Luis Viceira, George E. Bates Professor,<br />
Harvard Business School<br />
JOI: Should investors be using TIPS<br />
[Treasury Inflation-Protected Securities]?<br />
Viceir: When we think of what the safest asset<br />
is, the definition actually changes with investors’ horizons.<br />
For investors with very short horizons, typically Treasury bills<br />
or cash is the riskless asset. But over longer horizons, cash can<br />
be quite risky because the return on cash, after adjusting <strong>for</strong><br />
inflation, actually does change quite a bit over time.<br />
For longer horizons, the assets that basically provide you<br />
with the safest investment are TIPS, <strong>for</strong> two reasons. First,<br />
they protect you against inflation. Second, they protect you<br />
against unexpected falls in real interest rates, or the interest<br />
rate that you get after correcting <strong>for</strong> inflation on nominal<br />
interest rates, because if real interest rates fall, TIPS are<br />
going to experience capital gains.<br />
So, the idea in the popular press about TIPS being an<br />
exotic asset is, I think, incorrect. On the contrary, TIPS are<br />
one of the most elementary and fundamental pieces, in my<br />
view, in the construction of the portfolio of any long-term<br />
investor, such as someone saving <strong>for</strong> retirement, or an<br />
endowment or a pension fund with long duration of liabilities.<br />
That is the safe asset.<br />
JOI: Are there any <strong>com</strong>mon misconceptions that investors<br />
have about TIPS?<br />
Viceira: <strong>The</strong> big misconception is that of considering them<br />
to be exotic assets. <strong>The</strong>y are actually fundamental pieces of<br />
any long-term investment portfolio.<br />
<strong>The</strong>re is this issue about investors understanding how<br />
they work, and this situation where investors say, “Well, the<br />
coupon can change. And if there is deflation, then the coupon<br />
that I get paid might decline.” And that’s true in nominal<br />
terms. But in real terms, on an inflation-adjusted basis,<br />
you’re always getting the same coupon.<br />
<strong>The</strong>re is also the misconception that was highlighted in<br />
recent times, when there were a few occasions during which<br />
long-term TIPS were trading at negative yields. Many wondered<br />
how this could be possible, but it’s very possible. TIPS<br />
have a very particular feature, which is that you are always<br />
protected. <strong>The</strong> principal at issuance is always protected<br />
against deflation. If the Treasury issues TIPS today at $1,000 of<br />
principal value, and we have a prolonged period of deflation<br />
over the next 10 years, and this was a 10-year Treasury TIPS,<br />
you still would get $1,000 at the end of those 10 years even<br />
though the CPI inflation was negative over that period.<br />
That’s what the experts call a deflation put, which is really<br />
deflation protection on the par value of the bond. And when<br />
there is this expectation that deflation might happen, in<br />
that case, TIPS of issuance can be quite valuable assets. It’s<br />
perfectly possible that investors are willing to pay a little bit<br />
more than principal value to get that bond, because they are<br />
acquiring the bond and a put option on deflation.<br />
JOI: Should investors be using passive products <strong>for</strong> their<br />
TIPS exposure?<br />
Viceira: I’m not sure we have any evidence that one can<br />
make money by investing actively in TIPS. Now, when we are<br />
talking about hedge funds or investment vehicles that would<br />
be unconstrained, they could invest in TIPS and regular<br />
Treasurys, and in the so-called inflation swap market. <strong>The</strong>re is<br />
evidence that there is money to be made by playing between<br />
the markets, but <strong>for</strong> someone who is just saving <strong>for</strong> retirement<br />
and wants to just get inflation protection and real interest rate<br />
protection, a passive investment in TIPS should be fine.<br />
However, there is the question of whether an investor<br />
should be investing in a constant-duration TIPS mutual<br />
fund [or ETF]. Mutual funds that invest in fixed in<strong>com</strong>e tend<br />
to target some type of duration: For example, a TIPS mutual<br />
fund might be targeting a duration of five or six years. For<br />
an investor who is saving with a horizon of 20 years, it’s not<br />
clear to me that investing in that mutual fund with a constant<br />
duration would make sense.<br />
<strong>The</strong>re is an additional advantage <strong>for</strong> long-term investors<br />
to be in TIPS, which is that the TIPS market is less liquid than<br />
the Treasury market. <strong>The</strong>re is a liquidity premium built into<br />
TIPS. I have recently done research with Carolin Pflueger,<br />
a Harvard Business School graduate student, in which we<br />
have been estimating that liquidity premium; we currently<br />
estimate it at anything between 40 basis points and 70 basis<br />
points. This means that’s the extra return that those who<br />
buy and hold TIPS have been enjoying over time. If you’re<br />
a short-term investor, you’re going to pay that premium<br />
because those TIPS are less liquid. But if you are a buy-andhold<br />
TIPS investor, that’s a premium that you enjoy because<br />
you get to buy TIPS at a discount which is 40 to 70 basis<br />
points in normal times.<br />
That has another implication as well, which is that the<br />
spread between nominal Treasurys and TIPS yields, which<br />
is called breakeven inflation, understates expected inflation<br />
by this premium because TIPS have this liquidity premium<br />
embedded into that spread. So, when we use breakeven<br />
inflation as a measure of expected inflation, we need to add<br />
anything between 40 and 70 basis points to get a more accurate<br />
number <strong>for</strong> expected inflation.<br />
JOI: Are we facing inflation or deflation?<br />
Viceira: I think we have never had a period like the present<br />
one regarding the uncertainty we have about inflation versus<br />
deflation. On the one hand, we have a very expansionary<br />
monetary policy and a booming <strong>com</strong>modities market, which<br />
would indicate that inflation is around the corner. On the<br />
other hand, if you look at inflation expectations as reflected<br />
in the TIPS market, at inflation expectations reflected in the<br />
inflation swap market, or at inflation expectations from Wall<br />
Street economists or professional <strong>for</strong>ecasters, they expect<br />
that inflation will be tamed. <strong>The</strong> reason they’re expecting<br />
that is because the macroeconomic data have indicated<br />
there’s plenty of spare capacity in the economy.<br />
www.journalofindexes.<strong>com</strong> September / October 2011 29
So, on the one hand, we have a very expansionary monetary<br />
policy, and that could result in inflation if the Fed were<br />
not able to actually withdraw that liquidity should banks start<br />
deploying their reserves again. On the other hand, we have<br />
plenty of capacity in the economy that says there’s plenty<br />
of room <strong>for</strong> growth, so why should there be any inflationary<br />
pressures on wages or any other prices in the economy? I<br />
think we are in a period where we have very modest signals<br />
in both directions. Certainly, we are trusting that the Fed<br />
will be able to drain liquidity in time if necessary—I call that<br />
the Bernanke call. We used to talk about the Greenspan put.<br />
Now I think we have the Bernanke call. <strong>Market</strong>s are trusting<br />
that Bernanke will do his job and take that liquidity off the<br />
table when the time <strong>com</strong>es.<br />
<strong>The</strong>re’s another thing that could breed inflation—a<br />
sudden revaluation of emerging market currencies, particularly<br />
in China. We all think that inflation in China is<br />
much bigger than its official statistics acknowledge, and<br />
it has been avoiding exporting that inflation into whoever<br />
buys the goods from China, which is the United States and<br />
other developed economies. China has tried to neutralize<br />
the effect on the exchange rate, and it looks like those<br />
policies are reaching their limits. If that’s the case, China<br />
might decide to have a sudden revaluation of its currency,<br />
which immediately would make goods more expensive in<br />
the United States. And that could trigger inflation. I think<br />
the inflationary situation in the United States is actually—<br />
in more ways than we dare to think—dependent on the<br />
inflationary situation in emerging economies, which are<br />
our main providers of consumer goods.<br />
Michael Ashton, Managing Principal,<br />
Enduring Investments LLC<br />
JOI: Should investors be using TIPS?<br />
Ashton: We know that investors are supposed<br />
to be trying to maximize their real<br />
after-tax return over time. If that’s true, then it means that<br />
the true risk-free instrument is not a Treasury bond, but an<br />
inflation-linked Treasury bond. That’s really where their<br />
investments should be when they don’t have an opinion.<br />
<strong>The</strong>y shouldn’t be in Treasurys, they should be in inflationlinked<br />
Treasurys because they have to be neutral on the<br />
subject of inflation, and the TIPS allow you to be neutral.<br />
JOI: Are there any <strong>com</strong>mon misconceptions that investors<br />
have about TIPS?<br />
Ashton: I think one mistake that people make is that they<br />
think that when they buy TIPS, they’re making a bet on inflation.<br />
And that’s not the case. When you buy regular Treasurys,<br />
you’re making a bet on inflation. You’re betting that inflation<br />
will be lower, or certainly no higher, than the expected inflation<br />
embedded in the yield of a Treasury bond. But when you<br />
buy TIPS, you’re not making a bet. You don’t care whether<br />
inflation is high or low. Your real out<strong>com</strong>e will be the same.<br />
As investors, we tend to think in nominal terms because<br />
that’s the way we were taught, to think about what percentage<br />
return we have achieved. We don’t tend to think in real terms.<br />
But the right way to think is in real terms, and so that says you<br />
should always go back to the touchstone of TIPS.<br />
Right now, TIPS yields are ridiculously low. That probably<br />
reflects the overall investment landscape right now, that real<br />
returns in every asset class are low. And that sort of makes it<br />
harder to invest in TIPS at the moment, but I think they still<br />
should be your sort of “null” investment.<br />
JOI: Should investors be using passive products <strong>for</strong> their<br />
TIPS exposure?<br />
Ashton: I think that <strong>for</strong> basic exposures, the cleanest way<br />
is to invest in the TIPS directly. We know that investing in<br />
bonds directly is expensive, relative to stocks, if you’re going<br />
to be buying and selling them. That’s changing over time, of<br />
course, but it’s still harder to get into and out of a bond than<br />
a stock. You can buy TIPS <strong>for</strong> free from the Treasury, but selling<br />
them is more difficult.<br />
Having said that, there are not many groups that have<br />
demonstrated over time that they can add much alpha to<br />
a simple, long-only investment mandate in TIPS. And as a<br />
consequence of that, I think that arguing <strong>for</strong> active management<br />
in straight TIPS doesn’t seem to make a lot of sense<br />
to me. Buying indexed TIPS products is probably the most<br />
efficient way <strong>for</strong> most investors to invest.<br />
JOI: Are we facing inflation or deflation?<br />
Ashton: I think that we’ve conducted a marvelous experiment<br />
over the last couple of years about whether economic growth or<br />
monetary policy has more effect on inflation. And the examples<br />
of inflationary out<strong>com</strong>es in countries that have slow growth<br />
are myriad. <strong>The</strong>re are quite a few examples. In the 1970s in the<br />
United States, we had slow growth, and we had a lot of inflation.<br />
That doesn’t fit the Keynesian model. It was a similar—but<br />
more extreme—case with Zimbabwe in the 2000s.<br />
All major inflation occurs with large increases in transactional<br />
money. Not bank reserves, but in M2 money, in our<br />
case. In that context, we are now in a very risky time where<br />
there is a huge wall of money in bank reserves that have not<br />
passed into M2. Now, in the last couple of weeks, as it turns<br />
out, M2 has started to accelerate quite alarmingly, but it’s<br />
still too early to say that’s happening.<br />
We don’t really know how to drain all these bank reserves<br />
without having them pass into M2. If they do <strong>com</strong>e to M2, if<br />
the money multiplier suddenly goes back up to its historical<br />
level <strong>for</strong> some reason, then you’re going to have a massive<br />
problem of inflation. I don’t think that’s likely, but it is possible.<br />
<strong>The</strong> way I’d sum it up is to say that there are many<br />
inflation risks right now. <strong>The</strong> long tail’s on the upside and<br />
it’s critical <strong>for</strong> investors to be protecting themselves against<br />
the potentially inflationary out<strong>com</strong>e. And when the head of<br />
the Federal Reserve says he’s “100 percent” confident that<br />
he can control inflation, he’s either an idiot or a liar. And that<br />
should make you doubly concerned.<br />
JOI: Should investors be concerned about global inflation?<br />
Ashton: It turns out that the inflation experienced in this<br />
country—roughly two-thirds or a little more of it—<strong>com</strong>es<br />
from global sources. Some guys at the ECB did a wonderful<br />
30<br />
September / October 2011
paper a couple of years ago showing that most interconnected<br />
economies share much of the experience of inflation. And<br />
that’s because money is fungible. When the Fed eases aggressively,<br />
it doesn’t just drive up our domestic money supply, it<br />
drives up the global money supply. People take those dollars<br />
and they buy euros with them. And they borrow in the country<br />
where money is cheap, and spend it elsewhere.<br />
And so, it turns out that the more interconnected our<br />
economies get, the more concern investors should have<br />
about global inflation, or inflation from non-U.S. sources.<br />
What that means is that investors, in looking to protect<br />
themselves, should look beyond just holding U.S. TIPS.<br />
I think that investors, when they’re looking at inflationlinked<br />
investments, especially bonds, really should look to<br />
unhedged global TIPS <strong>for</strong> the best inflation-linked protection.<br />
Because a lot of our inflation does <strong>com</strong>e from global sources.<br />
JOI: Are there any key differences in the available<br />
TIPS indexes?<br />
Ashton: From the major index suppliers—the Merrills, the<br />
Lehman/Barclays—in TIPS, I don’t think there’s a whole lot<br />
of difference. <strong>The</strong>re are only a handful of bonds in the TIPS<br />
market, so there are only so many ways you can <strong>com</strong>bine<br />
them. It gets more interesting when you look at global indices,<br />
because then, your definition of which markets should be<br />
included matters a great deal. Is Greece in your index? Greece<br />
has inflation-linked bonds, and right now, they’re a joke. But<br />
how long do they stay in the index? Italy is the fourth-largest<br />
issuer of inflation-linked bonds, behind only the U.S., U.K.<br />
and France. <strong>The</strong>re’s $150 billion worth of inflation-linked<br />
bonds in Italy. How quickly are they going to drop out of the<br />
global index? I would pay a great deal of attention to what<br />
the rule is in the index you’re using, because when Italy falls<br />
out and you’re <strong>for</strong>ced to reinvest a very large proportion into<br />
other parts of the index, that can have a major effect.<br />
Michael Pond, Fixed In<strong>com</strong>e Strategist,<br />
Barclays Capital<br />
JOI: Should investors be using TIPS?<br />
Pond: We’ve seen studies in the past which<br />
indicate that TIPS add value to a well-diversified<br />
portfolio, whether it be a fixed-in<strong>com</strong>e portfolio or<br />
a broad asset class portfolio, by providing an asset that’s<br />
linked to inflation, and adding diversification properties relative<br />
to other asset classes. TIPS, over time, tend to improve<br />
the risk/return of a portfolio. Investors are also be<strong>com</strong>ing<br />
more worried about the long-term prospects of inflation and<br />
are looking to real assets to hedge the value, the real value,<br />
of their portfolios—the purchasing power of their returns,<br />
rather than just the absolute nominal returns. TIPS are the<br />
only asset directly linked to CPI inflation, even if there are<br />
some other asset classes that correlate well with inflation.<br />
What many investors are realizing is that while they certainly<br />
don’t want to shift 50 percent, or 80 percent, of their<br />
portfolio into TIPS, or real return in general, zero is not the<br />
answer. We’re seeing investors settle on different numbers.<br />
Some are looking to add or shift, say, 15 to 20 percent of their<br />
portfolio into real return strategies or TIPS specifically; and<br />
some, 3 percent. But we are consistently seeing investors<br />
realize that zero is not the right answer.<br />
JOI: Are there any <strong>com</strong>mon misconceptions that investors<br />
have about TIPS?<br />
Pond: <strong>The</strong>re are many. Probably the biggest one is that<br />
TIPS will per<strong>for</strong>m well or poorly depending on inflation<br />
itself. <strong>The</strong>se are real rate instruments. During times of<br />
strong growth, when it’s typical to get high inflation, TIPS<br />
may actually per<strong>for</strong>m poorly on an outright basis simply<br />
because that’s a situation where real rates are rising, and the<br />
price of the asset is likely going down, even though you have<br />
<strong>com</strong>pensation through higher inflation. TIPS per<strong>for</strong>m well<br />
when inflation goes up relative to nominal fixed-in<strong>com</strong>e<br />
investments, even if real yields are rising and the outright<br />
per<strong>for</strong>mance isn’t strong.<br />
Conversely, when inflation was low in 2008 and 2009, TIPS<br />
actually per<strong>for</strong>med quite well, because real yields were moving<br />
lower, and many investors who had thought that TIPS’ outright<br />
per<strong>for</strong>mance correlates with inflation were surprised when<br />
TIPS did so well, and have continued to do well this year.<br />
Another misconception is that TIPS are a tax disadvantage<br />
because investors have to pay what some refer to as a<br />
phantom tax. <strong>The</strong> inflation accretes on the principal rather<br />
than being paid out, so you don’t actually get the inflation<br />
<strong>com</strong>pensation until maturity, or when you sell the security,<br />
and yet you have to pay tax on that inflated principal on<br />
an annual basis. Some see that as a tax disadvantage. Our<br />
analysis shows that on an after-tax return to maturity, there<br />
isn’t a disadvantage, although many investors may shy away<br />
from TIPS because of what we do see as a cash-flow disadvantage.<br />
<strong>The</strong> fact that you have to pay tax on cash that you<br />
didn’t actually receive, while it doesn’t present a return disadvantage,<br />
does present a cash flow disadvantage. You have<br />
to somehow <strong>com</strong>e up with that cash in order to pay taxes,<br />
even though you didn’t receive it.<br />
I would also point out that often TIPS are said to be illiquid.<br />
And that’s just not the case on a relative basis versus<br />
many other asset classes. <strong>The</strong>y are less liquid than Treasurys,<br />
so that’s where that misconception <strong>com</strong>es from. But they’re<br />
a $740 billion market that is still quite a bit more liquid than<br />
many other asset classes out there.<br />
JOI: Does the Fed assess inflation correctly?<br />
Pond: <strong>The</strong> Fed, in particular, focuses on the PCE, the personal<br />
consumption expenditures index, <strong>for</strong> inflation. TIPS<br />
accrue inflation off of the CPI. <strong>The</strong> Fed prefers the PCE,<br />
which is generally lower by about 40 basis points, because it<br />
allows <strong>for</strong> what’s known as the substitution effect: As prices<br />
rise, say, on beef, consumers may switch to eating more<br />
chicken, because it’s at a lower price. It’s not necessarily<br />
wrong that the Fed prefers that measure over others, but<br />
consumers often tend to think that inflation is actually quite<br />
a bit higher than shown in published reports.<br />
Most economic studies show that consumers think this<br />
is so because their inflation experience is driven more by<br />
recently purchased goods. And because consumers tend to<br />
www.journalofindexes.<strong>com</strong> September / October 2011 31
experience food and energy price inflation more frequently<br />
than, say, inflation in TV prices or <strong>com</strong>puter prices or autos,<br />
etc., they base their own inflation expectations or inflation<br />
experience on a smaller subset of goods rather than on a<br />
broad-based subset of goods.<br />
JOI: Should investors be concerned about global inflation?<br />
Pond: We think investors in the United States should be<br />
concerned about global inflation pressures pushing up<br />
