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Burton Malkiel Excerpt And Interview From Wall Street To The Great Wall China Roundtable With Jim Rogers, Rob Arnott, Richard Gao and more Completing International Allocation Steven Schoenfeld and Stefanie Jaron Benchmarks For Fiduciaries Brian Jacobsen Plus Blitzer on Liquidity and the Curmudgeon as himself


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features The Chinese Market Considered by Burton Malkiel . . . . . . . . . . . . . . . . . . . . . . . . . 10 An excerpt from Malkiel’s new book, plus an exclusive interview on bubbles and boom times.

International Equities by Steven A. Schoenfeld and Stefanie Jaron . . . . 18 EAFE is obsolete; it’s time for more complete benchmarks.

The Value Of Currencies by Thomas Haines . . . . . . . . . . . . . . . . . . . . . . . . . 24 New tools have opened up the FX market.

China Forum . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 with Jim Rogers, Rob Arnott, Richard Gao and more Nine experts on China answer the question: Is it a bubble?

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A Window On The Chinese Markets by Heather Bell . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 A special paid research section from Hang Seng Indexes.

Talking Indexes by David Blitzer . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Gauging the trade-off between liquidity and completeness.

Benchmarks For Fiduciares by Brian J. Jacobsen . . . . . . . . . . . . . . . . . . . . . . . 42 Real-world benchmarks start with real-world assumptions.

The Curmudgeon By Brad Zigler . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Zigler looks at China and all he sees are Ferris wheels.

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Muni Bond Melee . . . . . . . . . . . . . . . . . . . . . . . . . . 50 MSCI Goes Public . . . . . . . . . . . . . . . . . . . . . . . . . . 50 A Hedge Fund Index Fund? . . . . . . . . . . . . . . . . . . 50 PowerShares Looks To Europe . . . . . . . . . . . . . . . . 51 Feds Consider ETN Tax Treatment . . . . . . . . . . . . . 51 Indexing Developments . . . . . . . . . . . . . . . . . . . . . 51 Around The World Of ETFs. . . . . . . . . . . . . . . . . . . 55 Know Your Options . . . . . . . . . . . . . . . . . . . . . . . . 58 Into The Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 On the Move. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

data Selected Major Indexes . . . . . . . . . . . . . . . . . . . . . 59 Returns Of Largest U.S. Index Mutual Funds . . . . . 60 U.S. Market Overview In Style . . . . . . . . . . . . . . . . 61 U.S. Economic Sector Review . . . . . . . . . . . . . . . . 62 Exchange-Traded Funds Corner . . . . . . . . . . . . . . . 63

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Contributors

Burton G. Malkiel

Burton G. Malkiel is the Chemical Bank Chairman’s Professor of Economics at Princeton University and author of the widely read investment book, A Random Walk Down Wall Street. He is also the chief investment officer of AlphaShares Inc., an investment management firm specializing in China and China-linked investments. He is a past appointee to the President’s Council of Economic Advisors, and currently serves or has served on the boards of several financial corporations, including Prudential Financial and the Vanguard Group.

David Blitzer

David Blitzer is the chairman of the S&P 500 Index Committee and a member of Standard & Poor’s Investment Policy Committee and Economic Forecast Council. He previously served as corporate economist at McGrawHill and as senior economic analyst with National Economic Research Associates. Blitzer is often quoted in the national business press and is the author of Outpacing the Pros: Using Indexes to Beat Wall Street’s Savviest Money Managers, McGraw-Hill, 2001.

Tom Haines

Tom Haines is a managing director at NYSE Euronext, where he is part of their ETF & Index Group in charge of Index Structured Products Listings. Prior to joining NYSE Euronext, Tom was an index and American Depository Receipt (ADR) arbitrage trader at BNP Paribas’ New York and Paris offices. He holds a B.S. in quantitative finance from James Madison University.

Brian J. Jacobsen

Brian J. Jacobsen, Ph.D., CFA, CFP, is associate professor of business administration at Wisconsin Lutheran College, a conservative Lutheran liberal arts college in Milwaukee, Wisconsin. He also lectures at the graduate level in money and banking, financial strategy, and advanced investment theory. Brian is also chief economist and partner at Capital Market Consultants, an investment research firm in Milwaukee. He is responsible for original investment research and analysis on the economy, the market and investment products.

Steven Schoenfeld

Steven A. Schoenfeld is the chief investment officer for the Global Quantitative Management business of Northern Trust Global Investments (NTGI), which manages more than $260 billion in index and quant-active strategies. Prior to joining NTGI, he was a managing partner of Global Index Strategies LLC and a managing director of Barclays Global Investors. Steven received a M.A. in international relations from the Johns Hopkins University School of Advanced International Studies. He is the editor of Active Index Investing, Wiley, 2004.

Brad Zigler

Brad Zigler formerly served as head of marketing, education and research for the Pacific Exchange and Barclays Global Investors. Zigler is a founding member of the Global Association of Risk Professionals Education Committee, and has contributed to theStreet.com, MarketWatch.com, Institutional Investor, Financial Planning, CRB Trader, Mutual Funds and Registered Rep.

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Editor’s Note

Is China For Real?

C

hina is an editor’s dream. A potent cocktail of high-octane returns, political intrigue and great future prospects make the Chinese economy and Chinese stocks a compelling story. But many questions linger: Is the economy for real? Should investors be overweight China? Is the current market a bubble? Will Chinese markets continue to open up? How prone are they to sudden intervention by the central government? Remarkably, this issue of the Journal of Indexes takes a serious shot at answering all of those questions, thoughtfully and in depth. First up is Burton Malkiel, the longtime index industry titan who has of late made China a sort of personal crusade. This issue includes not only an in-depth interview with Burton, but also an excerpt from his excellent new book on (you guessed it) China. On the heels of the Malkiel contributions is an outstanding roundtable of China and index industry experts including the likes of Jim Rogers, John Prestbo, Richard Gao and Mark Makepeace, among others. It is quite simply an outstanding and illuminating feature. Staying on the international theme is Steven Schoenfeld, with another unparalleled submission analyzing the shifting dynamics of thoughtful international allocation. Tom Haines weighs in with a feature on the role currencies and currency investing play. Anchoring the issue is Brian Jacobsen, who makes the case for better benchmarks to reflect the real-world possibilities created by investment policy statements. Bringing us home is a David Blitzer homily to liquidity and the Curmudgeon being as wacky as ever. We hope you enjoy the issue as much as we did, and wish you success in navigating the tricky terrain of the Chinese stock market.

Jim Wiandt Editor

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January/February 2008

Jim Wiandt Editor


The Chinese Market Considered The privatization of equity shares

By Burton Malkiel

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January/February 2008


The following is an excerpt from Professor Burton Malkiel’s forthcoming book, From Wall Street to the Great Wall: How Investors Can Profit from China’s Booming Economy, scheduled to be published in December 2007 by W.W. Norton. The book is cowritten by Patricia Taylor, Jianping Mei and Rui Yang. This excerpt comes from Chapter 4, “The Privatization Of Equity Shares,” and is reprinted here with permission. Following this excerpt is an in-depth interview with Professor Malkiel by Journal of Indexes editorial staff.

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distinctive feature of the Chinese stock market is the sometimes bewildering bifurcation of shares into tradable and nontradable categories. With the founding of the new Shanghai Stock Exchange—the SSE—in 1990, listed equities in the modern Chinese stock market were consigned to two categories: shares held by private investors that could be sold or purchased in the stock market; and shares controlled by state and other “legal persons” that could not be traded in the market. A “legal person” is generally another state or local government agency that participates in ownership of the company. The Chinese stock market was and remains to this day the only stock market in the world in which a majority of the listed companies are state-owned enterprises (SOEs). And a large portion of the listed shares cannot be traded. As the line from The King and I goes: “Is a puzzlement.” This structure was designed by the “founding fathers” of the new Chinese economy in order to ensure that the state retained control of the SOEs even after they were listed for trading, and that no pressures for a change in that status would occur in the future from subsequent trading activity. Approximately two-thirds of the capitalization of Chinese stocks listed in Shanghai and Shenzhen were held until recently by government agencies or by other economic entities on behalf of the state. Until the end of 2006, state-owned shares were not allowed to be traded on the open market. “Legal person” shares have only limited marketability, as their trading is subject to cumbersome state approval. The existence of state-owned shares has created a significant obstacle to the conversion of the Chinese economy to one that is fully market-oriented. They have also interfered with the growth and development of the Chinese stock market. Since 1999, many mainland financial analysts believe, the rise and fall of the Chinese stock market has been closely tied to the state’s efforts to reduce its holdings in listed companies. Two important problems have concerned investors. First, there are troublesome governance implications. Shareholders would like to believe that company management will be making decisions with the sole objective of benefiting the shareholders of the enterprise. When the government is the major shareholder, the minority owners have good reason to believe that the government is likely to have other objectives in mind. The government has little interest in the behavior of the share price. It neither benefits much from rising prices nor need it fear a hostile takeover if prices fall. The behavior of the majority-state-owned banks exemplifies this conflict. Often, the banks would find a manufacturing SOE www.indexuniverse.com/JOI

that would need financing to keep afloat. While the SOE might be unprofitable, with little chance of repaying the loan, the enterprise might also be a major employer in the region, and a collapse of the business could create widespread unemployment. The government would want to ensure that the bank makes the loan and thus preserves jobs, despite the small likelihood of repayment. This general example illuminates the actual situation responsible for many of the “nonperforming” loans that have plagued the Chinese banking system. A second problem arises if the state-owned shares are immediately made tradable and then quickly sold to the public. Dumping large numbers of previously locked-up shares could swamp the market and lead to devastating price declines. Investors call this phenomenon the “overhang” problem. In 2001, a state share reduction program was announced in which the sale of all state-owned shares would be completed over a five-year period. After the program started in mid-2001, prices in the Shenzhen and Shanghai markets plunged by about 40 percent and the program was suspended later that year. In the trial-and-error game, this was a big error. It became clear that a solution to the overhang problem required considerable care. In 2005, Shang Fulin, chairman of the China Securities Regulatory Commission, achieved what many in China’s financial community considered an impossible mission: He set up a method of compensation whereby public owners of a stateowned enterprise would receive a bonus when the nontradable shares were converted to tradable shares, thus alleviating the precipitous drops in value that usually resulted. In the summer of 2006, for example, Sinopec (SNP), Asia’s largest oil refiner by capacity, announced that mainland holders of its stock would receive 2.8 shares for every 10 shares held as compensation for allowing the company’s nontradable shares to become tradable. Shang’s plan provided holders of exchange-traded shares with the reassurance that the release and trading of state-owned shares would be achieved gradually and according to a timetable. Many in China’s financial community feel that this plan has contributed to the rise of the Chinese stock market during 2006 and 2007. On September 4, 2005, the China Securities Regulatory Commission officially issued a regulation with the rousing title “Listed Company Stock Ownership Diversification Reform and Management Methods.” Despite the bureaucratic name, it represents one of the world’s largest privatization movements. Wu Yalun explained its basic ramifications during our interview with him at the Shanghai Stock Exchange. First, there is an internal lock on all converted shares for one year after conversion. Second, those who originally held over 15 percent of the nontradable shares can sell no more than 5 percent of their holdings within the year following the lockup period, and no more than 10 percent within two years following the lockup period. With the conversion of nontradable shares into tradable equities, and the slow but steady release of these newly tradable shares into the market, both trading activity and market value have begun to climb dramatically. Still, with 70 percent of the shares nontradable at the start of the conversion effort, the practical but slow process of making all January/February 2008