on domestic inflation, particularly through import prices.<br />
Many have been surprised, given the amount of slack in<br />
the economy over the past several years, that the United<br />
States has not slipped into deflation. One of the reasons<br />
we have not is because while the United States has had<br />
plenty of slack, other countries did not. China and other<br />
emerging market economies continued to put upward<br />
pressure on goods prices globally, and we are actually<br />
experiencing the result of their inflation pressures<br />
through import prices, which have been rising pretty significantly<br />
over the past couple of quarters.<br />
If you’re a U.S. investor worried about domestic inflation,<br />
then you would look to U.S. TIPS. We have seen global<br />
clients—central banks and other <strong>for</strong>eign official institutions—look<br />
to global inflation-linked bonds. However,<br />
U.S. investors are looking at global linkers as a diversification<br />
tool and as a way to access higher real yields than they<br />
can find in the United States.<br />
Rick Harper, Director of Currency & Fixed<br />
In<strong>com</strong>e, WisdomTree Investments Inc.<br />
JOI: Should investors be using TIPS?<br />
Harper: TIPS do have a role within a<br />
portfolio. But they are by no means a<br />
<strong>com</strong>prehensive solution to an inflation protection strategy.<br />
<strong>The</strong>y do have weak spots. Obviously, they can get<br />
bid up, and right now the whole U.S. Treasury market’s<br />
been bid up. And there’s also the question of whether<br />
CPI is a good proxy <strong>for</strong> inflation, etc.<br />
I think it is in investors’ interest to pursue inflation-linked<br />
debt securities globally as well, and to look <strong>for</strong> disciplined<br />
<strong>com</strong>modity strategies, which might help provide a little<br />
more participation in surges in <strong>com</strong>modity prices when<br />
investor anxiety about inflation appears really fired up.<br />
JOI: Are there any <strong>com</strong>mon misconceptions that investors<br />
have about TIPS?<br />
Harper: Yes, that real yields cannot go higher. I think some<br />
people don’t think they can actually lose principal. <strong>The</strong>y<br />
don’t think they can lose money on them. <strong>The</strong>y think it’s a<br />
one-stop elixir, but nothing is a one-stop elixir. <strong>The</strong>re are<br />
pitfalls to every investment, and that’s why we would take<br />
a multi-asset approach when we look to provide as much<br />
protection as possible against inflation.<br />
JOI: Should investors be using passive products <strong>for</strong> their<br />
TIPS exposure?<br />
Harper: Within the bond area, we have obviously developed<br />
quite a foothold in actively-managed ETFs. We’ve found that<br />
investors really like the flexibility, and they like the fact that<br />
people are monitoring the risk in an investment portfolio<br />
on a consistent basis. Passive investments do have their<br />
place, specifically among investors who understand all the<br />
idiosyncrasies of the indexes. But <strong>for</strong> most investors, I think<br />
offering some responsibility to the investment manager in<br />
giving them the flexibility to make investment decisions is<br />
probably a more prudent way to go.<br />
JOI: Are we facing inflation or deflation?<br />
Harper: I think the historical backdrop would argue that<br />
if you look back over the 40 years we’ve been off the gold<br />
standard, inflation has averaged roughly in the 4.5 percent<br />
range. And over the last 20 years, it’s been 2.5 percent. In<br />
the fixed-in<strong>com</strong>e market, expectations are <strong>for</strong> around 2.5<br />
percent going <strong>for</strong>ward. So, they’re projecting this benevolent<br />
inflation environment going <strong>for</strong>ward, but I think there<br />
is a possibility that we see higher inflation, which incidentally<br />
could allow the government to float away a little of their<br />
debt. In terms of measuring inflation, you’ve really got to just<br />
understand the market environment, because different signals<br />
work differently. From my previous life as an economist<br />
and strategist, I know that in different environments, I was<br />
relying on different signals. <strong>Market</strong>-based indicators, I think,<br />
tend to be the most useful.<br />
JOI: Should investors be concerned about global inflation?<br />
Harper: <strong>The</strong>re’s a fairly well-developed global inflationlinked<br />
debt market, and actually some of the emerging markets<br />
are a little more attractive in terms of levels than are the<br />
developed markets, like the United States, Europe, and the<br />
United Kingdom. And they do offer real yields, they do offer<br />
some upside and some good returns.<br />
Global inflation, that’s the $64,000 question. How do<br />
you measure it? And can you find enough people that will<br />
collaborate to care about it, because they have their own<br />
agendas and concerns about taking care of their own countries<br />
and their own job security. I think the <strong>com</strong>modity price<br />
markets provide pretty good inflation signals on a global<br />
basis, because they’re actually a real global marketplace, as<br />
well as the fixed-in<strong>com</strong>e markets.<br />
I always <strong>com</strong>e back to market-based indicators. It’s sort of<br />
the best reflection of what people are thinking about inflation<br />
expectations. And I think that would probably be the best<br />
guide in terms of what the actual inflation experience will be.<br />
JOI: How do emerging markets figure into considerations<br />
about global inflation?<br />
Harper: Well, emerging market inflation-indexed instruments<br />
have offered some of the most attractive risk-adjusted<br />
returns over the last five to six years. Our WisdomTree Real<br />
Return ETF has a pretty broadly diversified global inflationlinked<br />
portfolio, <strong>com</strong>plemented by a disciplined <strong>com</strong>modities<br />
strategy. Within that global inflation-linked portfolio,<br />
a third of the portfolio is in inflation-linked securities from<br />
emerging market issuers. And in addition to that, we also<br />
tend to favor a lot of the <strong>com</strong>modity-exporting countries,<br />
32<br />
September / October 2011
which include many emerging markets, but also countries<br />
like Canada and Australia. Commodity currency and exposure<br />
to <strong>com</strong>modity currencies tend to offer a fairly good<br />
hedge against inflation, and also provide some in<strong>for</strong>mation<br />
about future <strong>com</strong>modity prices.<br />
JOI: Are there any key differences between the available<br />
TIPS indexes?<br />
Harper: I think some of the global indexes have Greece<br />
exposure. But I’m not particularly fired up about that. It’s<br />
about knowing what you hold. <strong>The</strong>re’s some that weight by<br />
market cap, and some do equal-weighted, but I think at the<br />
end of the day you have to know what you hold. ETFs are<br />
great vehicles <strong>for</strong> that, because every day we show our portfolios<br />
to the world, and I think it’s really valuable.<br />
Just like any fund, with any index you’ve got to be very<br />
careful about what could <strong>com</strong>e into the index, what kind of<br />
risks there may be. <strong>The</strong>re are so many different structures<br />
in the global inflation market in terms of little idiosyncratic<br />
things that tend to have a little bit of an effect, like day count<br />
differences, different reset frequencies, and things of that<br />
sort. It’s important to do that homework, really looking at all<br />
products that provide this exposure.<br />
Richard Christopher Whalen,<br />
Co-Founder of Institutional Risk<br />
Analytics and Author of Inflated:<br />
How Money and Debt Built <strong>The</strong><br />
American Dream<br />
JOI: Does the Fed assess inflation correctly?<br />
Whalen: Oh, no. Going back to the late ‘70s, early ‘80s,<br />
when the United States first saw a real fall-off in growth<br />
and employment, you also had inflation. This is the era<br />
right be<strong>for</strong>e Paul Volcker’s ef<strong>for</strong>ts to clamp down on what<br />
was essentially a demand-led inflationary surge. So, the<br />
Fed started tinkering with how it calculated inflation. This<br />
had large implications because it was not only <strong>for</strong> public<br />
policy consumption and public perception, but it also<br />
started to affect products that are indexed against inflation.<br />
Today, you have even more of that. <strong>The</strong>y’ll exclude<br />
fuel, they’ll exclude food, and whatever it is—all because<br />
they’re trying to manipulate public perception. And this<br />
has large implications <strong>for</strong> investors.<br />
If you buy TIPS, <strong>for</strong> example, or if you buy any other<br />
product that is benchmarked against public indices of<br />
inflation, you’re not being paid what you should be paid.<br />
<strong>The</strong> whole point of inflation indexing is that the government,<br />
the Fed, is not doing its job. <strong>The</strong>re<strong>for</strong>e, I want to<br />
have a security which adjusts <strong>for</strong> the rate of inflation. And<br />
this goes back to the Humphrey-Hawkins legislation. <strong>The</strong><br />
problem in U.S. policy and political life in the last half<br />
century and more is that we want to have our cake and<br />
eat it, too. We want to pretend that we have a low inflation<br />
mandate, but we want full employment. And the two are<br />
inconsistent. You can’t have both. So even today, the Fed<br />
is still driven by that duality, even though the two objectives<br />
are <strong>com</strong>pletely inconsistent.<br />
JOI: Are we facing inflation or deflation?<br />
Whalen: Both. Why limit yourself? You can have both. If you<br />
go back to Irving Fisher’s great essay that he wrote in 1933 <strong>for</strong><br />
Econometrica—he was one of the founders of that journal—<br />
he talked about inflation and deflation. It’s essentially the<br />
playbook that Ben Bernanke is using today, as are the rest of<br />
the members of the Federal Open <strong>Market</strong> Committee. What<br />
he said basically was that you can use monetary policy to<br />
fight deflation, but you also have to restructure. We haven’t<br />
done the restructuring part. We’re still trying to temporize;<br />
we’re still trying to preserve the illusion of par value, if you<br />
will, in a nominal sense of securities. You see this in Europe.<br />
In fact, John Taylor recently had a brilliant essay in the Wall<br />
Street Journal talking about the need <strong>for</strong> a reset. And what<br />
he’s saying is that we have to mark down the debt, lower<br />
the cost of debt service to <strong>com</strong>panies and individuals, and<br />
countries, really—and then we can start again.<br />
This implies a lot of really radical changes here in the<br />
United States, particularly regarding the New Deal institutions.<br />
If you look at it this way, we cover entitlements with<br />
tax revenues today. And so, we fund the rest of it with debt.<br />
That’s kind of like Argentina in the 1970s, but Americans<br />
don’t want to admit that. <strong>The</strong>y don’t want to admit the<br />
prosperity of the past 90 years was basically a function of the<br />
two world wars and America winning those wars, and then<br />
making peace. Of course we prospered. We destroyed the<br />
whole world and we rebuilt it. And our money was substituted<br />
<strong>for</strong> gold: Gold and the dollar were essentially seen as<br />
interchangeable after Breton Woods. We’ve <strong>com</strong>e full circle<br />
as a society and we’re pretty much repeating the mistakes of<br />
other societies in the past.<br />
[As <strong>for</strong> evaluating the risks] you clearly see inflation in<br />
the cost of living, in services, food, fuel, all of the things that<br />
still have a free market <strong>com</strong>ponent. But you have deflation<br />
in financial assets because we have excessive debt, and also<br />
this amazing bubble in the housing market that accelerated<br />
really from 2003-04 to today. Unwinding that asset bubble in<br />
housing—which is 60 percent of the U.S. banking industry’s<br />
exposure, by the way—is a painful process.<br />
So, you have both inflation and deflation at the same time,<br />
and what I think it means <strong>for</strong> investors is that you have to gravitate<br />
toward real assets that will allow you to protect principal.<br />
But you have to be careful, because we also had a bubble in<br />
metals—copper, even gold. I don’t think gold’s going to trade<br />
off significantly, but it certainly reflects fear. People are piling<br />
into gold, platinum, copper—anything they can.<br />
What I tell people is that you want to move to liquidity, you<br />
want to keep your powder dry. And when we bottom—and<br />
I think we’re going to go down again in terms of housing <strong>for</strong><br />
the next couple of years—then you want to start buying really<br />
well-placed, high-quality real estate. But be mindful that the<br />
urban sprawl, the suburbs, all of that, is over. <strong>The</strong> tract housing,<br />
the kind of manufactured housing that we saw over the<br />
last couple of decades, that’s really over. We’re going back to<br />
the old ‘50s and ‘60s model where the bank makes you a loan<br />
and the bank keeps it. It was not normal <strong>for</strong> banks to do all<br />
the securitization, and indeed, that contributed to the bubble<br />
in housing prices. So, it’s tough <strong>for</strong> investors now because<br />
www.journalofindexes.<strong>com</strong> September / October 2011 33
government is such a big part of the equation, and you see the<br />
prospect of default either explicitly or implicitly.<br />
JOI: Should investors be concerned about global inflation?<br />
Whalen: Oh, definitely. I think all the major industrial<br />
countries are going to have to basically print their way out<br />
of trouble. What this implies is that the fiat currencies in all<br />
of these systems are going to decline in real terms, in terms<br />
of their purchasing power, and then you may even see some<br />
interesting developments.<br />
I think you’re going to see countries that have the ability<br />
to <strong>com</strong>pete with higher-quality currencies, starting to do<br />
that. Maybe not this year or next, but I think it’s going to<br />
evolve. Because the dollar was the 20th century currency<br />
following the war. I’m not sure that’s going to continue to be<br />
the case, and I think it would be good <strong>for</strong> the United States if<br />
ours was no longer the global reserve currency, because the<br />
dollar has been overvalued by any measure. If you look at<br />
the debt we have, the dollar should be much lower against<br />
other global currencies. <strong>The</strong> only reason it hasn’t collapsed<br />
is because it’s still the means of exchange <strong>for</strong> <strong>com</strong>merce. It<br />
has nothing to do with the Treasury market.<br />
<strong>The</strong> other thing that really supports the dollar is that<br />
most <strong>com</strong>merce is still priced in dollars, just as a means of<br />
exchange, not as a store of value. Nobody wants to sit in dollars<br />
<strong>for</strong> a long time, at least not in the United States.<br />
JOI: How do emerging markets figure into considerations<br />
about global inflation?<br />
Whalen: That’s more of the irony, isn’t it? Twenty years ago,<br />
these were heavily indebted countries with high inflation<br />
rates. I used to do a lot of work with Mexico. Mexico used<br />
to have to pay 18 percent, 20 percent <strong>for</strong> T-Bills. Not today.<br />
And you see this in Brazil, India, and China, all of which<br />
used to be clients of the IMF and the World Bank. <strong>The</strong>y’ve<br />
all paid off their debt. So, you have this kind of “changing<br />
places” phenomenon where the developing economies are<br />
attracting a lot of capital. Much of it’s going to be lost, by the<br />
way. Look at China. All of the private equity guys I know are<br />
desperately trying to get out of China now because they see<br />
the writing on the wall.<br />
It’s kind of a cyclical thing. But the funny part is, the chaotic<br />
American political economy is still the most attractive<br />
because we’re still a relatively free society. You don’t see<br />
Chinese Communist party officials hiding money in China.<br />
<strong>The</strong>y want to go buy an apartment in San Francisco or in<br />
Canada. Meanwhile, the credulous [investors] in the United<br />
States and Europe are investing in China.<br />
Adam Patti, CEO and Founder, IndexIQ<br />
JOI: Should investors be using TIPS?<br />
Patti: <strong>The</strong> issue I have with TIPS is the fact<br />
that many investors don’t really understand<br />
how they work and, more important, how a<br />
laddered portfolio works, which is what you get when you’re<br />
buying a packaged product. If you buy a TIPS bond when it’s<br />
issued by the government and you hold it to maturity, you’re<br />
fine. You’re getting your inflation protection. <strong>The</strong> problem<br />
is when you buy a TIPS ETF, the price of the TIPS ETF is in<br />
many respects driven by market sentiment. If billions of dollars<br />
are flowing into what is not an extremely liquid market,<br />
it’s driving the prices of these bonds higher. And because<br />
this is a laddered portfolio, you’re getting pretty significant<br />
duration risk embedded in that portfolio.<br />
<strong>The</strong> prices of the TIPS ETFs have gone sky high on the<br />
back of very low interest rates. And the problem is that when<br />
interest rates ratchet up, you’re going to see the price of that<br />
ETF fall off a cliff. And to me, that’s potentially one of the biggest<br />
disasters <strong>for</strong> retail investors in the future, of which they<br />
just aren’t aware. Not only will they not get their inflation<br />
protection, but they will get a pretty significant drawdown in<br />
the price of the product <strong>for</strong> their investment.<br />
JOI: Are we facing inflation or deflation?<br />
Patti: Well, I think we’ve clearly seen inflation in the <strong>for</strong>m<br />
of food inflation and energy inflation. <strong>The</strong> one inflation that<br />
we’re really not seeing at this point is real estate inflation,<br />
and that’s a very big piece of the Consumer Price Index.<br />
That, I believe, has held inflation rates at bay to some extent,<br />
but I think the reality is that we are seeing inflation, and that<br />
is only going to be getting worse, given all the stimulus that<br />
has been sloshing into the marketplace and the debt issues<br />
that we have in the United States as well as overseas. <strong>The</strong><br />
prices of food are not <strong>com</strong>ing down—they’re only going up.<br />
And I think the same thing holds true <strong>for</strong> energy.<br />
I think investors absolutely need to be very fearful of inflation<br />
today, particularly as many analysts are re<strong>com</strong>mending<br />
taking money out of stocks and putting it into cash. You’re<br />
not getting any return on your cash, given the interest rate<br />
environment. And if inflation ratchets up, that cash is simply<br />
going to be worth less. I think that investors need to find a<br />
new way to hedge inflation. Packaged laddered portfolios of<br />
TIPS bonds are not necessarily the best solution—it’s a solution,<br />
but it shouldn’t be your only solution.<br />
What we found is that the best solution <strong>for</strong> inflation hedging<br />
is a multi-asset-class approach. We have a white paper<br />
on our website that we did with our academic board, which<br />
looks at inflation going back to 1900, to try to determine<br />
what the key drivers of inflation are, and what the most efficient<br />
way is to hedge your portfolio.And that’s why we built<br />
a product around that research.<br />
JOI: Should investors consider investing in international<br />
TIPS-style products?<br />
Patti: I don’t know that the average investor needs to be<br />
buying global TIPS products unless they’re looking <strong>for</strong> capital<br />
appreciation. I think you need to hedge your inflation<br />
risk in dollars in your home country, where you’re spending<br />
your capital. But again, if you look at capital appreciation,<br />
at what’s happened in the domestic TIPS market<br />
where the price of the laddered TIPS portfolio has gone sky<br />
high, it could very well happen overseas, where those TIPS<br />
pools of capital are even less liquid. So, I think that’s the<br />
only reason I would ever re<strong>com</strong>mend that an investor look<br />
overseas at this point.<br />
34<br />
September / October 2011
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Selection Bias<br />
How an index chooses stocks really does make a difference<br />
By Robert Arnott and Li-Lan Kuo<br />
36<br />
September / October 2011
An important contributor to per<strong>for</strong>mance <strong>for</strong><br />
any portfolio is the selection of <strong>com</strong>panies <strong>for</strong><br />
inclusion, no less so <strong>for</strong> indexes than <strong>for</strong> active<br />
portfolios. Rather than exploring this topic broadly, as<br />
many have done, we focus on the differences between<br />
two well-known lists of <strong>com</strong>panies: the Fortune 500 and<br />
the Standard & Poor’s (S&P) 500.<br />