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stock-trading activity truly market oriented means that the overhang issue will be around for a number of years.

The Alphabet Soup Of Share Types As if the tradable/nontradable share story isn’t confusing enough to those who just want to make some money investing in China, there is also the quagmire of a literal alphabet soup of share designations that indicate where the shares are traded and who can buy them. This is the second distinguishing feature of the Chinese stock market. In alphabetical order, these shares are described below.

A shares: Available to local investors. The predominant class of publicly held shares—comprising about 30 percent of the total—is called A shares. These shares are denominated in yuan and traded on the Shanghai and Shenzhen stock exchanges. Originally, only Chinese nationals were allowed to own A shares, but as we will see below, a limited number of foreign investors now have access to these shares as well. Ticker symbols for A shares are given in numbers, e.g., 600028.SH. The numerals identify the company and the two letters the exchange (here, Shanghai). Throughout much of China’s stock market history, A shares tended to represent ownership in the smaller, less-well-managed companies. That began to change in 2006, when the Ashare market started heading for the sky. Worried that a bubble was in the making, one that could burst just as the country was to demonstrate its modern economic power at the Beijing Olympics, the government started introducing new measures to increase the breadth of the market, thus reducing a situation in which a lot of money—much of it pouring out of savings accounts where the Chinese had traditionally put their assets—was chasing too few stocks and thus contributing to the rise in prices. Whereas in the past the larger, better-managed companies could not list locally and only appeared on foreign exchanges, in spring 2007 the government stepped up the transformation of the A-share market by unofficially requiring that any company wishing to list overseas had to also list locally. In addition, many of the larger companies, such as China Mobile and Aluminum Corporation of China, which had been listed only on overseas markets, requested and received government permission to list locally. The hope is that the newly available A shares of these larger, better-managed companies will mop up some of the excess liquidity and reduce some of the speculative frenzy that appears to be infecting the market. Furthermore, A-shares buyers have tended to be individuals rather than institutions (in the United States, institutions account for over 70 percent of stock ownership). When we talked to senior staff of the CSRC, we were told that the development of an institutional shareholder base is one of their top objectives. At the time we had our discussions, banks and insurance companies were legally limited to holding only a minute percentage of their assets in stocks. B shares: Available to foreign investors. These shares were created solely to allow foreign investors to participate in 12

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the domestic markets. The aim was to have outlets available for the investment capital of non-mainland Chinese investors so that Chinese companies had access to another source of capital. The B shares are traded in Hong Kong dollars on the Shenzhen exchange and in U.S. dollars on the Shanghai exchange. Since no arbitrage trades are possible between the two types of shares (mainland residents do not have ready access to B shares and foreigners have only limited access to A shares), the B and A shares of the same company typically trade at different prices. Moreover, the number of B shares is small and thus they are quite illiquid. The Chinese authorities currently are considering the termination of trading in the Bshare market, so we have not considered B shares in developing our strategies. H shares: Available to Hong Kong investors. The inability of the B shares to attract international capital led the government, in 1993, to allow the establishment of H shares. H shares represent mainland companies that are registered in Hong Kong and that trade on the Hong Kong Stock Exchange. They include SOEs that have gone through a major restructuring that satisfies the requirements for international issuance. Chinese government approval is required for an SOE to pursue an international listing, and in general, the companies listing in Hong Kong have been strong ones selected in part to showcase Chinese companies on the international stage. H shares are traded in Hong Kong dollars. As with A shares, the ticker symbols are in numbers (e.g., 0386.HK). Since Chinese residents cannot freely convert yuan to Hong Kong dollars, they have effectively been denied the opportunity to buy stock in some of China’s largest and most profitable companies. This situation started to change in 2006, and gained momentum in 2007, when the government gave permission to major companies such as Bank of China and China Life to list on the mainland as well as on the international stock exchanges. During 2007, however, these companies tended to trade at higher prices in Shanghai than their equivalent prices in Hong Kong and New York. Red Chips: In addition to H shares, so-called Red Chip shares trade in Hong Kong. The Red Chips are Hong Kong–registered companies that have a mainland Chinese corporate shareholder holding at least 35 percent of the shares. In many cases these listings are, in effect, “back door” listings. A non-listed Chinese company purchases a relatively dormant Hong Kong–listed company and inserts mainland assets into the Hong Kong “parent.” The Red Chip then becomes a kind of holding company with access to international financing that can be used as an acquisition vehicle for Chinese assets. All the shares traded in Hong Kong are available to international investors. N shares: Chinese shares traded in the United States. Some of the strongest Chinese companies have been chosen by the Chinese government to register with the U.S. Securities and Exchange Commission and trade in the United States. These companies are widely regarded as being “the best of the best”; strong and profitable enough to undergo the listing require-


ments of the U.S. exchanges. The trading typically takes place on the New York Stock Exchange or, particularly for high-tech companies, on the NASDAQ market—hence the designation “N shares.” Ticker symbols for shares traded on U.S. stock exchanges are given in letters (e.g., SNP for Sinopec). The shares are generally traded as American Depository Receipts (ADRs), which means that the trades take place in U.S. dollars; dividends are also credited in U.S. dollars. That would appear to make it easy for an American citizen wishing to invest in a foreign company. But, alas, things are not always what they seem in this case. ADRs are frequently bundled shares. Bundled shares! Where did that come from? When a foreign company lists on a U.S. exchange, it wants to look as enticing as possible. Because single shares of many foreign firms are so inexpensive, the feeling is that a single share listing would create the impression of a small, fly-bynight enterprise. Thus, foreign firms often will combine or bundle several shares and have these listed as one ADR share on a U.S. exchange. For example, one share of Sinopec (SNP) traded in New York represents 100 shares traded in Hong Kong. And all the rest: Shares listed on other international exchanges. Some of the Chinese companies that are permitted to list internationally have chosen to bypass New York and opted instead to list on the London Stock Exchange (L shares), the Tokyo Stock Exchange (T shares) or the Singapore Stock Exchange (S shares). While available to all international investors, these shares are traded respectively in British pounds, Japanese yen and Singaporean dollars. Listing in places other than New York avoids the costs of complying with SEC and Sarbanes-Oxley requirements, which some companies find increasingly burdensome. Slightly confused? Never strong on the alphabet? There’s more. If you have been paying close attention, you now know that some Chinese companies are only listed as A shares, others are listed only as H shares, some are listed as A and H shares, about two dozen are listed as H and N shares, about a dozen are only listed as N shares and a growing number are listed as A, H and N shares. Yes, a puzzlement indeed. To make this incredibly complex situation even more confusing, the same company often trades at different prices in the local and international markets. This price differential reflects extremely limited foreign access to mainland shares and limited local access to shares listed internationally. Thus, should a foreigner hold a share of Sinopec, for example, and see that it is trading at a 25 percent premium in Shanghai, it does her no good, because she is not allowed to sell her shares short in Shanghai while buying them in Hong Kong or New York. Whenever arbitrage is restricted, prices can deviate from market to market.

Changes In Chinese Regulations During the 2000s Since joining the World Trade Organization in 2001, China has accelerated the pace of reform to bring the legal environment for its capital markets up to international standards. The WTO, for example, calls for allowing foreign investment

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in all industries, with the exception of sensitive companies associated with national security. This meant that China had to open its investment doors. It did so in a very Chinese way. Cuefee and Quidee quotas: While they sound like new athletic challenges for Harry Potter, these are the pronunciations for two programs that China has initiated to further solidify its capital markets. The Qualified Foreign Investor Program (QFII—pronounced “Cuefee”), begun in November 2002, permits a limited number of qualified institutional investors, on an annual renewal basis, to participate directly in China’s domestic stock markets. UBS, Europe’s biggest bank, based in Zurich, was the first foreign bank to be issued a QFII quota. Since then a number of banks, insurance companies, brokers, universities and other investors have acquired QFII quotas. Although the quotas have been expanded over time, they are still relatively small. Moreover, there are limits to the number of A shares that QFIIs may acquire in any single company, and the program does not permit the unrestricted repatriation of the funds. The regulatory authorities are worried that since the capitalization of the domestic market is relatively small, it would be overwhelmed if foreign investors were given full access. In addition, the size and renewal of a QFII quota is often determined by the areas in which the institutions have invested. As this book goes to press, the government does not encourage foreign investment in real estate and new construction; thus, any institution concentrating its QFII quota investments in these areas will probably find it difficult to obtain additional quota the following year. The CSRC and the State Administration of Foreign Exchange administer the quotas. There are, we believe, many advantages to liberalizing these quotas substantially. China badly needs to develop an institutional investment culture, and the presence of foreign institutional investors can help foster a domestic professional investor culture as well. Institutional investors can perform an important monitoring function and thereby help improve corporate governance. They can also help smooth out some of the market anomalies created by the alphabet soup where companies trading in Shanghai, Hong Kong and New York often sell at different prices in the domestic market. The CSRC is well aware of these advantages and very much wants to establish an institutional investment climate in China. However, in our discussions with officials there, they also expressed a fear that moving too fast to liberalize the quotas could overwhelm the market. The total capitalization of all Chinese equities was less than 2 percent of the world market in July of 2007. The CSRC, therefore, has opted for gradualism in its policies over the liberalization of quotas and limitations on QFII’s ownership of the shares of any single company. But there is no question about the likely direction of policy change in the future as state-owned shares become fully tradable. China is moving to a system of private ownership where corporations will be run for the benefit of shareholders rather than the government. And the release of the state-owned shares to the private sector will lead to increased market liquidity, greater protection for