<strong>The</strong> Fortune 500 and the S&P 500, launched in 1955 and<br />
1957, respectively, offer similar cap-weighted returns, with a<br />
scant 21 bps difference over a 53½-year span. While this seems<br />
trivial, the two indexes share most of their largest names, leading<br />
to an almost 92 percent overlap, by some measures. If 21<br />
bps of return difference is attributable to as little as 8 percent<br />
of our portfolio, then the nonoverlap holdings must have<br />
materially different returns. Indeed, they do.<br />
In fact, the closer we look at the nonoverlap portfolios,<br />
the more significant the differences seem. Some <strong>com</strong>panies<br />
are in the Fortune 500 but not the S&P 500, and other<br />
<strong>com</strong>panies are in the S&P 500 but not the Fortune 500.<br />
When these two nonoverlap lists are cap weighted, the <strong>for</strong>mer<br />
list outper<strong>for</strong>ms the latter by 198 bps per year <strong>for</strong> over<br />
50 years. To be sure, there is substantial volatility around<br />
this mean, but this per<strong>for</strong>mance gap does achieve statistical<br />
significance and invites questions on the basic principle<br />
of selecting stocks based on market capitalization.<br />
It is neither our intent to promote the Fortune<br />
500—which does not exist as an index—nor to criticize<br />
the S&P 500. <strong>The</strong> S&P 500 is arguably the most widely<br />
used benchmark in the world, <strong>for</strong> many legitimate reasons.<br />
Our intent is simply to show that selection rules<br />
make a very significant difference … even <strong>for</strong> indexes.<br />
A Question Of Selection Bias<br />
Selection bias is an interesting and often-explored topic<br />
in the investment industry, and the differences between<br />
the Fortune 500 and S&P 500 exemplify its impact. Both<br />
lists were intended to be “representative” of the broad<br />
market, albeit in different ways. <strong>The</strong> Fortune 500, which<br />
is objectively selected to include the 500 largest U.S.-<br />
domiciled <strong>com</strong>panies as determined by the previous year’s<br />
revenues, might be viewed as an ef<strong>for</strong>t to capture the broad<br />
economy, focusing on business success. In contrast, the<br />
S&P 500 was launched to capture the per<strong>for</strong>mance of the<br />
U.S. stock market. <strong>The</strong> S&P 500 is subjectively selected<br />
by a <strong>com</strong>mittee with a preference <strong>for</strong> large-cap, actively<br />
traded <strong>com</strong>panies that are of greatest interest to the investing<br />
<strong>com</strong>munity. It has rules <strong>for</strong> profitability and domicile<br />
(which are infrequently waived <strong>for</strong> particularly important<br />
or popular <strong>com</strong>panies), but it is studiously not <strong>for</strong>mulaic in<br />
its stock selection, in order to prevent advance gaming of<br />
changes in its <strong>com</strong>ponent list.<br />
<strong>The</strong> two lists of <strong>com</strong>panies offer similar cap-weighted<br />
returns, with a 21 bps difference over a 53½-year span.<br />
Given that both indexes are cap weighted, that modest<br />
difference must be attributable to selection bias, or<br />
rather, the different selection criteria used to construct<br />
the Fortune 500 and the S&P 500.<br />
In fact, the closer we look at the nonoverlap holdings,<br />
the more significant the difference seems. <strong>The</strong> <strong>com</strong>panies<br />
that are in the Fortune 500 but not the S&P 500, weighted<br />
by Fortune’s revenue metric, 1 outper<strong>for</strong>m the <strong>com</strong>panies<br />
that are in the S&P 500 but not the Fortune 500, weighted<br />
by S&P’s market capitalization metric, by 303 bps per<br />
annum over a span of more than 50 years.<br />
If the S&P 500 and the Fortune 500 are equally<br />
weighted, which magnifies the importance of the small<br />
nonoverlapping names, the 21 bps per<strong>for</strong>mance gap<br />
widens to 57 bps per annum. To be sure, there is substantial<br />
volatility around this mean, but it does achieve<br />
statistical significance. And it highlights the importance<br />
of selection rules—even in an index.<br />
Past Studies Of Selection Bias<br />
Empirical cross-sectional differences in the equity<br />
risk premium have been explored extensively in the<br />
finance literature and point in the direction of a number<br />
of possible explanations <strong>for</strong> this substantial per<strong>for</strong>mance<br />
gap. Banz (1981) found that firms with small market values<br />
have higher risk-adjusted returns than firms with<br />
larger market values. Portfolios <strong>for</strong>med by low P/E or<br />
P/B ratios earn superior average returns to portfolios<br />
based on high ratios (Basu [1977]; Rosenberg, Reid and<br />
Lanstein [1985]; and Fama and French [1992]). Pástor<br />
and Stambaugh (2003) show that less liquid stocks are<br />
more sensitive to aggregate liquidity and have significantly<br />
higher expected returns. Dozens of other articles<br />
explore various explanations <strong>for</strong> these anomalies.<br />
<strong>The</strong> <strong>com</strong>panies that the S&P <strong>com</strong>mittee is likely to add<br />
to the index have higher market caps and higher volumes<br />
than the stocks that are dropped. <strong>The</strong>y often carry high valuation<br />
multiples. However, these are characteristics that<br />
have empirically presaged underper<strong>for</strong>mance. Recently,<br />
academia has embraced the notion of cross-sectional differences<br />
in equity premium, suggesting that popular <strong>com</strong>panies—exhibiting<br />
high multiples, high market cap or high<br />
trading volume—are also likely to offer a lower equity risk<br />
premium. Quite simply, they are perceived as less risky, so<br />
they should offer a lower risk premium.<br />
Reciprocally, the new entrants to the Fortune 500 may<br />
have high or low valuation multiples, high or low trading<br />
volume and high or low popularity. <strong>The</strong> key singular<br />
quality they have in <strong>com</strong>mon is a large revenue base. Even<br />
the market capitalization can be high or low, 2 because the<br />
selection methodology <strong>for</strong> the Fortune 500 is valuationindifferent.<br />
Treynor (2005) points out that a valuationindifferent<br />
selection method—which studiously avoids<br />
taking price into consideration—should mean a larger<br />
risk premium, and a higher return, than a valuationlinked<br />
index. It’s an easy extension of Treynor’s logic to<br />
note that valuation-indifferent stock selection should<br />
beat high-valuation-seeking stock selection.<br />
<strong>The</strong> efficiency of cap-weighted portfolios, or lack of<br />
same, has been widely explored. Haugen and Baker<br />
(1991), <strong>for</strong> example, assert that cap-weighted stock index<br />
portfolios are not an optimal strategy in the presence<br />
of investors’ differing opinions about risk and expected<br />
www.journalofindexes.<strong>com</strong> September / October 2011 37
eturns, short-sell constraints, tax exposure of investment<br />
in<strong>com</strong>e, and <strong>for</strong>eign investors in the domestic market.<br />
Furthermore, Hsu (2006) and Arnott and Hsu (2008) have<br />
shown that if stock prices are inefficient, the cap-weighted<br />
portfolio underper<strong>for</strong>ms a valuation-indifferent portfolio<br />
because the cap-weighted portfolio would overweight<br />
overpriced stocks and underweight underpriced stocks,<br />
relative to their eventual business prospects. 3<br />
Even if the cap-weighted portfolio is optimal, why<br />
should we rely on market cap to select stocks? <strong>The</strong> capweight<br />
selection rule excludes the smaller-cap <strong>com</strong>panies,<br />
which imposes suboptimality on our portfolio. And<br />
there are many studies suggesting statistically significant—even<br />
highly significant—market inefficiencies. As<br />
one of many examples, Anderson and Smith (2006) chose<br />
America’s most admired <strong>com</strong>panies identified annually<br />
by Fortune magazine to <strong>for</strong>m a portfolio, which substantially<br />
and consistently has outpaced the S&P 500. <strong>The</strong>ir<br />
study demonstrates that some portfolio strategies offer<br />
better per<strong>for</strong>mance than cap-weighted portfolios.<br />
<strong>The</strong> S&P <strong>com</strong>mittee selects S&P 500 constituents<br />
based in part on stock prices; rising prices lead to a<br />
higher market cap and often mean higher popularity,<br />
both of which should improve odds <strong>for</strong> inclusion<br />
in the index. This means that a fluctuation in stock<br />
price significantly influences the final selection. <strong>The</strong><br />
problem is that stock prices cannot be fully justified by<br />
the fundamental values of firms. For instance, Shiller<br />
(1981) used a simple model to show that observed<br />
price movements can’t be fully justified by subsequent<br />
changes in dividends. Factors such as psychological<br />
traps could also lead investors to behave irrationally<br />
and overreact to unexpected news or events.<br />
De Bondt and Thaler (1985, 1987) showed that the stock<br />
market does overreact. Assuming this kind of inefficiency,<br />
when stock prices chaotically deviate from their fair market<br />
value, a capitalization-weighting scheme could provide<br />
an automatic mechanism to increase the number of<br />
overpriced stocks (by adding new stocks that have be<strong>com</strong>e<br />
undeservedly large-cap) while decreasing the number of<br />
underpriced stocks (by trimming stocks that have be<strong>com</strong>e<br />
undeservedly small-cap). This arguably occurred during<br />
the tech bubble of the late 1990s. When the pricing errors<br />
correct, the cap-weighted portfolio might experience a significant<br />
price drop, as it did in 2000 and 2001, even as the<br />
median stock lofted to additional new highs.<br />
Many case studies illustrate the underper<strong>for</strong>mance<br />
of the S&P 500 portfolio relative to other perspectives<br />
on the investors’ opportunity set, such as equal weight<br />
or fundamental weight. 4 Does this underper<strong>for</strong>mance<br />
stem from the construction of the original index that<br />
led to deterioration of the whole portfolio afterward? Or<br />
is it possible that subsequent inclusion and deletion of<br />
constituents did not improve per<strong>for</strong>mance?<br />
Siegel and Schwartz (2006) found that a buy-andhold<br />
portfolio <strong>com</strong>posed of the original S&P 500 <strong>com</strong>panies<br />
outper<strong>for</strong>med the active updated S&P 500 with<br />
lower risk. <strong>The</strong>y offered three reasons <strong>for</strong> this observation:<br />
(1) temporary overvaluation pushes stock prices<br />
too high; overpriced stocks face the downward pressure<br />
in the future; (2) price pressure <strong>com</strong>es from indexers<br />
who must buy the stock when a new <strong>com</strong>pany is<br />
admitted to the index; and (3) the original stocks are<br />
often ignored by investors and result in low prices relative<br />
to fundamentals. We think a simpler explanation is<br />
that stocks are added when (indeed, because) they are<br />
expensive and popular, and are dropped when they<br />
either disappear or fall deeply out of favor.<br />
Carty and Blank (2003) tried to identify whether the<br />
Fortune 500 or the S&P 500 would be the better proxy <strong>for</strong><br />
large U.S. stocks based on precise criteria of consistency<br />
and objectivity, <strong>com</strong>position, sector diversification, market<br />
capitalization and per<strong>for</strong>mance. <strong>The</strong>y concluded that<br />
the Fortune 500 Index is a better benchmark <strong>for</strong> U.S. largecap<br />
stocks because it shows higher returns, lower volatility<br />
and less subjectivity bias than the S&P 500. At the end of<br />
their report, they attributed the superior per<strong>for</strong>mance to<br />
the selection process used in picking Fortune 500 stocks. 5<br />
Defining <strong>The</strong> Data And Portfolios<br />
Our study <strong>com</strong>pares the Fortune 500 <strong>com</strong>panies and<br />
the S&P 500 <strong>com</strong>panies, with particular attention to the<br />
nonoverlapping <strong>com</strong>panies. We didn’t use the published<br />
Fortune 500 Index introduced in 1999. Instead, we used<br />
the Fortune 500 roster year-by-year from its launch in<br />
1955 to simulate the Fortune 500 portfolio, using a June<br />
30 end-of-quarter reconstitution date each year, to reflect<br />
the April/May publishing month <strong>for</strong> the Fortune 500.<br />
Moreover, we extended our analysis to explore the two<br />
indexes’ overlap and nonoverlap holdings, and simulated<br />
all of these portfolios using three different weighting<br />
schemes: cap weight, equal weight and revenue weight.<br />
This gives us five indexes (S&P 500, Fortune 500, overlaps—<strong>com</strong>panies<br />
on both lists—and two nonoverlap portfolios:<br />
S&P not Fortune, and Fortune not S&P) and three<br />
weighting schemes, <strong>for</strong> a total of 15 portfolio histories.<br />
An average of 280 <strong>com</strong>panies are on both the Fortune<br />
500 and the S&P 500 lists—the “overlaps” portfolio. <strong>The</strong><br />
overlapping <strong>com</strong>panies were, unsurprisingly, the largest<br />
U.S. <strong>com</strong>panies in both revenues and market cap. We also<br />
require that they be publicly traded <strong>com</strong>panies. Some of<br />
the <strong>com</strong>panies on the Fortune 500 list are not publicly<br />
traded, so we had to exclude them from this analysis.<br />
<strong>The</strong> nonoverlapping <strong>com</strong>panies fall into two categories:<br />
(1) “Fortune not S&P,” <strong>com</strong>prising those <strong>com</strong>panies<br />
that are on the Fortune 500 list but not the S&P 500 list;<br />
and (2) “S&P not Fortune,” those on the S&P 500 list but<br />
not on the Fortune 500 list. <strong>The</strong> publicly traded <strong>com</strong>panies<br />
that are members of the “Fortune not S&P” list will<br />
typically be relatively large <strong>com</strong>panies that have market<br />
cap and trading volume that are too low to capture the<br />
attention of the S&P <strong>com</strong>mittee. <strong>The</strong>se will typically be<br />
deep value <strong>com</strong>panies. <strong>The</strong> <strong>com</strong>panies in the “S&P not<br />
Fortune” list will typically be <strong>com</strong>panies with relatively<br />
modest revenue, and yet trading at a high enough market<br />
cap and/or trading volume to garner the attention of the<br />
38<br />
September / October 2011
Figure 1<br />
Composition Of <strong>The</strong> Portfolios, July 1957–December 2010, Including <strong>The</strong> Overlap And Nonoverlap Holdings<br />
Portfolios<br />
# Of<br />
Names<br />
Avg. Size By<br />
<strong>Market</strong> Cap,<br />
% Of<br />
Overlap<br />
Avg. Size By<br />
Revenues,<br />
% Of<br />
Overlap<br />
<strong>Market</strong> Cap,<br />
% Of<br />
Fortune<br />
500<br />
Revenues,<br />
% Of<br />
Fortune<br />
500<br />
<strong>Market</strong> Cap,<br />
% Of<br />
Matched<br />
S&P 500<br />
Revenues,<br />
% Of<br />
Matched<br />
S&P 500<br />
Fortune 500 429 71.0 75.2 100.0 100.0 84.3 88.0<br />
S&P 500 499 74.2 74.2 123.2 116.9 102.1 100.0<br />
Matched S&P 468 77.8 79.4 120.7 116.9 100.0 100.0<br />
Overlaps 280 100.0 100.0 91.7 86.7 77.4 76.2<br />
Fortune not S&P 149 16.4 29.9 8.3 13.3 6.8 11.8<br />
S&P not Fortune 188 42.7 45.7 28.9 30.2 22.6 23.8<br />
Source: Research Affiliates, LLC<br />
S&P <strong>com</strong>mittee. <strong>The</strong>se are mostly small <strong>com</strong>panies trading<br />
at lofty multiples.<br />
<strong>The</strong> characteristics of the <strong>com</strong>panies on these five<br />
lists are summarized in Figure 1. As the data shows, all<br />
of the lists average less than 500 names. We used the<br />
Compustat/CRSP database as our database; <strong>for</strong> <strong>com</strong>panies<br />
that were members of the Fortune 500, we used<br />
revenue data from Fortune’s database; <strong>for</strong> the rest, we<br />
used Compustat revenues. Some <strong>com</strong>panies in the early<br />
years lack market-cap data, revenues data or subsequent<br />
one-year returns. We eliminate these <strong>com</strong>panies in order<br />
to make a fair <strong>com</strong>parison between the different weighting<br />
metrics. This problem cropped up occasionally be<strong>for</strong>e<br />
1973 and frequently be<strong>for</strong>e 1964. We’ll shortly see that<br />
most of these “problem <strong>com</strong>panies” are too small to<br />
make much of a difference.<br />
<strong>The</strong> Fortune 500 list was limited to publicly traded <strong>com</strong>panies<br />
<strong>for</strong> which investment per<strong>for</strong>mance can be measured,<br />
averaging 429 names. None of the publicly traded Fortune<br />
500 <strong>com</strong>panies lacked price in<strong>for</strong>mation in our database.<br />
<strong>The</strong> S&P 500 list averages 468 names. Why not 500?<br />
<strong>The</strong> difference is mostly due to lack of historical revenue<br />
data, typically <strong>for</strong> some of the smaller <strong>com</strong>panies, which<br />
would prevent revenue-weighting <strong>for</strong> these names. <strong>The</strong><br />
Compustat/CRSP database does not have fundamental<br />
data—notably revenues, because we’re <strong>com</strong>paring with the<br />
Fortune 500—<strong>for</strong> some of the stocks in the S&P 500 prior to<br />
1973. For any of these stocks that were also in the Fortune<br />
500, we used revenue data from Fortune’s database, which<br />
filled in <strong>for</strong> the missing revenues in Compustat.<br />
Naturally, there have been far more than 500 <strong>com</strong>panies<br />
that have been in each portfolio over the past half-century.<br />
Because the S&P 500 is not selected solely by market cap,<br />
they can be a bit patient with additions and deletions.<br />
Companies that barely make the top 500 by market cap are<br />
not likely to be selected <strong>for</strong> addition to the list; likewise,<br />
stocks that rank 501 by market cap are not likely to be<br />
targeted <strong>for</strong> removal. This keeps the rotation in the roster<br />
of names down; little <strong>com</strong>panies that briefly make the top-<br />
500 list, by market cap, never make the cut. So, from mid-<br />
1957 to end-2010, there have been 1,431 <strong>com</strong>panies that<br />
were on the S&P 500 at one time or another. Because the<br />
Fortune 500 is more mechanistic (they will briefly include<br />
<strong>com</strong>panies that reach No. 499 by revenues and then fade),<br />
there are 1,685 <strong>com</strong>panies that have been on the Fortune<br />
500 list at some time in the last half-century.<br />
As a robustness check, we <strong>com</strong>pare results <strong>for</strong> the<br />
published S&P 500 Index with the per<strong>for</strong>mance of the<br />
“Matched S&P 500,” the <strong>com</strong>panies <strong>for</strong> which both<br />
fundamental and per<strong>for</strong>mance data is available. Given<br />
that the missing names were smaller-cap <strong>com</strong>panies,<br />
which collectively <strong>com</strong>prised an average of less than 2<br />
percent of the S&P 500 portfolio, the returns and risk of<br />
the published S&P 500 and the “Matched S&P 500” are<br />
almost identical. Less than 1 bp separates the average<br />
annual return and the average annual volatility of the<br />
S&P 500 and the “Matched S&P 500” (which we might<br />
more reasonably have called the S&P 468!). This gives<br />
us some confidence that even the early data are deep<br />
enough to offer meaningful results.<br />
It’s interesting to note that the average market cap of the<br />
<strong>com</strong>panies in the Fortune 500 is only 71 percent as large<br />
as the average market cap of the 280 overlapping names,<br />
meaning that the nonoverlap <strong>com</strong>panies (members of<br />
the Fortune 500, but not the S&P 500) have much smaller<br />
market cap than the overlap <strong>com</strong>panies. Meanwhile, the<br />
average market cap of the “Matched S&P 500” <strong>com</strong>panies<br />
is 77.8 percent as large as the overlapping names. <strong>The</strong><br />
gap on average revenues is much the same. In short, the<br />
overlap <strong>com</strong>panies are the biggest <strong>com</strong>panies on both lists,<br />
considerably larger than the average <strong>com</strong>pany in either the<br />
full Fortune 500 or the “Matched S&P 500,” on both of our<br />
size measures (market cap and revenues).<br />
<strong>The</strong>re were surprisingly many nonoverlapping names.<br />
An average of nearly 150 <strong>com</strong>panies were on the “Fortune<br />
not S&P” list, and just about 190, on average, were on<br />
the “S&P not Fortune” list. <strong>The</strong> <strong>for</strong>mer are (unsurprisingly)<br />
mostly small-cap. <strong>The</strong> nonoverlapping names in<br />
the “Fortune not S&P” roster were, on average, just 16.4<br />
percent as large as the overlapping <strong>com</strong>panies by market<br />
cap and 29.9 percent as large by revenues. 6 <strong>The</strong>y collectively<br />
average a scant 6.8 percent of the market cap of the<br />
www.journalofindexes.<strong>com</strong> September / October 2011 39
Figure 2<br />