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minority investors, and increased efficiency for the stateowned firms themselves. In July 2006, the government introduced the Qualified Domestic Institutional Investing (QDII, pronounced “Quidee”) program. Similar to the QFII program, it allows local institutions to exchange yuan into foreign currencies in order to buy shares on international exchanges. The government believes that this program can, at least in part, reduce the mounting pressure on the yuan to appreciate because of the deluge of foreign exchange flooding into China. Nontradable share conversion: The nontradable share conversion is probably the biggest and most far-reaching reform under way in the Chinese market. At the start of 2007, all companies on the Chinese market had either announced or already completed a program to make restricted shares tradable. The full-flotation reform instituted in 2005 also included an additional QFII–like system. Foreign investors who do not have an unused QFII quota will be able to purchase some state-owned shares through a private transaction. Five government agencies issued a joint decision in 2006 that allows non-QFII foreign investors to purchase strategic interests in the state-owned shares. Such private purchases would comprise a minimum of 10 percent of the listed company’s shares and a three-year holding period would be required. New accounting standards: Until recently, the Chinese stock market has been without universally accepted accounting standards. It is widely believed that Chinese firms traditionally carried four sets of books—one for the government; one for official company records; one for foreigners; and one (obviously not widely available) for what was actually going on. Thus, when reviewing a financial statement, what one saw was not necessarily what one was paying for. In its inexorable effort to create a functioning world-class market, the government has acted to correct this situation. As of January 1, 2007, China’s Ministry of Finance now requires all companies listed on the Shanghai and Shenzhen stock exchanges to report their annual performance in terms of International Financial Reporting Standards (IFRS). This is an enormously ambitious project, particularly given the overlapping interests of many Chinese companies that consist of numerous subsidiaries, as well as the woeful lack of qualified accountants to process and clarify the raw numbers (the Chinese accounting profession is still recovering from having been sent lock, stock and barrel to the countryside to be reeducated during the Mao years). To give some idea of the task facing the listed companies, it has typically taken three years for expectant Chinese corporations to meet the listing requirements enunciated by the IFRS and mandated by the Hong Kong Stock Exchange. Though listed companies were supposed to have complied with the Ministry of Finance’s directive by 2007,

there is widespread feeling that many have yet to fully adhere to IFRS requirements. While progress has been slow, the new requirement is clearly a step in the right direction. As Martin Fahy, director of development for the Asia-Pacific region of the Chartered Institute of Management Accountants, has said, “You can’t have a functioning financial market and economy without objective and independent accounting.” Futures and other modern techniques: The Chinese government continues to work to make its capital markets more rational. For example, in September 2006, the Chinese Financial Futures Exchange inaugurated a new exchange focusing on financial derivatives trades. This will allow institutions to hedge against market risk by investing in the Shanghai and Shenzhen 300 Index futures. Furthermore, we anticipate that the government will soon be introducing two additional trading techniques: margin trades and short selling. Margin trades allow equity investors to borrow money to buy stocks. Short selling allows investors to sell stock they don’t own—perfectly legally—in the hopes of buying it back at a lower price. Without short selling, investors can only make money if their stock goes up. Since money can be made in both directions—and you do have to pick the directions correctly—short selling leads to more balanced trading patterns.

A Summing Up As this chapter has made clear, China has gone a long way toward reforming its financial markets and embracing a market-oriented economic system. In so doing, however, it has created what can only be termed a Chinese Puzzle: There’s an alphabet soup of different kinds of shares; the national government’s controlling hand in the release of shares; and the constant tinkering in devising new programs. Somehow, this hybrid conglomeration works—and recently has worked surprisingly well. But China is far from a full market system. State-owned enterprises still control a large portion of the nation’s economic output, and the privatization of state-owned shares, we feel, could be moving at a faster pace. Certainly, much more needs to be done. China’s markets are far from problem-free, and there is still far too much reliance on the state. China, then, is in an unprecedented position with regard to the development of its domestic stock market. It continues to restrict outside access, is trying to dampen domestic speculative enthusiasm for share ownership, is introducing new accounting standards and requirements for transparency, and is also trying to rein in corruption. It is an extremely delicate balancing act; one that will affect the future not only of China but of the entire world economy. Having met with officials at many levels and in many government agencies, we are impressed with the creativity and the dedication devoted to this task.

Reprinted from From Wall Street to the Great Wall by Burton G. Malkiel and Patricia A. Taylor, with Jianping Mei and Rui Yang (©2008 by Burton G. Malkiel, Patricia A. Taylor, Jianping Mei and Rui Yang) with permission of the publisher, W.W. Norton & Company, Inc.