Comparative Returns For Fortune 500 Versus S&P 500 Including <strong>The</strong> Overlap And Nonoverlap Holdings,<br />
Based On Three Weighting Schemes, July 1957–December 2010<br />
Average<br />
Standard<br />
Deviation<br />
Sharpe<br />
Ratio<br />
Best<br />
Month<br />
Worst<br />
Month<br />
Best<br />
Year<br />
Worst<br />
Year<br />
Panel A: Per<strong>for</strong>mance Of <strong>The</strong> Various Portfolios<br />
Portfolio Returns<br />
US 1-Month Treasury Bill 5.09% 0.85% 0.00 1.4% 0.0% 15.2% 0.0%<br />
Fortune (Cap Weight) 10.10% 15.70% 0.32 17.2% -22.8% 58.8% -42.2%<br />
S&P 500 (Cap Weight) 9.89% 15.54% 0.31 16.8% -21.5% 61.0% -42.2%<br />
Matched S&P (Cap Weight) 9.88% 15.55% 0.31 16.7% -21.5% 61.0% -42.2%<br />
Fortune (Equal Weight) 12.84% 18.44% 0.42 19.9% -28.2% 81.0% -46.7%<br />
S&P 500 (Equal Weight) 12.30% 17.64% 0.41 20.5% -25.7% 76.5% -44.9%<br />
Matched S&P (Equal Weight) 12.33% 17.57% 0.41 20.4% -25.7% 77.1% -44.8%<br />
Fortune (Revenue Weight) 11.42% 16.77% 0.38 17.1% -24.3% 68.1% -47.1%<br />
Matched S&P (Revenue Weight) 11.22% 16.28% 0.38 18.2% -23.1% 69.5% -46.4%<br />
Overlaps (Cap Weight) 9.95% 15.57% 0.31 17.1% -22.4% 57.8% -41.7%<br />
Fortune Not S&P (Cap Weight) 12.04% 18.74% 0.37 18.6% -27.7% 74.2% -52.0%<br />
S&P Not Fortune (Cap Weight) 9.64% 17.16% 0.26 15.7% -19.9% 69.3% -45.2%<br />
Overlaps (Equal Weight) 12.31% 17.71% 0.41 18.4% -27.3% 72.7% -44.9%<br />
Fortune Not S&P (Equal Weight) 13.67% 20.74% 0.41 23.6% -29.8% 113.5% -52.0%<br />
S&P Not Fortune (Equal Weight) 12.13% 18.08% 0.39 22.8% -23.7% 82.7% -44.6%<br />
Overlaps (Revenue Weight) 11.08% 16.41% 0.37 16.5% -23.8% 66.9% -46.4%<br />
Fortune Not S&P (Revenue Weight) 13.03% 20.49% 0.39 22.4% -27.8% 112.5% -52.6%<br />
S&P Not Fortune (Revenue Weight) 11.69% 17.31% 0.38 23.3% -21.9% 78.1% -46.1%<br />
Panel B: Excess Returns, For <strong>The</strong> Differenced Long-Short Portfolios<br />
Differences In Returns<br />
Fortune (CW) vs S&P (CW) 0.21% 1.55% 0.13 1.5% -1.9% 9.2% -7.6%<br />
Fortune (EW) vs S&P (EW) 0.57% 2.85% 0.20 3.1% -2.9% 11.4% -8.9%<br />
Fortune (RW) vs S&P (RW) 0.23% 1.99% 0.12 2.2% -2.1% 11.0% -7.6%<br />
Fortune (RW) vs S&P (CW) 1.46% 4.66% 0.31 6.8% -5.1% 29.0% -14.1%<br />
Non-Overlap Holdings Differences<br />
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%<br />
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%<br />
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%<br />
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%<br />
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%<br />
Source: Research Affiliates, LLC<br />
S&P 500. <strong>The</strong> overlap <strong>com</strong>panies—members of both the<br />
Fortune 500 and the S&P 500—<strong>com</strong>prised 91.7 percent of<br />
the aggregate market cap of the full Fortune 500 list.<br />
<strong>The</strong> same cannot be said of the “S&P not Fortune” list,<br />
which includes some <strong>com</strong>panies that are pretty large, in<br />
both market cap and revenues. Among all the <strong>com</strong>panies<br />
in the S&P 500, 77.4 percent of the total market cap of these<br />
<strong>com</strong>panies is also in the Fortune 500, with 22.6 percent of<br />
the S&P 500 falling into the “S&P not Fortune” list. Fortune<br />
excludes some large-cap names that are not domiciled in the<br />
United States; Schlumberger is the largest current example.<br />
<strong>The</strong>se are big <strong>com</strong>panies, both by revenues and by market<br />
cap; S&P includes them, while Fortune does not.<br />
How Much Selection Bias?<br />
At first blush, the results in Figure 2 would seem to suggest<br />
that the “selection bias” between the Fortune 500 and<br />
the S&P 500 is a nonevent. <strong>The</strong> Fortune “500” beats the S&P<br />
40<br />
September / October
“500” by 21 bps. <strong>The</strong> risk is also a touch higher <strong>for</strong> the capweighted<br />
Fortune 500; at only 15 bps higher standard deviation,<br />
the Sharpe ratio of the Fortune “500” is slightly better.<br />
<strong>The</strong> results are a bit more interesting when we look at<br />
weighting schemes other than cap weight, and even more<br />
so when we <strong>com</strong>pare the overlapping and nonoverlapping<br />
holdings. In particular, equal-weighting magnifies<br />
the impact of the nonoverlapping names. Consider that<br />
the Fortune 500 consists of the “overlap” portfolio and<br />
the “Fortune not S&P” portfolio. <strong>The</strong> “Fortune not S&P”<br />
list <strong>com</strong>prises over 35 percent of the Fortune 500, equally<br />
weighted, 7 but only 8.3 percent of the market cap of the<br />
Fortune 500. Clearly, equal-weighting increases the importance<br />
of these nonoverlap names fourfold. <strong>The</strong>re’s a similar,<br />
albeit less pronounced, effect on the “S&P not Fortune”<br />
list as a share of the “Matched S&P 500” portfolio. <strong>The</strong><br />
return difference between the S&P 500 and the Fortune<br />
500, equal-weighting both, is magnified accordingly: We<br />
find a 57 bps annual difference in returns instead of the 21<br />
bps difference on the cap-weighted indexes.<br />
<strong>The</strong> importance of selection rules in our portfolios is more<br />
evident when we look at the nonoverlapping-name portfolios.<br />
<strong>The</strong> returns <strong>for</strong> <strong>com</strong>panies in the “Fortune not S&P”<br />
portfolio are dramatically higher than <strong>for</strong> any of the alternative<br />
portfolios: the S&P 500, the Fortune 500, the overlapping<br />
holdings, and the “S&P not Fortune” portfolio. <strong>The</strong> margin<br />
of victory is anywhere from 102 bps per year to 198 bps per<br />
year, if we stick to apples-and-apples weighting schemes. 8<br />
If we cherry-pick the best and worst weighting scheme, we<br />
find that the best-per<strong>for</strong>ming portfolio is “Fortune not S&P,”<br />
weighted equally, and the worst-per<strong>for</strong>ming portfolio is<br />
“S&P not Fortune,” weighted by market cap. <strong>The</strong> gap here is<br />
enormous: 365 bps per year … <strong>for</strong> over 50 years!<br />
In Figure 2, Panel B, we explore the excess returns<br />
earned by an array of “differenced portfolios.” 9 With<br />
53½ years of data, anything above a Sharpe ratio of 0.25<br />
will have statistical significance at the 5 percent level (a<br />
p-value of 0.05). Focusing on the nonoverlap portfolios,<br />
we note that the “Fortune not S&P” beats the “S&P not<br />
Fortune” list with varying statistical significance, by anything<br />
from 126 bps per year to 365 bps per year.<br />
Does this mean that the S&P <strong>com</strong>mittee has made<br />
huge errors in their selections of stocks <strong>for</strong> their index?<br />
Not at all. <strong>The</strong>ir goal is <strong>for</strong> the S&P 500 to measure the per<strong>for</strong>mance<br />
of the overall stock market, not to pick winners<br />
of a per<strong>for</strong>mance derby. When a stock disappears through<br />
corporate action (e.g., merger or acquisition), it must be<br />
replaced. When a <strong>com</strong>pany flounders, so that its stock has<br />
a shadow of its past market cap and trading volume, it fails<br />
to make the cut as one of the 500 most important stocks in<br />
the U.S. market and must be replaced. In either event, the<br />
S&P <strong>com</strong>mittee will sensibly replace it with a <strong>com</strong>pany<br />
that <strong>com</strong>mands more interest (volume and market cap),<br />
and often <strong>com</strong>mands a premium valuation multiple, in<br />
order to con<strong>for</strong>m to their basic goal. This is wholly consonant<br />
with their goal of capturing the 500 stocks that are<br />
the most important in the U.S. stock market.<br />
<strong>The</strong> Fortune 500 is much more mechanistic. If a<br />
<strong>com</strong>pany’s revenues no longer rank in the top 500, it’s<br />
dropped in favor of a new<strong>com</strong>er that does make the list.<br />
<strong>The</strong> difference in selection mechanism clearly drives<br />
the per<strong>for</strong>mance difference, as indeed it must, with<br />
reasonable statistical significance.<br />
To explore the sources of value-add, we apply the classic<br />
CAPM analytics to these results. As Figure 3, Panel A shows,<br />
many of the portfolios exhibit noteworthy statistical significance<br />
in the alpha, measured against the S&P 500. Without<br />
exception, the statistically significant beta-adjusted alphas<br />
are <strong>for</strong> noncap-weight indexes, providing added support <strong>for</strong><br />
the valuation-indifferent index <strong>com</strong>munity. When we shift<br />
to equal-weighting or revenue-weighting, statistical significance<br />
be<strong>com</strong>es the norm <strong>for</strong> the beta-adjusted alpha.<br />
Given the historical evidence of the dominance of<br />
valuation-indifferent indexes, over long time spans, these<br />
results are unsurprising, except perhaps in their magnitude.<br />
For instance (cherry-picking the best result on the<br />
table), the equal-weighted Fortune 500 beats the capweighted<br />
S&P 500 by 290 bps per year <strong>for</strong> over 50 years.<br />
It’s worthwhile to pause and reflect on how vast this<br />
increment is. Over the entire time span, the S&P 500 has<br />
given us a 9.9 percent annual return, sufficient to give us<br />
155 times our starting wealth (assuming, of course, that<br />
we never needed to spend any of it along the way, pay no<br />
taxes and incur no trading costs or fees). Impressive! But,<br />
the equal-weighted Fortune 500 leaves us four times as<br />
wealthy, with 642 times our starting wealth!<br />
In Figure 3, we can see how much of this is due to<br />
selection bias, how much to beta and how much to equalweighting<br />
vs. cap-weighting. <strong>The</strong> equal-weight S&P 500<br />
beats the same portfolio cap weighted by 236 bps per year.<br />
On the more relevant apples-to-apples <strong>com</strong>parison, the<br />
equal-weighted Fortune 500 beats the equal-weighted S&P<br />
500 by 57 bps per year. That’s much better than the skinny<br />
21 bps margin <strong>for</strong> the cap-weighted <strong>com</strong>parison. <strong>The</strong><br />
weighting method matters more than the selection bias.<br />
Again, the nonoverlap portfolios are where we find<br />
the “real action.” If we cherry-pick the best- and worstper<strong>for</strong>ming<br />
portfolios, we find that the equal-weighted<br />
“Fortune not S&P” list beats the cap-weighted “S&P not<br />
Fortune” list by 365 bps per year over 53½ years. Over the<br />
full span, the cap-weighted “S&P not Fortune” has provided<br />
us a very respectable 9.64 percent annual return,<br />
sufficient to give us 137 times our starting wealth under<br />
the assumption of no additional costs or fees. However,<br />
the equal-weighted “Fortune not S&P” remarkably leaves<br />
us with nearly 1,000 times our starting wealth! 10<br />
Once again, we break the 365 bps added value down to<br />
see how much of this is due to selection bias, how much<br />
to beta and how much to our weighting scheme. In Figure<br />
3, the 365 bps can be partitioned into 150 bps <strong>for</strong> different<br />
<strong>com</strong>position (the equal-weighted “Fortune not S&P”<br />
versus equal-weighted “S&P not Fortune”) plus 228 bps<br />
from a different weighting scheme (the equal-weighted<br />
“S&P not Fortune” versus the cap-weighted “S&P not<br />
Fortune”). Some of this last 228 bps difference is due to<br />
beta (about 36 bps), but the substantial majority is not. 11<br />
www.journalofindexes.<strong>com</strong> September / October 2011 41
Figure 3<br />
Comparative Characteristics For Fortune 500 Versus S&P 500, Including <strong>The</strong> Overlap And Nonoverlap Holdings,<br />
Based On Three Weighting Schemes, July 1957–December 2010<br />
Beta<br />
Alpha<br />
Value<br />
Added<br />
Tracking<br />
Error<br />
Info<br />
Ratio<br />
Alpha<br />
t-St<br />
Panel A: Per<strong>for</strong>mance Of <strong>The</strong> Various Portfolios<br />
Portfolio Characteristics<br />
US 1-Month Treasury Bill 0.00 0.00% N.A. N.A. N.A. -0.03<br />
Fortune (Cap Weight) 1.01 0.19% 0.21% 1.55% 0.13 0.86<br />
S&P 500 (Cap Weight) 1.00 0.00% 0.00% 0.00% 0.00 0.00<br />
Matched S&P (Cap Weight) 1.00 0.00% 0.00% 0.00% 0.00 0.00<br />
Fortune (Equal Weight) 1.10 2.49% 2.90% 6.72% 0.43 2.59<br />
S&P 500 (Equal Weight) 1.08 2.04% 2.36% 5.37% 0.44 2.67<br />
Matched S&P (Equal Weight) 1.07 2.09% 2.38% 5.25% 0.45 2.79<br />
Fortune (Revenue Weight) 1.03 1.38% 1.46% 4.66% 0.31 2.06<br />
Matched S&P (Revenue Weight) 1.01 1.26% 1.24% 3.83% 0.32 2.29<br />
Overlaps (Cap Weight) 1.00 0.08% 0.05% 1.57% 0.03 0.34<br />
Fortune Not S&P (Cap Weight) 1.08 1.75% 2.13% 7.86% 0.27 1.55<br />
S&P Not Fortune (Cap Weight) 1.04 -0.45% -0.14% 5.48% -0.03 -0.58<br />
Overlaps (Equal Weight) 1.08 2.04% 2.37% 5.49% 0.43 2.61<br />
Fortune Not S&P (Equal Weight) 1.14 3.10% 3.75% 10.24% 0.37 2.11<br />
S&P Not Fortune (Equal Weight) 1.08 1.88% 2.21% 6.59% 0.33 2.00<br />
Overlaps (Revenue Weight) 1.01 1.13% 1.12% 4.34% 0.26 1.81<br />
Fortune Not S&P (Revenue Weight) 1.13 2.52% 3.14% 10.09% 0.31 1.74<br />
S&P Not Fortune (Revenue Weight) 1.04 1.62% 1.71% 6.02% 0.28 1.87<br />
Panel B: Excess Returns, For <strong>The</strong> Differenced Long-Short Portfolios<br />
Differences In Returns<br />
Fortune (CW) vs S&P (CW) 0.00 0.19% 0.21% 1.55% 0.13 0.89<br />
Fortune (EW) vs S&P (EW) 0.02 0.49% 0.57% 2.85% 0.20 1.26<br />
Fortune (RW) vs S&P (RW) 0.02 0.16% 0.23% 1.99% 0.12 0.59<br />
Fortune (RW) vs S&P (CW) 0.02 1.35% 1.46% 4.66% 0.31 2.13<br />
Nonoverlap Holdings Differences<br />
Fortune x-S&P (RW) vs S&P x-Fortune (RW) 0.08 0.90% 1.26% 9.70% 0.13 0.68<br />
Fortune x-S&P (EW) vs S&P x-Fortune (EW) 0.06 1.22% 1.50% 8.02% 0.19 1.12<br />
Fortune x-S&P (CW) vs S&P x-Fortune (CW) 0.03 2.20% 1.98% 9.44% 0.21 1.71<br />
Fortune not S&P (RW) vs S&P not Fortune (CW) 0.07 2.70% 3.03% 11.03% 0.27 1.80<br />
Fortune not S&P (EW) vs S&P not Fortune (CW) 0.08 3.29% 3.65% 10.97% 0.33 2.21<br />
Source: Research Affiliates, LLC<br />
In Figures 4-6, we show the cumulative growth of $100<br />
invested in mid-1957 following the launch of the S&P 500<br />
Index and the publication of the 1957 Fortune 500 list of<br />
America’s largest businesses through year-end 2010. As<br />
with any sensible long-term per<strong>for</strong>mance graph, these are<br />
shown on a log scale.<br />
<strong>The</strong> very-worst-per<strong>for</strong>ming strategy on the list (“S&P not<br />
Fortune,” cap-weighted) still gives us 137 times our money<br />
in a bit over a half-century. <strong>The</strong> very best (<strong>com</strong>panies<br />
that are in the Fortune 500, but not the S&P 500, equally<br />
weighted) delivers 948 times our starting wealth. Of course,<br />
with all of these results unimpeded by trading costs, taxes<br />
or spending in the intervening half-century, we see ratification<br />
of Einstein’s whimsical observation that “the most<br />
powerful <strong>for</strong>ce in the universe is <strong>com</strong>pound interest”!<br />
<strong>The</strong>se per<strong>for</strong>mance graphs reveal consistent patterns of<br />
42<br />
September / October 2011
Figure 4<br />
Figure 5<br />
Per<strong>for</strong>mance Of Various Indexes,<br />
Cap-Weight, 1957–2010<br />
Per<strong>for</strong>mance Of Various Indexes,<br />
Equal-Weight, 1957–2010<br />
$100,000<br />
$10,000<br />
Growth of $100, from various<br />
cap-weighted indexes<br />
$100,000<br />
$10,000<br />
Growth of $100, from various<br />
equal-weighted indexes<br />
$1,000<br />
$1,000<br />
$100<br />
$100<br />
Source: Research Affiliates, LLC<br />
Figure 6<br />
$0<br />
Jun<br />
’57<br />
Jun<br />
’62<br />
Jun<br />
’67<br />
Jun<br />
’72<br />
Jun<br />
’77<br />
Jun<br />
’82<br />
Jun<br />
’87<br />
Jun<br />
’92<br />
Jun<br />
’97<br />
Jun<br />
’02<br />
N Fortune Not S&P (Cap Weighted) N Fortune 500 (Cap Weighted)<br />
N Overlaps (Cap Weighted) N S&P 500 (Cap Weighted)<br />
N S&P Not Fortune (Cap Weighted) N US 1-Month Treasury Bill<br />
Per<strong>for</strong>mance Of Various Indexes,<br />
Revenue-Weight, 1957–2010<br />
Jun<br />
’07<br />
Figure 7<br />
$0<br />
Jun<br />
’57<br />
Jun<br />
’62<br />
Jun<br />
’67<br />
Source: Research Affiliates, LLC<br />
Jun<br />
’72<br />
Jun<br />
’77<br />
Jun<br />
’82<br />
Jun<br />
’87<br />
Jun<br />
’92<br />
Jun<br />
’97<br />
Jun<br />
’02<br />
N Fortune Not S&P (Equal Weighted) N Fortune 500 (Equal Weighted)<br />
N Overlaps (Equal Weighted) N S&P 500 (Equal Weighted)<br />
N S&P Not Fortune (Equal Weighted) N US 1-Month Treasury Bill<br />
Relative Per<strong>for</strong>mance Of Various<br />
Equal-Weight Indexes, 1957–2010<br />
Jun<br />
’07<br />
$100,000<br />
$10,000<br />
Growth of $100, from various<br />
revenue-weighted indexes<br />
$100,000<br />
$10,000<br />
Relative returns, <strong>for</strong><br />
various index <strong>com</strong>parisons<br />
$1,000<br />
$1,000<br />
$100<br />
$100<br />
$0<br />
Jun<br />
’57<br />
Jun<br />
’62<br />
Jun<br />
’67<br />
Source: Research Affiliates, LLC<br />
Jun<br />
’72<br />
Jun<br />
’77<br />
Jun<br />
’82<br />
Jun<br />
’87<br />
Jun<br />
’92<br />
Jun<br />
’97<br />
Jun<br />
’02<br />
Jun<br />
’07<br />
N Fortune Not S&P (Revenue Weighted) N Fortune 500 (Revenue Weighted)<br />
N Overlaps (Revenue Weighted) N Matched S&P (Revenue Weighted)<br />
N S&P Not Fortune (Revenue Weighted) N US 1-Month Treasury Bill<br />
$0<br />
Jun<br />
’57<br />
Jun<br />
’62<br />
Jun<br />
’67<br />
Source: Research Affiliates, LLC<br />
Jun<br />
’72<br />
Jun<br />
’77<br />
Jun<br />
’82<br />
Jun<br />
’87<br />
Jun<br />
’92<br />
Jun<br />
’97<br />
Jun<br />
’02<br />
Jun<br />
’07<br />
N Fortune Not S&P (Equal Weighted) N Fortune 500 (Equal Weighted)<br />
N Overlaps (Equal Weighted) N S&P 500 (Equal Weighted)<br />
N S&P Not Fortune (Equal Weighted) N Fortune x-S&P (EW) vs. S&P x-Fortune (CW)<br />
return. <strong>The</strong> Fortune 500 beats the S&P 500 over the entire<br />
time span using any of the three weighting metrics, by<br />
anywhere from 21 to 57 bps per year. It then follows that<br />
the “Fortune not S&P” portfolio must beat the “S&P not<br />
Fortune” portfolio, using any of the three weighting metrics.<br />
It does so, by anywhere from 126 to 198 bps per year.<br />
By <strong>com</strong>paring Figures 4, 5 and 6, we find the equalweighting<br />
scheme shows the highest returns <strong>for</strong> any of<br />
the portfolios, whereas the cap-weighting scheme is the<br />
lowest <strong>for</strong> any of the portfolios, with no exceptions. This<br />
also is not a surprise: As with revenue-weighting, equalweighting<br />
results in a valuation-indifferent index; but,<br />
equal-weighting has the added benefit of introducing<br />
a substantial small size effect, while revenue-weighting<br />
still maintains a large-<strong>com</strong>pany (hence, in most cases,<br />
large-cap) bias. Conversely, the cap-weighting scheme<br />
tends to concentrate our investments in the most popular<br />
and expensive <strong>com</strong>panies: the growth stocks and the<br />
safe havens. It seems unsurprising—to those of us outside<br />
of the die-hard efficient markets crowd—that this<br />
should deliver a lower risk premium to investors than<br />
the other two weighting schemes.<br />
We can also note that the “Fortune not S&P” portfolio<br />
is the top per<strong>for</strong>mer over the entire time span, using any<br />
of the three weighting metrics. <strong>The</strong> “S&P not Fortune”<br />
is the worst per<strong>for</strong>mer <strong>for</strong> two of the three weighting<br />
schemes, with the “overlap” portfolio bringing up the rear<br />
on revenue-weighting. <strong>The</strong> per<strong>for</strong>mance gap between<br />
the “Fortune not S&P” and the “S&P not Fortune” largely<br />
reflects the superior stock selection that stems from<br />
choosing stocks on fundamental size of the business (revenues)<br />
vs. popularity (market cap and trading volume).<br />
www.journalofindexes.<strong>com</strong> September / October 2011 43
<strong>The</strong>se two portfolios exhibit the largest per<strong>for</strong>mance gap<br />
when weighted by market cap.<br />
In Figure 7, we examine the cumulative relative per<strong>for</strong>mance<br />
of the various equal-weighted indexes, all<br />
measured relative to the cap-weighted S&P 500 matched<br />
list (near-identical in per<strong>for</strong>mance to the published S&P<br />
500 Index). All five equal-weighted portfolios beat the<br />
cap-weighted S&P 500 over the entire time span (though,<br />
of course, not in every year). Although not shown in our<br />
exhibits, all of the five revenue-weighted portfolios beat<br />
the cap-weighted S&P 500, albeit by a lesser margin. <strong>The</strong><br />
consistency of these results is very interesting. 12<br />
<strong>The</strong> top line in Figure 7 is different from the others. It<br />
introduces an apples-with-oranges <strong>com</strong>parison, reflecting<br />
the value added <strong>for</strong> the equal-weighted “Fortune not S&P”<br />
portfolio relative to the cap-weighted “S&P not Fortune”<br />
portfolio. Yes, this is cherry-picking the best-per<strong>for</strong>ming<br />
index against the worst-per<strong>for</strong>ming index, 13 but the line<br />
illustrates the <strong>com</strong>bined effects of different stock selection<br />
methods and different weighting schemes <strong>for</strong> two 100<br />
percent nonoverlapping portfolios. <strong>The</strong> per<strong>for</strong>mance difference,<br />
as noted previously, is 3.65 percent per annum. To<br />
be sure, it also delivers 10.97 percent annual volatility. But,<br />
with 53½ years of data, it achieves statistical significance.<br />
Conclusion<br />
To explore how selection bias affects the per<strong>for</strong>mance<br />
of indexes, we <strong>com</strong>pare the per<strong>for</strong>mance of two simple<br />
decision rules: (1) an objective selection rule based on<br />
relative <strong>com</strong>pany revenues (Fortune 500); and (2) a subjective,<br />
cap- and growth-oriented selection approach<br />
(S&P 500). Using portfolios of overlapping names and<br />
nonoverlapping names, we show that selection rules<br />
make a material difference in per<strong>for</strong>mance, even <strong>for</strong><br />
quasi-passive indexes. We also find that the weighting<br />
rules make a difference, though that finding is secondary<br />
to the main purpose of this research.<br />
Our results show that the Fortune 500 outper<strong>for</strong>ms the<br />
S&P 500 in all of our weighting schemes: cap-weighting,<br />
revenue-weighting or equal-weighting, with reasonably<br />
impressive consistency. In addition, in the nonoverlap<br />
portfolios, the <strong>com</strong>panies that are in the Fortune 500 but<br />
not the S&P 500 outper<strong>for</strong>m the <strong>com</strong>panies that are in the<br />
S&P 500 but not the Fortune 500, with much larger return<br />
differences, in any of these three weighting schemes. And,<br />
in general, equal-weighting beats revenue-weighting<br />
which beats cap-weighting <strong>for</strong> any of these indexes.<br />
By including more large-cap, high-volume and popular<br />
growth <strong>com</strong>panies, the S&P 500 exhibits selection<br />
bias relative to the Fortune 500, objectively based on the<br />
<strong>com</strong>panies’ revenue base. Whether the large-cap and<br />
growth bias leads to overweighting overvalued stocks or<br />
these “<strong>com</strong><strong>for</strong>t” biases lead to a lower risk premium is<br />
immaterial. Either way, the result is lower per<strong>for</strong>mance,<br />
some of which is directly attributable to the selection<br />
methodology. In contrast, the index that selects <strong>com</strong>panies<br />
by a fundamental metric, which is unrelated to<br />
market cap, provides a simple way that investors can<br />
capture the pricing errors and achieve returns superior<br />
to the cap-weighted index.<br />
Endnotes<br />
1. A revenue-based selection of <strong>com</strong>panies, which are then revenue weighted, would fall cleanly into the now-classic definition of a “Fundamental Index®” strategy. <strong>The</strong><br />
copyright and patent <strong>for</strong> such strategies are owned by Research Affiliates, LLC. A revenue-reweighted S&P 500—which is currently available in the marketplace from<br />
RevenueShares—is more accurately considered a “fundamentally reweighted index.” We chose revenue weighting <strong>for</strong> this exercise, because that’s the metric that<br />
Fortune uses in selecting the 500 stocks <strong>for</strong> the Fortune 500.<br />
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 <strong>com</strong>mand growth multiples<br />
sufficient to make them reasonably large-cap. An illustrative example would be Google, which almost immediately ranked in the top 50 <strong>com</strong>panies by market cap.<br />
3. Some observers have argued that the cap-weighted market index cannot have an alpha because the market portfolio is cap weighted. <strong>The</strong>y suggest that the cap-weighted index<br />
cannot overweight the overvalued and underweight the undervalued because the index weights match the market weights. <strong>The</strong>se arguments are tautological, when the portfolios<br />
are viewed from a cap-weight-centric worldview and when the index is <strong>com</strong>plete, spanning the full market. <strong>The</strong>se critics are not correct when we view the market from the vantage<br />
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<br />
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.<br />
4. Again, a tautology: Relative to the market, defined as the S&P 500, the S&P 500 cannot underper<strong>for</strong>m the market. Critics often make this counterargument as if it has<br />
intellectual rigor.<br />
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<br />
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<br />
were irrelevant from a business development perspective. Never mind the resistance to an index that per<strong>for</strong>ms better, lest it be used as a benchmark!<br />
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<br />
names, in part because it’s also a shorter list of names.<br />
7. <strong>The</strong> “Fortune not S&P” list averages 149 names out of an average of 429 <strong>for</strong> the Fortune 500. That works out to 35 percent, with equal-weighting of the names.<br />
8. <strong>The</strong> smallest win is 102 bps per year <strong>for</strong> “Fortune not S&P” vs. “Fortune,” equal-weighted; the largest win is 198 bps per year <strong>for</strong> “Fortune not S&P” vs. “S&P not<br />
Fortune,” cap-weighted.<br />
9. It’s important to note that we do not re<strong>com</strong>mend any of these long/short strategies. While the turnover is low, and the value added in some cases is large, the volatility is<br />
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<br />
going to be a nightmare to trade and manage, especially in institutional size. <strong>The</strong>se are typically illiquid small-cap names, equally weighted; and the equal-weighting<br />
44<br />
September / October 2011
tends to involve higher turnover than the other weighting schemes. <strong>The</strong>se differenced portfolios, or long/short strategies, are merely a very interesting ratification of<br />
the core focus of this article; namely, that selection bias matters, even in index construction.<br />
10. This excludes implementation drag—trading costs, fees, etc.,—much the same as the broader indexes. Still …<br />
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.”<br />
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<br />
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 <strong>com</strong>mon—<br />
“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<br />
portfolios, 0.03 percent of the time.<br />
13. This is data mining of the worst kind. But, it’s too fun to ignore!<br />
References<br />
Anderson, Jeff, and Gary Smith. 2006. “A Great Company Can Be a Great Investment.” Financial Analysts Journal, vol. 62, no. 4 (July/August):86–93.<br />
Arnott, Robert D. 2007. “Price-Indifferent Indexes: <strong>The</strong> Equal-Weight Alternative.” Fundamentals (July).<br />
Arnott, Robert D. 2010. “Fifty Years of the Popularity Weighted Index.” Fundamentals (April).<br />
Arnott, Robert D. 2011. “Little Things Make Big Things Happen.” Fundamentals (February).<br />
Arnott, Robert D., Jason C. Hsu, and Philip Moore. 2005. “Fundamental Indexation.” Financial Analysts Journal, vol. 61, no. 2 (March/April):83–99.<br />
Arnott, Robert D., Jason C. Hsu. 2008. “Noise, CAPM and the Size and Value Effects.” Journal of Investment Management, vol. 6, no. 1, 1–11.<br />
Arnott, Robert D., Feifei Li, and Katrina Sherrerd. 2009a. “Clairvoyant Value and the Value Effect.” Journal of Portfolio Management, vol. 35, no. 3 (Spring):12–26.<br />
___<br />
. 2009b. “Clairvoyant Value II: <strong>The</strong> Growth/Value Cycle.” Journal of Portfolio Management, vol. 35, no. 4 (Summer):142–157.<br />
Banz, Rolf W. 1981. “<strong>The</strong> Relationship between Return and <strong>Market</strong> Value of Common Stocks.,” Journal of Financial Economics, vol. 9, no. 1 (March): 3–18.<br />
Basu, Sanjoy. 1977. “Investment Per<strong>for</strong>mance of Common Stocks in Relation to <strong>The</strong>ir Price-earnings Ratios: A Test of the Efficient <strong>Market</strong> Hypothesis.” Journal of Finance,<br />
vol. 32, no. 3 (June):663–682.<br />
Carty, C. Michael, and Herbert D. Blank. 2003. “<strong>The</strong> Fortune 500 versus the S&P 500.” Financial Advisor Magazine (January).<br />
De Bondt, Werner F. M., and Richard Thaler. 1985. “Does the Stock <strong>Market</strong> Overreact?” Journal of Finance, vol. 40, no. 3 (1985):793–805.<br />
___<br />
. 1987. “Further Evidence on Investor Overreaction and Stock <strong>Market</strong> Seasonality.” Journal of Finance, vol. 42, no. 3 (July):557–581.<br />
Fama, Eugene F., and Kenneth R. French. 1992. “<strong>The</strong> Cross-Section of Expected Stock Returns.” Journal of Finance, vol. 47, no. 2 (June):427–465.<br />
Haugen, Robert A., and Nardin L. Baker. 1991. “<strong>The</strong> Efficient <strong>Market</strong> Inefficiency of Capitalization-Weighted Stock Portfolios.” Journal of Portfolio Management, vol. 17,<br />
no. 3 (Spring):35–40.<br />
Hsu, Jason C. 2006. “Cap-Weighted Portfolios Are Sub-Optimal Portfolios.” Journal of Investment Management, vol. 4, no. 3 (Third Quarter):1–10.<br />
Pástor, Lubos, ˘ and Robert F. Stambaugh. 2003. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy, vol. 111, no. 3 (June):642–685<br />
Rosenberg, Barr, Kenneth Reid, and Ronald Lanstein. 1985. “Persuasive Evidence of <strong>Market</strong> Inefficiency.” Journal of Portfolio Management, vol. 11, no. 3 (Spring): 9–16.<br />
Shiller, Robert J. 1981. “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” American Economic Review, vol. 71, no. 3 (June):421–436.<br />
Siegel, Jeremy J., and Jeremy D. Schwartz. 2006. “Long-Term Returns on the Original S&P 500 Companies.” Financial Analysts Journal, vol. 62, no. 1 (January<br />
February):18–31.<br />
Treynor, Jack L. 2005. “Why <strong>Market</strong>-Valuation-Indifferent Indexing Works.” Financial Analysts Journal, vol. 61, no. 5 (September/October):65–69.<br />
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www.journalofindexes.<strong>com</strong> September / October 2011 45
In Perspective<br />
Considerations<br />
For <strong>The</strong> Index Shopper<br />
Different users have different needs<br />
By David Krein and John Prestbo<br />
David Krein<br />
John Prestbo<br />
Choosing a benchmark is not a decision to be taken<br />
lightly. Whether you are a retail trader, pension<br />
fiduciary, active fund manager or investment product<br />
provider, when weighing the various pros and cons<br />
among different indexes, it is critical to understand the key<br />
factors that should be involved in such an evaluation.<br />
Choosing A Provider<br />
First, it should be acknowledged that the indexing<br />
business is, above all, a business. As a result, choosing an<br />
index that will underlie an investment product or serve as<br />
a benchmark <strong>for</strong> a plan involves establishing a long-term<br />
business relationship with another <strong>com</strong>mercial enterprise—the<br />
index provider. That introduces unique risks<br />
and rewards that must be considered in context, and are<br />
too often overlooked by investors.<br />
This index provider does not pull an index from the<br />
ether; it must, quite literally, manufacture the index.<br />
Index manufacture requires its own widget-making process<br />
in which certain raw materials <strong>com</strong>e in one door<br />
and certain final products go out a different door. It<br />
brings together all kinds of market data from around<br />
the world and a set of rules to produce an index value.<br />
<strong>The</strong> largest and most successful index providers build<br />
thousands of high-quality indexes across asset classes,<br />
generating values <strong>for</strong> many of them every few seconds.<br />
Indexes also must be reviewed and maintained regularly,<br />
too. <strong>The</strong>se are not trivial tasks.<br />
Would-be customers looking to choose an index should<br />
seek answers to key questions about the index provider and<br />
its manufacturing process. How long has the index provider<br />
been in business? What is its long-term viability in supporting<br />
this index? Does it have the necessary distribution relationships<br />
to create scale? Can its research and technology<br />
incorporate necessary changes in the marketplace? What<br />
about its maintenance and quality control processes?<br />
Different classes of index users will weight these<br />
(and other) questions differently depending on their<br />
own needs and concerns. For example, a pension fiduciary<br />
seeking to benchmark a multibillion-dollar U.S.<br />
equity allocation may choose an index provider with<br />
a long track record of successfully publishing indexes<br />
<strong>for</strong> the institutional marketplace over many years or<br />
even decades, which matches the pension’s expected<br />
investment-decision horizon. Further, it would look <strong>for</strong><br />
an index provider that offers a full suite of benchmarks,<br />
broken down by size, style and industry, in a way that<br />
logically and <strong>com</strong>prehensively captures the investment<br />
opportunity set <strong>for</strong> all of the pension’s asset managers.<br />
Finally, it would ensure that the index and <strong>com</strong>ponentlevel<br />
benchmark data be readily available to all of the<br />
participants in the process (asset managers, investment<br />
consultants and the pension itself) <strong>for</strong> per<strong>for</strong>mance<br />
reporting, attribution analysis and so on.<br />
Each of these <strong>com</strong>ponents—track record, offering suite<br />
and availability—reflects how a successful index provider<br />
chooses to execute its business strategy and <strong>com</strong>pete <strong>for</strong><br />
this market segment. Index analysis alone does not indicate<br />
whether a specific index provider can support the<br />
user in the a<strong>for</strong>ementioned ways.<br />
In contrast, an ETF issuer looking <strong>for</strong> a thematic index<br />
in, say, an area like water or infrastructure, may place<br />
a greater emphasis on other considerations such as<br />
the providers’ quality of underlying stock research and<br />
<strong>com</strong>pany-level due diligence.<br />
On occasion, index providers attempt to leverage exist-<br />
46<br />
September / October 2011
ing in-house tools and data to build thematic indexes;<br />
here, the provider usually <strong>com</strong>es with a shorter track<br />
record in understanding the theme or segment, and has<br />
difficult-to-verify due diligence processes and related<br />
quality control. This approach (which is separate from<br />
the index calculation and maintenance requirements)<br />
may raise the overall business relationship risk with<br />
regard to accurately and credibly capturing the theme.<br />
Occasionally, it’s possible to get the best of both worlds,<br />
however. In some cases, a research house or investment<br />
firm specializing in a niche area and an index provider<br />
will collaborate to create indexes, <strong>com</strong>bining specialized<br />
industry knowledge with a well-developed maintenance,<br />
calculation and distribution framework.<br />
Like the pension fund, the ETF issuer will consider<br />
each of the different approaches to determine which will<br />
best satisfy its business needs.<br />
A customer’s choice of provider is a key element in<br />
the search <strong>for</strong> a benchmark, as it is the starting point <strong>for</strong><br />
an important (even if not-so-obvious) risk/reward relationship.<br />
<strong>The</strong> process of asking certain questions and<br />
finding the answers allows the user to more thoroughly<br />
understand how well the relationship will satisfy their<br />
needs. Often as not, the sensible choice is likely to favor<br />
the more established index provider.<br />
Selecting An Index<br />
But what of the index itself? Does the choice matter?<br />
Of course it does.<br />
<strong>The</strong> process may be <strong>com</strong>plicated by the fact there are far<br />
more indexes than index providers, so there is more in<strong>for</strong>mation<br />
to sift through be<strong>for</strong>e making a selection.<br />
Continuing the pension example is useful here.<br />
Suppose a pension fund decides to benchmark its U.S.<br />
equity allocation to a large-cap index from one provider<br />
and a small-cap index from a different provider. <strong>The</strong>re are<br />
more than a few funds that use the S&P 500 to benchmark<br />
their large-cap mandates and simultaneously employ the<br />
Russell 2000 to benchmark their small-cap mandates. For<br />
a long time, this was the accepted standard.<br />
Even if both of the indexes were selected because<br />
of their popularity and broad use, the <strong>com</strong>bination<br />
introduces gaps and overlaps in the fund’s aggregate<br />
exposure. <strong>The</strong> S&P 500 is a basket of 500 stocks that<br />
are selected by <strong>com</strong>mittee. Although they are generally<br />
large, the stocks are certainly not simply the largest 500.<br />
(If they were, S&P wouldn’t need a <strong>com</strong>mittee <strong>for</strong> selection.)<br />
Roughly speaking, the stocks are chosen subjectively<br />
based on how well they collectively represent the<br />
overall U.S. market, rather than strictly based on market<br />
capitalization. As a result, the S&P 500 contains the largest<br />
350 or so, and then a smattering of smaller securities<br />
further down the spectrum of market capitalization.<br />
In contrast, the Russell 2000 is a basket of stocks that<br />
includes the 2,000 stocks that fall below the top 1,000 stocks<br />
in the U.S. market, in terms of market capitalization. When<br />
paired with the S&P 500, there are hundreds of stocks that<br />
are simply not accounted <strong>for</strong> by either index—and a few<br />
that are, that appear in both indexes.<br />
Although perhaps convenient, the <strong>com</strong>bination is not<br />
an appropriate measure <strong>for</strong> a pension fund seeking to<br />
benchmark the total portfolio. Gaps and overlaps tend<br />
to create opportunities <strong>for</strong> managers to take risks and<br />
earn additional <strong>com</strong>pensation <strong>for</strong> “beating the index”<br />
when, in fact, such risks are simply not being accounted<br />
<strong>for</strong> properly. A more appropriate benchmark could be<br />
created by using <strong>com</strong>plementary indexes that provide<br />
seamless exposure to, and measure of, the U.S. equity<br />
opportunity set. In short, index selection creates unique<br />
risks if the indexes involved are not constructed using a<br />
consistent methodology, even if both indexes (and both<br />
index providers) are of the highest caliber.<br />
Not surprisingly, an ETF provider that is more concerned<br />
with covering a specific segment of the market—as<br />
opposed to a particular asset class within the context of a<br />
broad-market investment scheme—is going to be focused<br />
on a slightly different set of considerations. When scrutinizing<br />
individual indexes that supposedly cover the same<br />
slice of the market, the seemingly significant similarities<br />
of purpose can obscure some of the more nuanced—but<br />
highly relevant—design differences. For example, is the<br />
index designed with an eye <strong>for</strong> <strong>com</strong>plete coverage or<br />
<strong>for</strong> efficient representation? How many holdings does it<br />
have? What is the turnover? How does it weigh individual<br />
securities? <strong>The</strong> list goes on, with the user’s choice of index<br />
influenced by specific needs.<br />
Users should look beyond the index itself to its governing<br />
principles, considering how the index defines its<br />
stated objective, how well the index addresses the user’s<br />
investment objective, how well it adheres to that objective,<br />
and whether it is transparent and rules-based. A<br />
firm grasp of these facets of the index is crucial to evaluating<br />
whether any perceived tracking error, per<strong>for</strong>mance<br />
shortfall and unnecessary costs are the result of poor<br />
index construction and maintenance or simply anomalies<br />
in that particular market’s per<strong>for</strong>mance.<br />
<strong>The</strong>se are not easy questions, and truly identifiable<br />
answers may not exist until an index is tested, as evidenced<br />
by what occurred in the markets during the dot-<strong>com</strong> bust<br />
and the financial crisis. During those periods, technology<br />
indexes, homebuilder indexes and dividend indexes faced<br />
serious and previously unanticipated challenges.<br />
As the housing bust roiled the markets, homebuilder<br />
indexes, <strong>for</strong> example, needed to respond to a rapid and<br />
unprecedented decline in the number of eligible securities.<br />
Index providers responded in different ways, with at<br />
least one including nonhomebuilding stocks as per their<br />
published rules in order to maintain a predetermined<br />
number of securities. However, such shifts in portfolio<br />
focus seriously alter risk exposure and per<strong>for</strong>mance characteristics<br />
on a go-<strong>for</strong>ward basis, and such minutiae may<br />
escape investors’ notice. Even so, it should not escape the<br />
product provider’s notice.<br />
At around the same time the homebuilding market was<br />
imploding, dividend indexes also experienced a period of<br />
continued on page 49<br />
www.journalofindexes.<strong>com</strong> September / October 2011 47
Talking Indexes<br />
From A Provider’s<br />
Perspective<br />
Looking out from inside the index<br />
By David Blitzer<br />
In institutional money management, portfolio managers<br />
and traders work side by side. <strong>The</strong> portfolio manager<br />
sets investment strategy, chooses the securities<br />
to buy and relies on the trader to handle the tactics and<br />
execute the trades. <strong>The</strong>y work as a team with continuous<br />