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January/February 2008


An Interview With Burton Malkiel As the preceding excerpt makes clear, Burton Malkiel knows China. The Chemical Bank Chairman’s Professor of Economics at Princeton University, Malkiel is the author of A Random Walk Down Wall Street and one of the most-respected names in finance. He spoke with Journal of Indexes contributing editor Heather Bell about recent developments in the Chinese markets, and whether China truly remains an exciting place to invest today … or whether it’s a bubble. Journal of Indexes (JOI): As of October 26, 2007, the Chinese equity market was up over 100 percent since March. Is this rapid rise troubling? Burton Malkiel (Malkiel): It’s an issue of concern, but as discussed in the book, it is important to realize that there are many different kinds of Chinese stock. The A shares [which are primarily available only to domestic investors] are in my judgment quite worrisome, in part because of the rapid rise in the market. The A share market was up 130 percent in 2006, so the recent 100 percent increase is on top of that. It’s particularly worth noting that there are some companies that trade in New York, Hong Kong and Shanghai, with different share classes. And those shares are priced at premiums of 50 percent to 100 percent on the Shanghai market. That, of course, is extremely worrisome. It violates what we economists call the law of one price. There is no reason why China Life or Sinopec should trade at a 50 percent higher price in Shanghai than in the other markets. Am I worried about the A share market? Yes. However, in my judgment, H shares [which trade in Hong Kong] and N shares [which trade in New York] are still reasonably priced relative to their growth rates. JOI: Are the growth rates recorded by the Chinese government real? Malkiel: I think they are. A lot of people say, “Oh, China’s not growing at 10 percent.” But when I look at statistics—not those compiled by the Chinese, but statistics on the amount of raw materials coming in—you see that growth rate confirmed. So yes, I do believe they are growing at those rates. JOI: How does the Chinese market volatility affect the global economy? Malkiel: The Chinese market is extremely volatile. It’s even more volatile than Brazil, which is always thought of as “the” really volatile market. I don’t think, however, that one can point to any specific effects on the world economy as of yet. But as the capitalization of the Chinese market grows, it undoubtedly will have more of an effect. It is interesting that the Chinese market is so extraordinarily volatile, when it is also up so sharply over recent periwww.indexuniverse.com/JOI

ods. There were three times in the last year when it was down 10 percent in one day. The first time that happened, I think it brought the S&P 500 down about 4 percent. But the next two times it happened, the S&P 500 was essentially unaffected. The market’s volatility has a potential effect on the volatility of markets around the world, but in terms of total capitalization, it is still a small market, so its impact is not as large as one might imagine. JOI: Should investors be tilting their portfolios toward China? Malkiel: I believe every investor should have some exposure to China, and in my judgment, that exposure should take one of three forms: either a direct investment in H and N shares; exposure to Chinese real estate; or an indirect exposure by investing in companies that are domiciled in other countries but that get much of their growth from China. I would also add companies that make, mine or process commodities, because I think that one of the reasons that oil is so expensive now and other commodities have gone up is that the Chinese have had a really voracious appetite for commodities. JOI: Speaking of commodities, people talk about China as a driver of commodities inflation. Is the Chinese market exposed to the risk of an oil shock? January/February 2008

15


Malkiel: Clearly China needs to import its oil just like we do, but just as I think it is true in the United States that we are less vulnerable to oil than we were 20 to 30 years ago, I don’t think the Chinese economy is particularly vulnerable to oil. They get most of their power by burning coal, which is abundant. That creates its own problems, and they do have a serious pollution problem. But I don’t think growth in China is highly vulnerable to oil prices. Just because oil has exceeded $90 a barrel, I don’t think that that will stop the growth of the Chinese economy. JOI: What about other risks? For instance, is the Chinese real estate market vulnerable to something like the subprime crisis that has hurt us in the U.S.? Malkiel: As far as I know, the kinds of things that we worry about in the United States—newfangled adjustable rate mortgages and negative amortization mortgages and so forth are probably peculiar to an economy like the United States. I’m not saying the Chinese real estate market is immune from speculation. I am sure that in some areas there may be some froth in the real estate market; there have been, in the major cities, substantial increases in real estate prices. I am sure that the growth in real estate valuations will not always be smooth. JOI: How does the Chinese real estate market compare with other real estate markets globally? Malkiel: In my judgment, there are really great opportunities in the Chinese real estate market. I think the difference is that the United States has basically gone through its period of urbanization, while China has just started to do that. The urbanization process has gone along quite far in the eastern part of the country, where cities like Beijing and Shanghai are very well-developed. But it is just beginning in the central and western parts of the country. In my judgment, real estate development, while it may be mature in Beijing and Shanghai, is not a mature market in the center and west of the country. China is developing about two cities a year the size of Philadelphia. JOI: What is Hong Kong’s current and future role in the Chinese markets? It’s been called the gateway to investing in China. Malkiel: I think that is correct, and it’s about the only gateway. Either you buy stuff that’s listed in the United States or in Hong Kong. However, if you wanted me to put my future