<strong>com</strong>munication back and <strong>for</strong>th. Institutional index investing,<br />
on the other hand, can be quite different. Key parts of<br />
the portfolio manager’s role—security selection and the<br />
weighting of securities in the portfolio—are handled by<br />
the index provider, while trading and execution remain<br />
with the fund manager.<br />
Communication is also different from active management<br />
in that the index provider publicly announces portfolio<br />
changes a few days be<strong>for</strong>e the change is effected in the<br />
index. <strong>The</strong> roles of portfolio management and trader are<br />
carried out in separate <strong>com</strong>panies with different objectives.<br />
An institutional investor’s goal is generally to seek superior<br />
investment per<strong>for</strong>mance, and decades of data indicate<br />
tracking an index is the best way to do that. While the index<br />
provider recognizes the desire <strong>for</strong> high returns, low risks and<br />
outstanding investment per<strong>for</strong>mance, the index provider’s<br />
objective is to represent a particular market or segment of<br />
a market with the index. Examples range from investable<br />
equities on a global basis to developed markets to large-cap<br />
U.S. equities to a sector or an even narrower example, such<br />
as stocks with consistent records of paying dividends.<br />
As the de facto portfolio manager, the index provider<br />
publishes a methodology document <strong>for</strong> the index, similar<br />
to a portfolio manager’s investment policy statement.<br />
<strong>The</strong> index provider also issues announcements about any<br />
changes to the portfolio <strong>for</strong> institutional investors tracking<br />
the index. While the index provider determines what is in<br />
the index, it is the institutional fund manager who ultimately<br />
decides when to trade stocks and how closely the fund’s<br />
holdings will match the index. When the index <strong>com</strong>ponents<br />
are reasonably liquid and relatively easy-to-trade stocks in<br />
a single market, the fund’s holdings will usually match the<br />
index closely and be able to achieve per<strong>for</strong>mance within<br />
a few basis points of the index’s calculated results, after<br />
adjusting <strong>for</strong> fees or other costs that may be involved. In<br />
other situations, institutional investors and fund managers<br />
may choose to hold only some of the securities in the index<br />
and may under- or outper<strong>for</strong>m the index.<br />
Another difference from active management is that with<br />
index funds, there may be a number of institutional investors<br />
<strong>com</strong>peting with one another while tracking the same<br />
index. Further, those offering products, such as ETFs or<br />
mutual funds, are required to publish their results <strong>for</strong> all to<br />
see. <strong>The</strong> product’s success is measured against the results<br />
calculated by the index provider giving the theoretical<br />
returns earned by the index. Such returns are considered<br />
“theoretical” because the index provider is not trading and<br />
does not include such costs related to trading as <strong>com</strong>missions<br />
or market impacts. For index products tracking the<br />
same index, a <strong>com</strong>petitive advantage <strong>com</strong>es down to basis<br />
points of operating expense and per<strong>for</strong>mance <strong>com</strong>pared<br />
with their peers. In few places in the investment world can<br />
<strong>com</strong>parisons depend so much on only costs and returns<br />
and so little on qualitative factors.<br />
Communication between the index provider and the<br />
investors is public and must maintain equal access <strong>for</strong> a<br />
level playing field. <strong>The</strong> <strong>com</strong>munications are not in<strong>for</strong>mal<br />
conversations. <strong>The</strong>y are governed by rules established by<br />
the index provider as well as state and federal laws and regulations.<br />
Active, or nonindex, money managers may enjoy<br />
some secrecy about their investing intentions, while index<br />
48<br />
September / October 2011
investors do not. Active investors may be concerned about<br />
being front-run; if they execute a series of large trades, they<br />
may try to “disguise” their intentions or spread trades over<br />
a few days to avoid being noticed. Index investors, on the<br />
other hand, know that any pertinent news hits the market<br />
at the same time <strong>for</strong> everyone. However, this does not<br />
mean that the institutional index investors are blindly waiting<br />
<strong>for</strong> the next add or drop announcements to pop up on<br />
the screen. <strong>The</strong> index provider’s methodology—the guidelines<br />
and procedures used to run the index—is public.<br />
Unlike an active manager worried about front-running, the<br />
index fund manager has no need to “disguise” his actions<br />
or spread out his trades. On the contrary, in some cases the<br />
index provider prefers to be predictable.<br />
Occasionally an investor will argue that making the index<br />
methodology public and giving investors five days’ notice<br />
of any change invites hedge funds or other sophisticated<br />
investors to trade in front of, and thereby gain from, index<br />
funds that instead time their trades to exactly match any<br />
changes in an index. However, as shown by the Standard<br />
& Poor’s SPIVA reports, this concern about fast trading is<br />
misplaced. In fact, as documented in these reports, 1 over<br />
the last several years, index funds remain very difficult to<br />
consistently outper<strong>for</strong>m. This holds true in most markets—<br />
large-cap or small, developed or emerging—even <strong>for</strong> the<br />
largest index funds. Published methodologies and public<br />
announcements don’t disadvantage investors.<br />
<strong>The</strong>re are some other differences in <strong>com</strong>munication <strong>for</strong><br />
indexes versus active managers. For index providers, <strong>com</strong>munication<br />
is largely one way, except <strong>for</strong> an occasional<br />
clarification; and there is little opportunity to change one’s<br />
mind after an announcement. For example, an index provider<br />
can’t say anything more than “no <strong>com</strong>ment” when an<br />
investor—or a <strong>com</strong>pany CFO—calls to discuss the implications<br />
of whether <strong>com</strong>pany A or B may be a better fit <strong>for</strong> a<br />
certain index. While there may be times when an experienced<br />
trader might have valuable in<strong>for</strong>mation about the<br />
likely market reaction to a particular index announcement,<br />
an index provider can do no more than listen stone-faced<br />
to the <strong>com</strong>ments, say “thank you” and conclude the call.<br />
Communication from an index provider is public and<br />
broadcast to the market through the media as well as<br />
delivered by email or FTP. <strong>The</strong>re is no way to tell who<br />
received it—and who would need to be told if it were being<br />
changed. Once an announcement is made, investors will<br />
begin planning and executing trades to take advantage<br />
of pending index changes. As tempting as it might be in<br />
unusual circumstance to revise an announcement after<br />
it is published, it is virtually impossible unless the trades<br />
suggested by the announcement can’t be <strong>com</strong>pleted.<br />
Such rare cases might happen if a merger or a spinoff<br />
were canceled after an announcement or if trading in<br />
a stock is halted indefinitely. Given these constraints,<br />
announcements sometimes omit such details as the specific<br />
date when a stock will join an index until a second<br />
announcement, such as when a merger is expected to<br />
close shortly but the date is not yet known.<br />
When thinking about how an active institutional money<br />
manager <strong>com</strong>pares with an institutional index manager, it<br />
is easy to believe that the index investor following the index<br />
provider’s announcements has little to do—just a few trades<br />
now and then as suggested by an announcement. This is far<br />
from the truth. <strong>The</strong> success of the institutional index manager<br />
depends on how effectively and efficiently the trading<br />
is done, on whether the trade exactly tracks the index or<br />
when the trader anticipates other market adjustments. Such<br />
challenges may be just as great, if not greater, <strong>for</strong> the index<br />
manager in <strong>com</strong>parison with the active manager.<br />
Endnote<br />
1. See www.spiva.standardandpoors.<strong>com</strong>.<br />
In Perspective continued from page 47<br />
extreme stress as banks and other financial institutions<br />
altered their dividend policies to preserve capital or as a<br />
condition of federal support. Financial <strong>com</strong>panies were of<br />
the largest sector in virtually every dividend-focused index,<br />
and they possessed some of the highest yields. With their<br />
<strong>com</strong>ponent share prices now plunging, dividend indexes<br />
also saw their levels plummet. This was <strong>com</strong>pounded<br />
by subsequent dividend cuts or outright eliminations as<br />
the relevant stocks plumbed their lows. Index providers<br />
were then <strong>for</strong>ced to kick most of the financials out of their<br />
indexes, and scramble to find replacement securities.<br />
However, the market rebound was later led by many of the<br />
very financial stocks that had been excised from <strong>com</strong>ponent<br />
lists of the dividend indexes. As a result, those indexes<br />
suffered the full brunt of the market’s collapse, but did not<br />
fully share in the subsequent market recovery. This turned<br />
out to be a big disappointment <strong>for</strong> investors—though they<br />
have since returned to these indexes <strong>for</strong> reasons pertaining<br />
to the low-yield environment.<br />
While these nuances of index construction likely did not<br />
seem terribly important be<strong>for</strong>e 2008’s market disaster, they<br />
should be taken into account by product providers when<br />
choosing indexes in the future.<br />
Clearly, the process of deciding on just the right index is<br />
quite exacting. <strong>The</strong>re’s little doubt, however, that customers<br />
who take the time to thoughtfully consider all of the<br />
relevant factors that go into the selection of an index will<br />
be far more satisfied than those who don’t.<br />
www.journalofindexes.<strong>com</strong> September / October 2011 49
News<br />
MSCI Says Korea,<br />
Taiwan Still <strong>Emerging</strong><br />
South Korea and Taiwan will<br />
retain their developing market status<br />
in the MSCI <strong>Emerging</strong> <strong>Market</strong>s Index<br />
because they still lack accessibility, but<br />
they remain under review <strong>for</strong> possible<br />
reclassification to developed status a<br />
year from now, MSCI said.<br />
In its June announcement of its annual<br />
reclassification review, MSCI also said<br />
further consideration of whether Qatar<br />
and the United Arab Emirates ought to<br />
be shifted to emerging market status<br />
from their current frontier market status<br />
will be extended until December of<br />
this year. <strong>The</strong> indexing <strong>com</strong>pany noted<br />
it needed more time to assess recent<br />
changes to those two markets.<br />
While MSCI will weigh in on the two<br />
Persian Gulf countries in November<br />
of this year, a potential reclassification<br />
of the two to emerging market<br />
status wouldn’t be implemented until<br />
November 2012, at the earliest.<br />
As it stands, both MSCI’s emerging<br />
and frontier market indexes will<br />
remain unchanged <strong>for</strong> now, the <strong>com</strong>pany<br />
said in a press release.<br />
MSCI, widely considered the market<br />
leader in international benchmarks,<br />
also said it isn’t adding any new<br />
countries <strong>for</strong> potential reconsideration<br />
in next year’s review. It announces<br />
changes every June and provides the<br />
first warning that changes to its indexes<br />
could be <strong>com</strong>ing the following June.<br />
Remy Briand, a managing director<br />
and the global head of index research<br />
at MSCI, in a news conference, also<br />
briefly touched on Egypt’s status as an<br />
emerging market country, which MSCI<br />
said earlier this year might <strong>com</strong>e under<br />
review because the civil unrest there<br />
that led to the resignation of President<br />
Hosni Mubarak had left the stock market<br />
closed <strong>for</strong> almost 40 days.<br />
Briand said the feedback MSCI has<br />
received from investors suggests that<br />
trading on Egypt’s stock exchange is<br />
going smoothly. But he also noted that<br />
MSCI would be continuing to monitor<br />
the situation, though its eligibility<br />
would not be reviewed.<br />
Russell Rebalances<br />
Russell Investments added 186 <strong>com</strong>panies<br />
to its broad-market Russell 3000<br />
Index as part of its annual reconstitution<br />
this year, of which it said 22 were initial<br />
public offerings. Overall market capitalization<br />
of the index meanwhile grew by<br />
almost 25 percent in the past year.<br />
<strong>The</strong> <strong>com</strong>ponents of the reconstituted<br />
Russell 3000, which reflects about<br />
98 percent of the U.S. equities universe,<br />
had a total market value of $16.7 trillion<br />
as of May 31, up from $13.4 trillion a<br />
year earlier.<br />
<strong>The</strong> changes to U.S. <strong>com</strong>panies in<br />
Russell indexes—as well as additions<br />
and deletions to the Russell Global<br />
Index—were finalized on June 27.<br />
Changes to the index are available on<br />
the <strong>com</strong>pany’s website.<br />
<strong>The</strong> process of reconstituting<br />
benchmarks takes place annually<br />
and revisits the inclusion of particular<br />
<strong>com</strong>panies in various indexes<br />
through rules such as market-capitalization<br />
rankings, the <strong>com</strong>pany said in<br />
May when it announced the timing of<br />
this year’s changes.<br />
Russell also noted in its press release<br />
that the median market capitalization<br />
of the Russell 3000 was to increase by<br />
23 percent—to $1.04 billion from $802<br />
million in 2010.<br />
It said its lists showed a relatively<br />
even distribution of additions among<br />
sectors, and included 35 firms in the<br />
health care sector, 33 in financial services<br />
and 31 in technology.<br />
Russell said its research shows Exxon<br />
Mobil and Apple remain the two largest<br />
<strong>com</strong>panies in the Russell 3000 Index,<br />
with market values of $411.2 billion and<br />
$321.7 billion, respectively, and that<br />
Chevron was to re-enter the top 10 as<br />
the fourth-largest stock in the index.<br />
FTSE Acquires DJI’s Share In ICB<br />
In mid-June, FTSE announced it<br />
had acquired the 50 percent it didn’t<br />
already own of the global sector classification<br />
system, ICB, from Dow Jones<br />
Indexes. Terms weren’t disclosed.<br />
FTSE and Dow Jones developed ICB,<br />
one of three major classification systems<br />
that dominate global sector indexing, in<br />
2005. ICB is the broadest classification<br />
system available to the market, with a<br />
universe of 80,000 stocks, and is consistently<br />
evolving to respond to market<br />
requirements, FTSE said.<br />
Three major classification systems<br />
dominate sector indexing worldwide:<br />
r5IF41.4$*#BSSB(MPCBM<br />
Industry Classification Standard<br />
(GICS)<br />
r5IF5IPNTPO3FVUFST#VTJOFTT<br />
Classification (TRBC)<br />
r5IF%PX+POFT'54&*OEVTUSZ<br />
Classification Benchmark (ICB)<br />
Although details differ, the goal of<br />
each system is the same: to sift through<br />
tens of thousands of available stocks<br />
and organize them into discrete yet<br />
<strong>com</strong>prehensive categories.<br />
Dow Jones Indexes will continue<br />
to maintain its own classification<br />
system based on the ICB going <strong>for</strong>ward,<br />
FTSE said.<br />
<strong>Case</strong>-Shiller Benchmarks<br />
Move Higher<br />
U.S. home prices in April inched<br />
higher <strong>for</strong> the first time in eight months,<br />
after falling in March to their lowest<br />
levels since 2009, helped by warmer<br />
weather and an uptick in buying inter-<br />
FTU UIF MBUFTU 41$BTF 4IJMMFS )PNF<br />
Price report said.<br />
Housing prices are typically stronger<br />
in the spring and summer months,<br />
as people strive to move into their new<br />
homes by fall when school resumes,<br />
50<br />
September / October 2011
and it appears that dynamic helped<br />
support the 10-City and 20-City <strong>com</strong>posites,<br />
which rose marginally—less<br />
than 1 percent—from March levels.<br />
It was the first positive month-overmonth<br />
per<strong>for</strong>mance since July 2010,<br />
though prices in most markets remain<br />
lower than in the same year-earlier<br />
period, the report said.<br />
According to an S&P spokesman,<br />
there was no way to tell if the upturn<br />
was a turning point or just the result of<br />
the warm weather.<br />
A total of 13 out of 20 cities surveyed<br />
saw home prices inch higher in April vs.<br />
March, and half of them posted gains of<br />
more than 1 percent. But, again, nearly<br />
all the cities in the indexes remained<br />
well below year-ago levels.<br />
<strong>The</strong> exception was Washington, D.C.,<br />
where home prices rose 3 percent in<br />
April <strong>com</strong>pared with March, and are now<br />
4 percent higher than a year earlier.<br />
By contrast, housing values dropped<br />
in seven cities in April, and six of them<br />
even <strong>for</strong>ged new lows. Charlotte,<br />
Chicago, Detroit, Las Vegas, Miami<br />
and Tampa each fell into deeper negative<br />
territory in April.<br />
Minneapolis was the only city that<br />
posted a double-digit annual decline—<br />
home prices there are 11 percent lower<br />
than they were a year ago. On the same<br />
note, Cleveland, Detroit and Las Vegas<br />
have home prices that are now lower<br />
than they were 11 years ago.<br />
INDEX DEVELOPMENTS<br />
Guggenheim To<br />
Change SEA’s Index<br />
Guggenheim Funds filed paperwork<br />
with the Securities and<br />
Exchange Commission to change the<br />
index on its Guggenheim Shipping<br />
ETF (NYSE Arca: SEA). <strong>The</strong> change<br />
appears to cut U.S. weighting in the<br />
fund by 80 percent.<br />
<strong>The</strong> ETF, which is currently based on<br />
the Delta Global Shipping Index, will be<br />
organized around the Dow Jones Global<br />
Shipping Index once the change takes<br />
place, according to the filing. It said the<br />
change will be<strong>com</strong>e effective 60 days<br />
after the filing, “pursuant to paragraph<br />
(A)(1) of Rule 485.” <strong>The</strong> Guggenheim<br />
filing was dated May 27.<br />
<strong>The</strong> proposed new Delta Global<br />
Shipping Index weighted U.S. <strong>com</strong>panies<br />
at 36.3 percent as of March 3, while<br />
the Dow Jones Global Shipping Index<br />
had a U.S. weighting of 7.8 percent as of<br />
April 30. <strong>The</strong> new benchmark index also<br />
weights certain Asian countries more<br />
heavily than the existing index.<br />
<strong>The</strong> fund has almost $12 million in<br />
assets, according to data <strong>com</strong>piled by<br />
<strong>IndexUniverse</strong>.<br />
10 New Russell-Axioma<br />
Indexes Debut<br />
In late May, Russell Investments<br />
announced it was launching 10<br />
more indexes through its partnership<br />
with Axioma Inc.<br />
<strong>The</strong> new indexes are designed to target<br />
risk factor exposures through longonly<br />
positions. <strong>The</strong> benchmarks are derivations<br />
of the Russell 1000 and Russell<br />
2000 indexes, and individually offer high<br />
and low volatility and beta exposures.<br />
<strong>The</strong>y also offer high momentum factor<br />
exposure <strong>for</strong> both size segments. Russell<br />
launched 10 ETFs based on each of the<br />
new indexes at the end of May.<br />
<strong>The</strong> index provider first announced<br />
its collaboration with Axioma in<br />
December 2009, with the first resulting<br />
indexes debuting in November 2010.<br />
S&P Launches ‘RC 2’ Indexes<br />
S&P said in early June that it was<br />
launching a new series of “next-generation”<br />
risk control indexes. <strong>The</strong> index<br />
provider already offers a wide array of<br />
indexes focusing on different regions<br />
and strategies that control risk by aiming<br />
<strong>for</strong> specific risk levels and allocating<br />
a percentage of the theoretical<br />
portfolio to cash accordingly.<br />
However, the ‘RC 2’ (risk control 2)<br />
indexes allocate part of the portfolio to<br />
bonds instead of cash, allowing investors<br />
to benefit from the yields offered<br />
by fixed-in<strong>com</strong>e investments, a press<br />
release said. Also, unlike S&P’s origi-<br />
www.journalofindexes.<strong>com</strong> September / October 2011 51
News<br />
nal risk control series, the new indexes<br />
do not use leverage or shorting to<br />
achieve their exposures, but they can<br />
allocate entirely to the equity index or<br />
the bond index <strong>com</strong>ponents.<br />
According to its website, S&P currently<br />
offers RC 2 versions of the S&P<br />
500, S&P Euro 75, S&P Asia 50 and S&P<br />
BRIC 40 indexes that target volatility<br />
levels of 8, 10 and 15 percent.<br />
FTSE, TOBAM Create Maximum<br />
Diversification Indexes<br />
An early June announcement from<br />
FTSE outlined a new partnership with<br />
TOBAM, a France-based asset management<br />
firm known <strong>for</strong> its “anti-benchmark”<br />
strategies. <strong>The</strong> joint collaboration<br />
will focus on the creation of a family<br />
of alternatively weighted indexes<br />
built on a quantitative methodology<br />
designed to minimize concentration<br />
risk and achieve as much diversification<br />
as possible, the press release said.<br />
No launch date was given.<br />
S-Network Unveils CEFMX<br />
S-Network Global Indexes LLC<br />
rolled out the S-Network Municipal<br />
Bond Closed-End Fund Index in<br />
early June. Paul Mazzilli, previously<br />
executive director and director of ETF<br />
research at Morgan Stanley, helped to<br />
create the index, a press release said.<br />
Mazzilli was the firm’s senior closedend<br />
fund and ETF analyst. He left<br />
Morgan Stanley in November 2008.<br />
According to the press release, the<br />
index employs a modified weighting<br />
methodology based on net assets.<br />
Components are drawn from a universe<br />
of roughly 130 funds. All of the<br />
eligible funds have at least $100 million<br />
in net assets; they must also meet<br />
specific requirements regarding maximum<br />
expense ratio and maximum<br />
average trading premium levels.<br />
<strong>The</strong> index underlies the <strong>Market</strong><br />
Vectors CEF Municipal In<strong>com</strong>e<br />
ETF (NYSE Arca: XMPT), which<br />
launched in July.<br />
New S&P Index Targets Africa<br />
In mid-June, Standard & Poor’s<br />
debuted the S&P Access Africa<br />
Index, which is designed as a bluechip<br />
benchmark.<br />
According to the press release, the<br />
selection universe includes the stocks listed<br />
on the Johannesburg Stock Exchange;<br />
all <strong>com</strong>panies based in Africa but listed<br />
on developed-market exchanges; and<br />
developed-market <strong>com</strong>panies that operate<br />
mainly in Africa and generate their<br />
profits there. As a general rule, eligible<br />
<strong>com</strong>panies must generate at least 50 percent<br />
of their revenues from Africa.<br />
<strong>The</strong> index’s methodology also<br />
requires <strong>com</strong>ponents have a minimum<br />
market capitalization of $200<br />
million and meet a minimum daily<br />
volume requirement, the press<br />
release said. In all, the index includes<br />
45 stocks, the largest of which were<br />
Tullow Oil (9.78 percent); Anglo<br />
American Plc (9.51 percent); and<br />
Old Mutual (6.82 percent) as of May<br />
31, 2011. <strong>The</strong> top countries were the<br />
United Kingdom (35 percent); South<br />
Africa (30.8 percent); and Canada<br />
(20.1 percent).<br />
S&P has also launched a series of<br />
risk-controlled indexes based on the<br />
S&P Access Africa Index, the press<br />
release said.<br />
Stoxx Rolls Out ‘World’ Index<br />
Stoxx Limited launched the blue-chip<br />
iStoxx World Select Index in early July,<br />
the <strong>com</strong>pany said in a press release.<br />
<strong>The</strong> index targets some of the<br />
world’s most followed developed markets,<br />
rolling the narrow-based Euro<br />
Stoxx 50, Stoxx 50 and Stoxx Japan<br />
50 up into one 150-stock benchmark.<br />
Interestingly, the benchmark equalweights<br />
its three <strong>com</strong>ponent indexes,<br />
which according to Stoxx, means that<br />
the outsized influence usually wielded<br />
by the U.S. in any developed-market<br />
index is significantly reduced. <strong>The</strong><br />
<strong>com</strong>ponents index themselves, follow<br />
similar methodologies and are<br />
weighted by free-float market capitalization,<br />
the press release notes.<br />
<strong>The</strong> <strong>com</strong>ponent indexes are rebalanced<br />
quarterly, and the broader<br />
index resets their equal weightings on<br />
a quarterly basis as well, according to<br />
the press release.<br />
Stoxx Launches Minimum<br />
Variance Index<br />
Stoxx Ltd. rolled out the iStoxx Europe<br />
Minimum Variance Index in late June,<br />
the <strong>com</strong>pany said in a press release.<br />
<strong>The</strong> new index is derived from<br />
the free-float capitalization-weighted<br />
Stoxx Europe 600 Index. Using an<br />
algorithm, it selects its <strong>com</strong>ponents<br />
from its parent index and reweights<br />
them to create a benchmark that is<br />
designed to exhibit minimal expected<br />
variance, the press release said. <strong>The</strong><br />
index’s design is based on the principles<br />
of modern portfolio theory.<br />
With caps on sector and individual<br />
<strong>com</strong>ponent weightings, in<br />
addition to diversification requirements,<br />
the iStoxx Europe Minimum<br />
Variance Index typically has a <strong>com</strong>ponent<br />
list of about 80 stocks, the<br />
press release said.<br />
Ossiam, which assisted in the development<br />
of the index, has signed a<br />
licensing agreement that will allow it to<br />
use the index as the basis <strong>for</strong> an ETF.<br />
DJ Global Commodity<br />
Equity 100 Index Debuts<br />
In late June, Dow Jones Indexes<br />
rolled out of the Dow Jones Global<br />
Commodity Equity 100 Index.<br />
According to a press release, the<br />
index covers <strong>com</strong>panies operating in<br />
the <strong>com</strong>modities industry, including<br />
in the areas of “agriculture, energy,<br />
metals, precious metals and water.”<br />
<strong>The</strong> index’s launch included the<br />
debut of four subindexes. Two cover<br />
agriculture and energy, respectively,<br />
while a third—the Dow Jones Global<br />
Equity Scarcity Index—covers nonrenewable<br />
resources. <strong>The</strong> fourth<br />
subindex is the Dow Jones Islamic<br />
<strong>Market</strong> Global Equity Commodity<br />
Index, which screens out the <strong>com</strong>ponents<br />
in the parent index that are<br />
not permissible investments under<br />
Shariah law, the press release said.<br />
According to a DJI fact sheet,<br />
the U.S. is the largest country in<br />
the main index, with a weighting<br />
of 30.5 percent, followed by the<br />
United Kingdom (20.37 percent) and<br />
Canada (13.16 percent).<br />
52<br />
September / October 2011
Thomson Reuters Designs<br />
Islamic Indexes<br />
A July 4 announcement from<br />
Thomson Reuters indicates it is<br />
the latest index provider to offer its<br />
own lineup of Shariah-<strong>com</strong>pliant<br />
indexes. <strong>The</strong> <strong>com</strong>pany teamed up<br />
with IdealRatings, a firm that offers<br />
Shariah-<strong>com</strong>pliant funds and evaluation<br />
research, to create the Thomson<br />
Reuters IdealRatings Islamic Indices.<br />
<strong>The</strong> <strong>com</strong>ponent <strong>com</strong>panies are<br />
monitored on an ongoing basis via<br />
quarterly reviews conducted by <strong>com</strong>puters<br />
using algorithms and human<br />
researchers, the press release said;<br />
the index methodology keeps track of<br />
more than 30 different types of revenue<br />
sources that require scrutiny under<br />
Shariah law, it added.<br />
<strong>The</strong> indexes draw their <strong>com</strong>ponents<br />
from more than 60 countries,<br />
using Thomson Reuters’ universe of<br />
71,000 <strong>com</strong>panies. Currently the index<br />
family has nine regional benchmarks,<br />
including subindexes covering the Gulf<br />
Cooperation Council and the Middle<br />
East and North Africa region, the<br />
announcement said.<br />
<strong>The</strong> press release noted that the<br />
indexes were designed to meet the<br />
standards set <strong>for</strong>th by the Accounting<br />
and Auditing Organisation <strong>for</strong><br />
Islamic Financial Institutions, a nonprofit<br />
that establishes ethical and<br />
accounting standards <strong>for</strong> the Islamic<br />
financial <strong>com</strong>munity.<br />
S&P Consults On<br />
Country Classifications<br />
Standard & Poor’s launched a consultation<br />
document in June seeking<br />
feedback from market participants on its<br />
country classification system. Responses<br />
were requested by Aug. 26, 2011.<br />
<strong>The</strong> index provider’s queries targeted<br />
seven countries in particular, asking<br />
survey participants if they thought each<br />
country’s development status should be<br />
reclassified. S&P is considering whether<br />
it should promote the Czech Republic<br />
from emerging to developed status, and<br />
whether it should downgrade Greece<br />
from developed to emerging status. <strong>The</strong><br />
index provider is also reviewing whether<br />
Jordan, Kuwait, Oman, Qatar and the<br />
United Arab Emirates should be promoted<br />
from frontier to emerging status.<br />
<strong>The</strong> consultation paper also asks<br />
participants if they think that <strong>com</strong>panies<br />
trading in renminbi on the<br />
Hong Kong Stock Exchange should be<br />
included in the S&P indexes.<br />
In a separate release in early June,<br />
S&P also announced that Colombia, a<br />
frontier market, would be promoted to<br />
emerging market status as of the S&P<br />
indexes’ September 2011 reconstitution.<br />
DJI Unveils European<br />
Titans Indexes<br />
In June, Dow Jones Indexes said<br />
it had launched a pair of indexes targeting<br />
European blue-chip stocks; the<br />
indexes are its latest additions to the<br />
Dow Jones “Titans” index family.<br />
<strong>The</strong> Dow Jones Eurozone Titans 80<br />
Index and the Dow Jones Europe Titans<br />
80 Index each have 80 <strong>com</strong>ponents<br />
chosen based on float-adjusted market<br />
capitalization, revenues and net profits,<br />
according to the press release. While<br />
the Eurozone index selects its <strong>com</strong>ponents<br />
from the markets of Austria,<br />
Belgium, Finland, France, Germany,<br />
Greece, Ireland, Italy, the Netherlands,<br />
Portugal and Spain, the more broadly<br />
focused DJ Europe Titans 80 Index canvasses<br />
those countries and Denmark,<br />
Iceland, Norway, Sweden, Switzerland<br />
and the U.K., the press release said.<br />
UniCredit has licensed the indexes<br />
to underlie structured products that will<br />
be offered in Germany and Austria.<br />
MSCI Adds To ESG Index Family<br />
MSCI announced in late June the<br />
addition of 25 indexes to its family<br />
of environmental sustainability governance<br />
(ESG) indexes.<br />
Nine of the indexes screen out<br />
“controversial weapons” such as land<br />
mines, biological weapons and depleted<br />
uranium weapons, according to a<br />
press release. <strong>The</strong>y were largely created<br />
to respond to demand from the<br />
institutional sector and have already<br />
been licensed to BlackRock to underlie<br />
index funds. <strong>The</strong> group of indexes<br />
includes screened versions of the MSCI<br />
ACWI, MSCI World, MSCI USA and<br />
MSCI <strong>Emerging</strong> markets indexes.<br />
MSCI also debuted the MSCI World<br />
Socially Responsible Index and four<br />
subindexes, the press release said. <strong>The</strong><br />
stocks included in the main benchmark<br />
have the highest ESG scores out<br />
of the <strong>com</strong>panies in MSCI’s universe,<br />
and also have been screened to exclude<br />
<strong>com</strong>panies with operations in the areas<br />
of tobacco, nuclear energy and genetically<br />
modified products.<br />
<strong>The</strong> remaining 11 indexes mentioned<br />
in the announcement cover<br />
different regions and countries as<br />
well as the <strong>com</strong>panies with the highest<br />
ESG scores in each of MSCI’s 10<br />
sectors, with an eye to achieving a<br />
close correlation to their corresponding<br />
standard MSCI indexes.<br />
Markit Debuts European ABS Index<br />
In June, Markit rolled out the<br />
Markit iBoxx European ABS Index,<br />
which targets the European assetbacked<br />
securities. <strong>The</strong> new index<br />
includes floating-rate ABS denominated<br />
in euros, British pounds or U.S.<br />
dollars, an announcement said.<br />
<strong>The</strong> index can be broken down into<br />
eight subindexes, including ones that<br />
target the various parts of Europe’s<br />
www.journalofindexes.<strong>com</strong> September / October 2011 53
News<br />
<strong>com</strong>mercial and residential ABS markets,<br />
respectively, AAA-rated ABS and<br />
ABS in different countries.<br />
In the press release, Markit said<br />
that the index could be used <strong>for</strong><br />
benchmarking purposes or to underlie<br />
investment products.<br />
AROUND THE WORLD OF ETFs<br />
Barclays Redeems VZZ<br />
Due To Price Drop<br />
Barclays Bank automatically<br />
redeemed its iPath Long Enhanced<br />
S&P 500 Mid-Term Futures ETN (NYSE<br />
Arca: VZZ) on July 1 because the price<br />
of the notes fell just below the $10 per<br />
share redemption barrier.<br />
VZZ, which had $12.8 million in<br />
assets as of June 30, was halted by Arca,<br />
the New York Stock Exchange’s electronic<br />
trading plat<strong>for</strong>m, after the ETN<br />
fell to $9.98 a share. That was $1.82<br />
lower on the day.<br />
VZZ’s 15 percent slide could have<br />
been related to the looming possibility<br />
of the automatic redemption,<br />
as its nonleveraged counterpart—the<br />
iPath S&P 500 VIX Mid-Term Futures<br />
ETN (NYSE Arca: VXZ)—was down<br />
just about 4 percent at the time Arca<br />
halted trade in VZZ.<br />
First Trust Debuts<br />
Cloud Computing ETF<br />
First Trust rolled out in July the<br />
First Trust ISE Cloud Computing Index<br />
Fund (Nasdaq GM: SKYY). <strong>The</strong> ETF<br />
is based on the ISE Cloud Computing<br />
Index and includes <strong>com</strong>panies actively<br />
involved in the cloud <strong>com</strong>puting industry,<br />
according to a filing the <strong>com</strong>pany<br />
made with the SEC on April 20.<br />
Cloud <strong>com</strong>puting refers to <strong>com</strong>puter<br />
users accessing many different servers<br />
to meet their needs, as opposed to<br />
using centralized <strong>com</strong>puting resources.<br />
Companies such as Amazon with<br />
immense <strong>com</strong>puting resources that<br />
go beyond internal demands have<br />
be<strong>com</strong>e big players in the expanding<br />
world of cloud <strong>com</strong>puting.<br />
SKYY <strong>com</strong>es with an annual expense<br />
ratio of 0.60 percent.<br />
Pimco Launches<br />
Short-Dated Corp. Junk ETF<br />
On June 17, Pimco rolled out a highyield<br />
corporate bond index ETF focused<br />
on the short end of the yield curve. <strong>The</strong><br />
Pimco 0-5 Year High Yield Corporate<br />
Bond Index Fund (NYSE Arca: HYS)<br />
tracks the BofA Merrill Lynch 0-5 Year<br />
US High Yield Constrained Index and<br />
costs 0.55 percent after a fee waiver, the<br />
<strong>com</strong>pany said on its website.<br />
Noninvestment-grade debt offers a<br />
way to obtain extra yield at a time when<br />
benchmark short-term interest rates<br />
remain near zero. <strong>The</strong> noninvestmentgrade<br />
debt in the new Pimco fund must<br />
be dollar denominated and issued in<br />
the U.S. It must have fewer than five<br />
years’ remaining term to final maturity,<br />
a fixed coupon schedule and a<br />
minimum amount outstanding of $100<br />
million, issued publicly, the <strong>com</strong>pany<br />
said. Also, allocations to an individual<br />
issuer will not exceed 2 percent.<br />
<strong>Emerging</strong> Global<br />
Unveils Sector ETFs<br />
<strong>Emerging</strong> Global Advisors launched<br />
a first-of-its-kind suite of sector funds<br />
on June 23, canvassing the developing<br />
markets that are tied to the Dow<br />
Jones <strong>Emerging</strong> <strong>Market</strong> Titans Index<br />
series. <strong>The</strong> new funds are marketed<br />
as the Global <strong>Emerging</strong> <strong>Market</strong> Sector<br />
ETFs, or “GEMS.” <strong>The</strong> family is the<br />
first to represent a <strong>com</strong>plete lineup<br />
of sector ETFs drawing their <strong>com</strong>ponents<br />
entirely from emerging markets.<br />
<strong>The</strong> ETFs, which all have net expense<br />
ratios of 0.85 percent, are:<br />
• EGShares Basic Materials GEMS<br />
ETF (NYSE Arca: LGEM)<br />
• EGShares Consumer Goods<br />
GEMS ETF (NYSE Arca: GGEM)<br />
• EGShares Health Care GEMS ETF<br />
(NYSE Arca: HGEM)<br />
• EGShares Industrials GEMS ETF<br />
(NYSE Arca: IGEM)<br />
• EGShares Technology GEMS ETF<br />
(NYSE Arca: QGEM)<br />
• EGShares Tele<strong>com</strong> GEMS ETF<br />
(NYSE Arca: TGEM)<br />
• EGShares Utilities GEMS ETF<br />
(NYSE Arca: UGEM)<br />
• EGShares Consumer Services<br />
GEMS ETF (NYSE Arca: VGEM)<br />
IndexIQ Rolls Out<br />
Small-Cap REIT ETF<br />
In June, IndexIQ launched a<br />
small-cap ETF focused on REITs,<br />
providing investors with what the<br />
<strong>com</strong>pany called an opportunity to<br />
earn higher dividends than on REIT<br />
ETFs focused on bigger firms.<br />
<strong>The</strong> IQ US Real Estate Small<br />
Cap Index ETF (NYSE Arca: ROOF)<br />
<strong>com</strong>es with a 0.69 percent annual<br />
expense ratio, and is based on<br />
the IQ US Real Estate Small Cap<br />
Index—a float-adjusted, marketcap-weighted<br />
benchmark focused<br />
squarely on small-capitalization<br />
U.S. real estate <strong>com</strong>panies.<br />
IndexIQ said ROOF’s dividend of<br />
about 5 percent is as much as 200<br />
basis points higher than those on<br />
many large-cap ETFs.<br />
<strong>The</strong> index that ROOF is built on<br />
includes the bottom 10 percent of<br />
U.S. REITs by market capitalization.<br />
IndexIQ also said that small-cap REITs<br />
have significantly outper<strong>for</strong>med largecap<br />
REITs over most time frames.<br />
54 September / October 2011
iShares Joins<br />
Floating-Rate ETF Party<br />
iShares rolled out a new ETF in<br />
June to help investors weather fluctuations<br />
in interest rates. <strong>The</strong> iShares<br />
Floating Rate Note Fund (NYSE Arca:<br />
FLOT) invests in dollar-denominated,<br />
investment-grade floating-rate<br />
bonds. By having adjustable interest<br />
rates, the bonds fluctuate less in<br />
value when interest rates are changing<br />
than fixed-yield bonds.<br />
FLOT’s launch follows both the<br />
<strong>Market</strong> Vectors Investment Grade<br />
Floating Rate ETF (NYSE Arca: FLTR),<br />
which also invests in high-quality<br />
notes; and the Invesco PowerShares’<br />
Senior Loan Portfolio (NYSE Arca:<br />
BKLN), which holds noninvestmentgrade<br />
bank loans.<br />
Floating-rate bonds are often<br />
linked to highly leveraged borrowers,<br />
as they are issued <strong>for</strong> recapitalization<br />
needs and acquisitions, such<br />
as leveraged buyouts.<br />
<strong>The</strong> new iShares ETF <strong>com</strong>es with<br />
an annual expense ratio of 0.20 percent,<br />
the <strong>com</strong>pany said on its website.<br />
By contrast, BKLN costs 0.83<br />
percent including acquired fund fees,<br />
while FLTR has a net expense ratio of<br />
0.19 percent.<br />
New UBS ETNs<br />
Hone In On Contango<br />
In June, UBS added to its family of<br />
“ETRACS” ETNs with the rollout of<br />
two first-to-market securities that try<br />
to profit from contango in the crude<br />
oil and natural gas futures markets.<br />
<strong>The</strong> ETNs, which UBS marketing<br />
materials said both <strong>com</strong>e with annual<br />
expense ratios of 0.85 percent, are:<br />
r&53"$4/BUVSBM(BT'VUVSFT<br />
Contango ETN (NYSE Arca: GASZ)<br />
r&53"$40JM'VUVSFT$POUBOHP<br />
ETN (NYSE Arca: OILZ)<br />
GASZ is designed to achieve its<br />
objective by going short the frontmonth<br />
contract, and going long an<br />
equivalent amount that’s divided into<br />
three equal investments in the 12th-,<br />
13th- and 14th-month contracts on<br />
the futures curve. OILZ is meanwhile<br />
designed to achieve its objective by<br />
going short the front-month contract<br />
and simultaneously establishing a<br />
long position that’s worth 150 percent<br />
of the short position. <strong>The</strong> long<br />
position is divided into three equal<br />
investments in the sixth-, seventhand<br />
eighth-month contracts on the<br />
crude oil futures curve.<br />
Deutsche Debuts<br />
Leveraged Dollar Index ETNs<br />
Deutsche Bank and Invesco<br />
PowerShares rolled out in late May<br />
the first-ever U.S. dollar index leveraged<br />
ETNs that provide triple-long<br />
and triple-short exposure to futures<br />
contracts on the currency benchmark<br />
that measures the value of the<br />
greenback <strong>com</strong>pared with six of the<br />
world’s most-traded currencies.<br />
<strong>The</strong> PowerShares DB 3x Long US<br />
Dollar Index Futures ETN (NYSE Arca:<br />
UUPT) and the PowerShares DB 3x<br />
Short US Dollar Index Futures ETN<br />
(NYSE Arca: UDNT) each charge an<br />
annual expense ratio of 0.95 percent.<br />
<strong>The</strong>y are designed to replicate<br />
the per<strong>for</strong>mance of the dollar relative<br />
to a basket of six currencies: the<br />
euro, Japanese yen, British pound,<br />
Canadian dollar, Swedish krona<br />
and Swiss franc.<br />
<strong>The</strong> ETNs are rebalanced monthly.<br />
Global X Debuts<br />
Fertilizer, Farming ETFs<br />
Global X Funds launched two ETFs<br />
in May that focus on global fertilizer<br />
producers and farming equities.<br />