glasses on and look 10, 20 years into the future, I do not think, as China continues to develop, that these restrictions are likely to be as stringent as they are now. JOI: What kind of role do you see for Taiwan? Malkiel: Right now there’s a lot of tension. There are often politicians in Taiwan who say that they ought to claim their independence. And of course, the Chinese government says, “We won’t accept that.” And there’s some saber rattling. I don’t worry about it as much as some other people do, because I know that the people on both sides of the Taiwan Strait are very practical. And the economic ties between Taiwan and what they call the mainland are in fact very, very strong. I don’t expect there to be anything like a shooting war; the Chinese government knows that that would be the surest way of ending what I call the Chinese miracle. Will Taiwan and China eventually be integrated as East and West Germany were? I don’t know when, but at some point I think that’s likely, particularly as the mainland continues its growth and becomes more democratic. I certainly don’t expect this any time very soon. JOI: Why did you decide to write a book on China? Malkiel: I think it’s absolutely fascinating. I think China is likely to be the largest economy in the world in the 2020s. The growth rate that has been achieved in China is absolutely unprecedented. There is nobody who has grown as fast as China in history. It’s just a fascinating place and a very interesting place to study. JOI: Did you have any interesting encounters in China when you were developing the book and researching it? Malkiel: Well, I did do three trips to China. I had many fascinating experiences. You can’t go to China and walk down the streets of their cities without feeling an almost palpable energy. Sir W. Arthur Lewis, the Nobel laureate in economic development, used to tell me that if you want to know why some countries develop and some don’t, look at the culture. Is it a culture that reveres education? The Chinese have done that since the time of Confucius. Is it a culture that’s entrepreneurial? Is it a culture that’s risk taking? Is it a culture that’s hard working? It’s one thing to read about these kinds of characteristics, but you can almost feel it when you are in China, and that to me is one of the main reasons why I think that this Chinese economic miracle is likely to continue.

SAVE THE DATE

4.16 16

January/February 2008

Financial Advisor Symposium • April 16-18, 2008 Mandalay Bay Resort & Casino, Las Vegas, Nevada Visit www.financialadvisorsymposium.com/lasvegas/main.asp


International Equities Seeking a more complete definition

By Steven A. Schoenfeld and Stefanie Jaron

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January/February 2008


A

s investors become more global in orientation, they are also becoming more sophisticated in their search for additional sources of return and diversification. While most U.S. investors have long held core positions in international equities, this exposure has been heavily concentrated in the large-cap equities of developed countries, supplemented to some extent with emerging market equities. Meanwhile, smaller-cap international companies have been largely ignored, despite their strong performance in recent years and their potential diversification benefits. In this article, we will argue for the inclusion of these smaller-cap companies as part of a comprehensive international equity strategy. One hurdle keeping investors out of this “sub-asset class” historically has been the complexity and unfamiliarity of available benchmarks.1 This paper assesses the international benchmark issue and how it has impacted the investment approach taken by most U.S. managers. We then discuss why existing approaches are sub-optimal from a risk-and-return perspective, and suggest ways to better integrate small-cap international into a global portfolio. In today’s market, accessing international markets in an appropriate manner is increasingly important. Today, the international markets represent more than half of total world market cap, and U.S. investors have finally starting addressing their home country bias in a major way by adding to international exposure. As this trend continues, investors need and deserve better and more transparent access to global small caps, to help them build better asset allocation portfolios.2

portfolio, and that’s exactly what’s happened with EAFE. The MSCI EAFE index covers 21 developed countries with a total market capitalization of $14 trillion, ranging in size from the U.K at 22 percent to Portugal at 0.4 percent. Three countries—the U.K., Japan, and France—account for over 50 percent of the index weight. The index draws its constituents from the larger-cap companies within these countries. In total, EAFE captures approximately 69 percent of total non-U.S. equity market cap, about on par with the 72 percent market coverage offered by the S&P 500. But while few sophisticated investors would argue that the S&P 500 is a comprehensive benchmark for U.S. equities, many take EAFE at face value. In the U.S., they supplement the S&P 500 benchmark with indexes such as the S&P SmallCap 600, Russell 2000 or the DJ Wilshire 4500, which include smaller-cap companies, to fill in the “benchmark gap” shown in Figure 1. Why restrict the portfolio choices of an active manager unnecessarily? Figure 1

U.S. Equity Market Capitalization Breakdown US Equity Market Capitalization by Size/Segment

S & P 500 72%

Small/Mid Cap 28%

Is MSCI EAFE Obsolete? MSCI EAFE (Europe, Australasia and Far East) has been the dominant international equity benchmark for U.S. investors for over 30 years. Yet in an integrated global capital market, it is increasingly outdated as a measure of the opportunity set available outside the border. As we’ve said before, EAFE is obsolete. Let us be clear: EAFE is not obsolete as a proxy for the largecap equities of non-U.S. developed markets (except, of course, for its noted omission of Canada). But as a proxy for the true global ex-U.S. equity markets, it is most definitely outdated. Unfortunately, it is in exactly this capacity that MSCI EAFE has served too many U.S. investors for far too long. As a result, while there has been a tremendous flow of assets from the U.S. equity market into EAFE-benchmarked strategies—and more recently, to the similarly constructed MSCI Emerging Markets Index—two key … and increasingly important … segments of the international markets have been largely ignored. To fully understand this issue, one needs to grasp the major impact that a benchmark’s composition has on managed portfolios. With index funds, the linkage is direct and obvious. With active managers, the linkage is less direct, but nonetheless, very important. Most active managers pay very close attention to the benchmark against which they are being measured. They will stray from a benchmark, but not too far, and tracking error versus the index is a frequently cited measure of the “active risk” a manager incurs. Thus, a large-cap benchmark will generally translate into a large-cap www.indexuniverse.com/JOI

Source: NTGI Global Quantitative Management Group

We hereby challenge U.S. investors to perform the same exercise with their international allocations as they do with their U.S. allocations. Such an exercise is long overdue by both asset owners and their consultants.