<strong>The</strong> Global X Fertilizers/Potash<br />
ETF (NYSE Arca: SOIL), which tracks<br />
the Solactive Global Fertilizers/<br />
Potash Index, owns the largest and<br />
most liquid global names involved<br />
in various aspects of the fertilizer<br />
industry. SOIL <strong>com</strong>es with a 0.69<br />
percent price tag.<br />
<strong>The</strong> Global X Farming ETF (NYSE<br />
Arca: BARN), on the other hand,<br />
will likely face stiff <strong>com</strong>petition from<br />
the likes of the $5.25 billion <strong>Market</strong><br />
Vectors Agribusiness ETF (NYSE Arca:<br />
MOO). Still, BARN claims to be more<br />
narrowly focused than its <strong>com</strong>petitors,<br />
as it only includes <strong>com</strong>panies in<br />
the agricultural products, livestock<br />
operations and farming equipment<br />
manufacturing segments.<br />
BARN tracks the Solactive Global<br />
Farming Index from Germany-based<br />
Structured Solutions AG. <strong>The</strong> benchmark<br />
<strong>com</strong>prises 50 securities screens <strong>for</strong><br />
liquidity, and weights securities based<br />
on free-float market capitalization.<br />
FROM THE EXCHANGES<br />
Shareholders Approve NYSE,<br />
Deutsche Boerse Combo<br />
In July, NYSE Euronext announced<br />
that its shareholders and the shareholders<br />
of Deutsche Boerse had<br />
approved the latter exchange’s acquisition<br />
of the <strong>for</strong>mer.<br />
<strong>The</strong> proposed deal involves<br />
Deutsche Boerse acquiring the<br />
NYSE Euronext <strong>for</strong> $9.5 billion via<br />
an all-stock transaction. A fact sheet<br />
about the <strong>com</strong>bination said shares in<br />
Deutsche Boerse could be exchanged<br />
<strong>for</strong> one share of the new <strong>com</strong>pany<br />
and shares of NYSE Euronext could<br />
be exchanged <strong>for</strong> 0.47 share.<br />
According to press releases from<br />
NYSE Euronext, more than 96 percent<br />
of NYSE Euronext shareholders voted to<br />
approve the deal in a “special meeting,”<br />
and a few days later, on July 13, more<br />
than 82 percent of Deutsche Boerse<br />
shareholders had tendered their shares<br />
<strong>for</strong> shares in the new <strong>com</strong>pany, exceeding<br />
the 75 percent approval needed.<br />
<strong>The</strong> fact sheet states that the deal<br />
is expected to be finalized by the<br />
close of 2011; however, it must still<br />
be approved by regulatory agencies<br />
in both the U.S. and Europe.<br />
CME Launches Corn,<br />
Soybean Volatility Indexes<br />
In early June, CME Group unveiled<br />
two new volatility indexes tied to<br />
CBOT corn and soybean contracts.<br />
<strong>The</strong> CBOE/NYMEX WTI Crude<br />
Oil Volatility Index and the CBOE/<br />
COMEX Gold Volatility Index are<br />
constructed using the Chicago Board<br />
Options Exchange’s VIX methodology.<br />
<strong>The</strong> indexes are based on the<br />
CBOT options contracts <strong>for</strong> corn and<br />
soybeans, and are designed to mea-<br />
www.journalofindexes.<strong>com</strong> September / October 2011<br />
55
News<br />
sure the underlying contracts’ implied<br />
volatility <strong>for</strong> the next 30 days, the press<br />
release said.<br />
According to the CME, corn and<br />
soybean volatility has increased as<br />
global demand <strong>for</strong> those <strong>com</strong>modities<br />
has increased.<br />
BACK TO THE FUTURES<br />
CME Volumes Rise<br />
Year-Over-Year<br />
CME Group said in a press release<br />
that its volumes <strong>for</strong> June had increased<br />
by 22 percent from the prior year; the<br />
daily average <strong>for</strong> the month was 14.9<br />
million contracts.<br />
Despite the overall increase, the<br />
average monthly volumes <strong>for</strong> equity<br />
index futures were down 3 percent<br />
year-over-year. <strong>The</strong> monthly volume<br />
<strong>for</strong> the e-mini S&P 500 futures contract,<br />
the CME’s most actively traded<br />
index contract, was down 3.4 percent<br />
from the prior year to just under 60<br />
million contracts, while the e-mini<br />
Nasdaq-100 futures contract’s volume<br />
was down 15.8 percent to 6.8<br />
million contracts. At the same time,<br />
the e-mini S&P 500 options contract<br />
saw its monthly volume increase by<br />
nearly 80 percent to more than 3<br />
million contracts.<br />
KNOW YOUR OPTIONS<br />
CBOE Options See Increase<br />
<strong>The</strong> CBOE reported a 4 percent<br />
increase in its average daily volume<br />
<strong>for</strong> June to 4.3 million options contracts,<br />
up from 4.1 million in June of<br />
the prior year.<br />
According to the press release,<br />
index options in particular saw an<br />
outsized increase in ADV to 1.3 million<br />
contracts, a 28 percent yearover-year<br />
increase. Meanwhile, ETF<br />
options also came in with an ADV<br />
of 1.3 million contracts, a 10 percent<br />
increase from June 2010.<br />
Of the index and ETF options traded<br />
on the CBOE, the most active contracts<br />
in June were those tied to the S&P<br />
500 Index, the SPDR S&P 500 ETF, the<br />
CBOE VIX, the iShares Russell 2000<br />
Index Fund (NYSE Arca: IWM) and<br />
the PowerShares QQQ (Nasdaq GM:<br />
QQQ). In particular, the VIX contracts<br />
saw a year-over-year ADV increase of<br />
96 percent, while the S&P 500 contracts<br />
saw an ADV increase of 18 percent.<br />
ON THE MOVE<br />
Fuhr Leaves BlackRock<br />
Deborah Fuhr, head of BlackRock’s<br />
ETF research and implementation<br />
strategy unit, is leaving the firm, the<br />
world’s largest issuer of exchange-traded<br />
funds said in a July press release.<br />
Fuhr joined BlackRock in 2008<br />
after leaving Morgan Stanley, where<br />
she was a managing director. She had<br />
been based in London.<br />
BlackRock plans to centralize<br />
all its ETF-related research in<br />
a new unit, called the BlackRock<br />
Investment Institute, the firm said in<br />
the prepared statement.<br />
Russ Koesterich, the chief investment<br />
strategist <strong>for</strong> iShares, will help<br />
define ETF research at the institute,<br />
which will be led by Lee Kempler,<br />
the <strong>com</strong>pany said. Koesterich will be<br />
supported by Joe Linhares in Europe,<br />
the Middle East and Africa; Jennifer<br />
Grancio in the U.S. and Canada; Daniel<br />
Gamba in Latin America; and Nick<br />
Good in the Asia-Pacific region.<br />
BlackRock declined to say whether<br />
Fuhr had been dismissed or if she<br />
had resigned, citing <strong>com</strong>pany policy<br />
regarding personnel matters.<br />
Russell Names New<br />
CEO/President …<br />
Russell Investments said in a mid-<br />
July press release that it had named<br />
Len Brennan as its new chief executive<br />
officer and president.<br />
Brennan held a variety of management<br />
roles at Russell from 1985 until<br />
2005, when he left the <strong>com</strong>pany to<br />
be<strong>com</strong>e the president and CEO of<br />
Rainier Investment Management. He<br />
returned just this year to be<strong>com</strong>e the<br />
chief executive of Russell’s EMEA operations,<br />
be<strong>for</strong>e taking over the leadership<br />
of the <strong>com</strong>pany. Not only will Brennan<br />
continue to head the EMEA operations,<br />
but he will also join the <strong>com</strong>pany’s<br />
board as a director, the press release<br />
said. It noted that he would divide his<br />
time between the <strong>com</strong>pany’s Seattle<br />
and London offices.<br />
Brennan replaces Andrew Doman,<br />
who has held the CEO and president<br />
posts <strong>for</strong> 2½ years. Doman had succeeded<br />
Kelly Haughton after the latter’s<br />
retirement. He will replace Ed<br />
Zore as chairman of Russell’s board,<br />
while Zore stays on as a director.<br />
… And Adds New<br />
Sales Director For Indexes<br />
Russell also named a new sales<br />
director in its index business division.<br />
Shelton Unger is to head up<br />
domestic sales of the firm’s indexes<br />
to plan sponsors.<br />
Unger joins Russell after 25 years<br />
with the Vanguard Group. <strong>The</strong>re, she<br />
was involved in multiple facets of the<br />
<strong>com</strong>pany’s business operations targeting<br />
the institutional retirement<br />
area, a press release said.<br />
Unger reports to the managing<br />
director overseeing Russell’s index<br />
sales, Kevin Lohman.<br />
VelocityShares Adds<br />
iShares’ Parsons To Board<br />
VelocityShares, the new ETN <strong>com</strong>pany<br />
known <strong>for</strong> its volatility-linked<br />
products, in May named to its board<br />
J. Parsons, who was previously global<br />
head of iShares sales while it was part<br />
of Barclays Global Investors.<br />
VelocityShares first entered the<br />
ETP market with the launch of six<br />
VIX-based ETNs in November 2010,<br />
among them the VelocityShares Daily<br />
2X VIX Short-Term ETN (NYSE Arca:<br />
TVIX). <strong>The</strong> <strong>com</strong>pany said its family of<br />
ETNs has since amassed about $180<br />
million in assets.<br />
Parsons, who led iShares’ global<br />
business development from its inception<br />
through its sale to BlackRock,<br />
said he is “thrilled” to help the <strong>com</strong>pany<br />
continue to grow.<br />
VelocityShares’ lineup of VIX-linked<br />
ETNs includes leveraged as well as<br />
inverse strategies. It said TVIX now<br />
trades more than 1 million shares a<br />
day, and is one of the most liquid ETPs<br />
launched in the last six months.<br />
Parsons left BlackRock in 2010.<br />
56 September / October 2011
Rydex Equal Weight Sector ETFs.<br />
Invest in an entire sector, equally.<br />
Rydex Equal Weight Sector ETFs (unlike traditional cap-weighted funds) give investors exposure to every stock in a sector<br />
index. This takes risk and spreads it across all stocks in the index. Investing in energy? Get all the energy stocks. Not<br />
just the big ones. Same <strong>for</strong> tech. Health Care. Financials. All nine of RydexShares’<br />
Equal Weight Sector ETFs. Find out why equal weight might be a more intelligent<br />
way to invest in sectors. Call 800.820.0888 or go to rydex-sgi.<strong>com</strong><br />
<strong>The</strong> intelligent pursuit of wealth.<br />
RYE<br />
S&P 500 ®<br />
Energy<br />
RYF<br />
S&P 500 ®<br />
Financials<br />
RYH<br />
S&P 500 ®<br />
Health Care<br />
RGI<br />
S&P 500 ®<br />
Industrials<br />
RTM<br />
S&P 500 ®<br />
Materials<br />
RYT<br />
S&P 500 ®<br />
Technology<br />
RYU<br />
S&P 500 ®<br />
Utilities<br />
RHS<br />
S&P 500 ®<br />
Consumer<br />
Staples<br />
RCD<br />
S&P 500 ®<br />
Consumer<br />
Discretionary<br />
For more <strong>com</strong>plete in<strong>for</strong>mation regarding RydexShares, ® call 800.820.0888 or visit www.rydex-sgi.<strong>com</strong> <strong>for</strong> a prospectus and a summary prospectus<br />
(if available). Investors should carefully consider the investment objectives, risks, charges and expenses of a fund be<strong>for</strong>e investing. <strong>The</strong> fund’s<br />
prospectus and its summary prospectus (if available) contain this and other in<strong>for</strong>mation about the fund. Please read the prospectus and summary<br />
prospectus (if available) carefully be<strong>for</strong>e you invest or send money.<br />
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.<br />
Rydex Equal Weight ETFs may not be suitable <strong>for</strong> all investors. • Investment returns and principal value will fluctuate so that when shares are redeemed, they<br />
may be worth more or less than original cost. Most investors will also incur customary brokerage <strong>com</strong>missions when buying or selling shares of an ETF. • Investments<br />
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”). <strong>The</strong> NAV<br />
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 <strong>for</strong> shares<br />
Scan with phone to<br />
download ETF kit.<br />
will develop or be maintained. Sector funds may not be suitable <strong>for</strong> all investors. Investing in sector funds is more volatile than investing in broadly diversified funds, as there is<br />
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 <strong>for</strong> more in<strong>for</strong>mation of the risks<br />
associated with each ETF.<br />
“Standard & Poor’s®,” “S&P®” and “S&P 500®,” are trademarks of Standard and Poor’s Financial Services, LLC and have been licensed <strong>for</strong> use by Rydex Investments and its affiliates. Rydex S&P ETFs are not sponsored,<br />
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.<br />
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<br />
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<br />
more than $100 billion in assets under supervision.
Global Index Data<br />
58<br />
September / October 2011
STOXX LIMITED<br />
INNOVATIVE GLOBAL<br />
INDICES<br />
Innovation means, literally, “the introduction of something better” – a definition STOXX has always lived up to,<br />
first and <strong>for</strong>emost with the EURO STOXX 50®, Europe’s leading blue-chip index. But STOXX has more to offer<br />
than that: a truly global index family, ranging from blue-chip indices to broader benchmarks <strong>for</strong> virtually every<br />
country and region. And because innovation is part of our DNA, STOXX offers advanced index concepts such<br />
as Risk Control, Global ESG Leaders, and enhanced infrastructure indices – all applying a transparent, purely rulesbased<br />
methodology. Besides being one of the financial world’s most renowned index brands, STOXX Ltd. also<br />
markets and distributes the <strong>com</strong>plete portfolio of DAX® and SMI Indices®, the leading brands from Deutsche<br />
Börse AG and SIX Swiss Exchange AG. While innovation is our driver <strong>for</strong> product development, established<br />
values such as trustworthiness and responsiveness are what matters most to us in client relationships. A successful<br />
<strong>com</strong>bination, as the figures clearly show: in 2010, approx. 185,000 structured products were issued on STOXX®,<br />
DAX®, and SMI® indices, and our indices are the fourth-largest underlying <strong>for</strong> ETFs worldwide. More about the<br />
index innovators on www.stoxx.<strong>com</strong><br />
STOXX is part of Deutsche Börse and SIX Group<br />
STOXX®, EURO STOXX 50®, DAX®, and SMI® indices are protected through intellectual<br />
property rights. <strong>The</strong> use of these indices <strong>for</strong> fi nancial products or <strong>for</strong> other purposes<br />
requires a license from STOXX Ltd. (“STOXX”), Deutsche Börse AG (“DBAG”), and/or<br />
SIX Swiss Exchange AG (“SIX”). STOXX, DBAG, and SIX do not make any warranties or<br />
representations, express or implied, with respect to the timeliness, sequence, accuracy,<br />
<strong>com</strong>pleteness, currentness, merchantability, quality, or fi tness <strong>for</strong> any particular purpose<br />
of their indices and index data. STOXX, DBAG, and SIX are not providing investment<br />
advice through the publication of the STOXX®, DAX®, and SMI® indices or in connection<br />
therewith. In particular, the inclusion of a <strong>com</strong>pany in an index, its weighting, or the<br />
exclusion of a <strong>com</strong>pany from an index, does not in any way refl ect an opinion of STOXX,<br />
DBAG, or SIX on the merits of that <strong>com</strong>pany or qualifi es as an investment advice.<br />
Contacts<br />
Zurich, Headquarters: +41 58 399 5300 stoxx@stoxx.<strong>com</strong>
Index Funds<br />
60<br />
September / October 2011
Morningstar U.S. Style Overview Jan. 1 - June 30, 2011<br />
Source: Morningstar. Data as of June 30, 2011<br />
Source: Morningstar. Data as of 2/29/08<br />
www.journalofindexes.<strong>com</strong><br />
September / October 2011<br />
61
Dow Jones U.S. Industry Review<br />
62<br />
September / October 2011
Exchange-Traded Funds Corner<br />
www.journalofindexes.<strong>com</strong> September / October 2011<br />
63
Test Your Skills<br />
Inflation Consternation<br />
Having fun<br />
with a distinctly<br />
“un-fun” subject<br />
ACROSS<br />
7 U.S. president whose<br />
1971 counter-inflation<br />
measures were a “Shock”<br />
8 Russian leader’s title<br />
until 1917<br />
9 Allowance <strong>for</strong> the<br />
difference in value of<br />
two currencies<br />
11 U.S. president<br />
during the creation of<br />
the Federal Reserve<br />
12 French revolutionary<br />
paper money, backed by<br />
confiscated lands<br />
13 What France enjoyed<br />
between 1718–1720<br />
as a result of 18D’s<br />
new concept<br />
15 Slang term <strong>for</strong> diamonds<br />
16 Black ____, European<br />
disaster of which one<br />
consequence was<br />
massive inflation<br />
19 First name of the king<br />
responsible <strong>for</strong> 24D’s<br />
financial crisis in 1716<br />
20 German emergency<br />
money of the 1920s<br />
23 ____ and desist!<br />
25 ____-Margret, Elvis<br />
Presley’s “Viva Las<br />
Vegas” co-star<br />
26 To change periodically,<br />
as 28A can<br />
28 ____ Rates, often raised<br />
to counter inflation<br />
30 Continent whose countries’<br />
currencies include<br />
kwanza, dalasi and naira<br />
32 Share index of 100 U.K.<br />
<strong>com</strong>panies<br />
1<br />
2 3 4 5<br />
7 8 9<br />
10<br />
11 12<br />
13 14 15 16<br />
19<br />
23<br />
28 29<br />
24<br />
27<br />
32 33<br />
33 David ____, economist who<br />
suggested that oversupply of<br />
banknotes led to depreciation<br />
34 James ____, proponent of a<br />
tax on currency trading<br />
DOWN<br />
1 Nickname given to the New<br />
Zealand dollar<br />
2 <strong>The</strong> annual percentage<br />
change of this price index is<br />
used as a measure of inflation<br />
3 Family of ETFs managed by<br />
BlackRock<br />
4 Financial collapse, which<br />
often follows 13A!<br />
5 Bargain or argue over a price<br />
6 Former currency of Vatican City<br />
10 Indexes in England<br />
22<br />
25<br />
20<br />
18<br />
30<br />
34<br />
21<br />
26<br />
14 Red ____, pigment once used<br />
as <strong>com</strong>modity money in<br />
Swaziland<br />
17 Silver coin, used in Europe <strong>for</strong><br />
400 years<br />
18 Scotsman, known as the<br />
father of paper money<br />
21 Mervyn King’s position<br />
in relation to the Bank of<br />
England<br />
22 Hobby, such as numismatics<br />
24 Country whose currency was<br />
the riksdaler throughout the<br />
18th century<br />
27 New ____, capital city where<br />
rupees are spent<br />
29 A dollar bill, <strong>for</strong> example<br />
31 Metal money, often clipped<br />
by Henry VIII, leading to<br />
devaluation<br />
6<br />
17<br />
31<br />
Solution<br />
ACROSS: 7. Nixon; 8. Tsar; 9. Agio; 11. Wilson; 12. Assignat; 13. Boom; 15. Ice; 16. Death; 19. Charles;<br />
20. Notgeld; 23. Cease; 25. Ann; 26. Vary; 28. Interest; 30. Africa; 32. FTSE; 33. Hume; 34. Tobin.<br />
DOWN: 1. Kiwi; 2. Consumer; 3. iShares; 4. Crash; 5. Haggle; 6. Lira; 10. Indices; 14. Ochre; 17. Taler;<br />
18. John Law; 21. Governor; 22. Pastime; 24. Sweden; 27. Delhi; 29. Note; 31. Coin.<br />
64<br />
September / October 2011
INDICES CLEARLY FOCUSED<br />
ON YOUR WORLD.<br />
"#!<br />
!""" " ,1%)#*)<br />
)!,'3 3!,-*"!2+!,%!)!%).$!%) !2/-%)!--1!*""!,3*/"/''-+!.,/(*"%) %!-",*(!..*<br />
'+$'*)#1%.$/-.*(%4.%*)) %))*0.%0!-.,.!#%!-.*(!!.)3%)0!-.(!).)!! *)!3()#!,-<br />
,*/) .$!1*,' /-!*/,62! %)*(!%) %!-) ,%-&)'3.%-.*!)$(,&.$!+!,"*,()!*"<br />
.,%''%*)-*" *'',-*""/) - 1$%$%-1$3*/,*) %) %!-,!.$!(*-.1% !'3/-! 3+,*0% !,-<br />
1%.$*0!,%''%*)%)!)$(,&! .*.$!(#'*''3 *))!.3*/,1*,' .*,'3-+%.'<br />
) !2) '!,'3"*/-*)3*/,-/!--<br />
*,%) !2) ,%-&()#!(!).-*'/.%*)-+'!-!!(%'%) !2,+*(<br />
""<br />
<br />
!!-.(!).''%)!.-!/)! ETF Landscape Global Handbook from BlackRock,--/! 3,'3-)&/.$*,%4! ) ,!#/'.! 3.$!%))%'!,0%!-<br />
/.$*,%.3) (!(!,*".$!*) *).*&2$)#!,'3-+%.'%-.$!%)0!-.(!).)&%)# %0%-%*)*",'3-)&1$%$/) !,.&!--!/,%.%!-/-%)!--%).$!)(!<br />
*"%.-1$*''3*1)! -/-% %,3,'3-+%.'))) (!(!,5,'3-)&'',%#$.-,!-!,0! ,'3-+%.'%-., !(,&*",'3-)&''<br />
*.$!,., !(,&--!,0%!(,&-*,,!#%-.!,! ., !(,&-,!.$!+,*+!,.3) /-! 1%.$.$!+!,(%--%*)*".$!%,,!-+!.%0!*1)!,-
BND<br />
Vanguard Total Bond <strong>Market</strong> ETF<br />
BND has 12 times more index coverage than the industry average.*<br />
Are you Vanguarding ® your clients’ portfolios?<br />
Broader coverage can mean more accurate tracking. When you take a closer look at BND,<br />
you’ll see that it has 4,907 holdings versus the industry average of 424 holdings, and that can<br />
have a real impact on your clients’ portfolios.<br />
Take a closer look at advisors.vanguard.<strong>com</strong>/ BND<br />
800-523-0664<br />
All investments are subject to risk. Vanguard funds are not insured or guaranteed. Investments in bond funds are subject to<br />
interest rate, credit, and inflation risk.<br />
To buy or sell Vanguard ETFs, contact your financial advisor. Usual <strong>com</strong>missions apply. Not redeemable. <strong>Market</strong> price may be<br />
more or less than NAV.<br />
For more in<strong>for</strong>mation about Vanguard ETF Shares, visit advisors.vanguard.<strong>com</strong>/BND, call 800-523-0664, or contact your<br />
broker to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important in<strong>for</strong>mation are<br />
contained in the prospectus; read and consider it carefully be<strong>for</strong>e investing.<br />
*Source: Morningstar as of 05/01/2011. Based on 2011 industry average bond ETF holdings of 424 and BND holdings of 4,907.<br />
© 2011 <strong>The</strong> Vanguard Group, Inc. All rights reserved. U.S. Pat. No. 6,879,964 B2; 7,337,138. Vanguard <strong>Market</strong>ing Corporation, Distributor.
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