What Are Investors Missing? Because of the “benchmark gap” inherent in using MSCI EAFE as a primary measure of the international equity markets, investors tend to systematically underweight or overlook three important segments of the world outside of the U.S.: Canada, developed international small caps and emerging markets. Collectively, these three markets account for more than $4 trillion of market cap, almost one-third of the total $12.5 trillion market cap for non-U.S. equity assets (see Figure 2).3 As shown in Figure 3, all three of these market segments have had periods of dramatic outperformance relative to EAFE and its equivalents. More importantly, they have offered different performance, which was not captured by the EAFE benchmark. Despite its incomplete representation of the international equity class, however, MSCI EAFE still prevails as the default benchmark. It is used as a proxy for “international exposure” in asset allocation analyses and as a performance benchmark for both active and passive managers. In January/February 2008

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Figure 2

International Equity Market Sub-Asset Classes Non-US Market Capitalization by Region Bombardier Research in Motion (RIM)

Canada 6%

MSCI EAFE 69% Other 31%

Small Cap 9%

Yokohama Rubber Saab Hitachi Koki Easy Jet

Emerging Markets 16%

Samsung Hyundai Embraer

CNOOC TEVA Haier

But I’m Exposed To International Small Cap With My EAFE Mandate!

Source: NTGI MSCI Standard & Poor’s August 2007

Figure 3

Potentially Missed Performance of Int’l Sub-Asset Classes Diferential Market Performance 100% 80% 60% 40% 20% 0% -20% 1990

1992

1994

1996

1998

2000

2002

2004

2006

-40%

■ EAFE ■ Canada ■ International Small Cap ■ Emerging Marketsl Source: NTGI, FactSet, MSCI, Standard & Poor’s

Figure 4

Developed International Small-Cap Short-Term Performance Comparison 350% 300% 250% 200% 150% 100% Sept 03

March 04

Sept 04

March 05

Sept 05

March 06

Sept 06

March 07

Sept 07

50%

■ S&P/C iti EMI ■ MSCI EAFE ■ Russell 2000 ■ S&P 500 Source: : NTGI, Standard & Poor’s, MSCI, Russell Indexes

the retail investor and financial advisor space, this “large and developed” bias is even more pronounced. As American investors allocate a higher proportion of their equity portfolios to international stocks, the importance of precision in the measurement of and allocation to the opportunity set has also increased. By ignoring or underweighting three key market segments—Canada, developed international small cap and emerging markets—investors are leaving attractive investment opportunities on the table. They should consider shifting to more complete “total international equity” policy benchmarks concurrent with an increased overall allocation to international equities. Filling this wide bench20

mark gap can increase portfolio returns while lowering risk, because of the improved diversification. We have seen progress. More and more investors are integrating Emerging Markets and Canada into their policy framework with the growing popularity of such “integrated international” benchmarks as the MSCI All Country World excluding U.S. (ACWI ex-U.S.) Index or FTSE AllWorld ex-U.S. Index. But even that is not enough. 4 Inevitably we ask, shouldn’t international small-capitalization stocks be integrated as well?

January/February 2008

Some managers with an MSCI EAFE benchmark have invested “opportunistically” in smaller-cap companies, seeing these as a source of potential alpha. In the same spirit, it is not at all uncommon for a manager to invest a (small) portion of an MSCI EAFE mandate in emerging market equities— “dabbling,” as it were. Many asset owners and their consultants explicitly allow or even encourage this approach (with maximum bands) as a way of getting exposure to both subasset categories.5 While a case can be made for having a manager make these sorts of active decisions, the benchmark will still have a significant influence on the weightings. If the benchmark has no exposure to smaller-cap companies, a portfolio’s neutral position will have no exposure either. As a result, any exposure will be carefully monitored for its impact on overall risk. If, on the other hand, an exposure to smallcap equities is included in the benchmark, the portfolio’s neutral position will reflect that. If a manager is holding small-cap issues as a core component of his/her strategy, one must question whether MSCI EAFE is really the appropriate benchmark to use in measuring performance. As Figure 4 notes, over the last four years, developed-market international small-cap stocks have outperformed MSCI EAFE by 6.3 percent on an annualized basis. A manager making an allocation to this space will likely outperform the benchmark, but does this reflect skill in selecting these stocks or merely the beta of this sub-asset class? Will the opportunistic manager be able to time his/her moves in and out of this area effectively? We feel strongly that any attractive asset class should be captured in the benchmark used to evaluate a manager. This holds for value- and growth-oriented managers within international equity.6 The neutral position should represent the mix of assets with which the investor is genuinely comfortable, i.e., “the true opportunity set” for the investment manager.

The Appeal Of International Small-Cap Stocks Since this decade’s stock market bottom in the spring of 2003, international small-cap stocks (as represented by the S&P/Citi Extended Market Index (EMI)7) have significantly outperformed the MSCI EAFE, S&P 500 and Russell 2000 indexes, as shown in Figure 4. It should be noted that U.S. small-cap benchmarks such as the Russell 2000 and S&P SmallCap 600 also significantly outperformed their largecap peers over this time period.


This strong performance by small-cap stocks is a recent phenomenon, however, as can be seen in Figure 5. Here, we look at returns over a 17.5-year time period, which includes general market cycles. International small-cap stocks may have been “unloved and underappreciated” by most American investors during the 1990s, but not without reason: As shown, U.S. equities significantly outperformed international equities, and neither large-cap nor small-cap international stocks made much comparative headway. While it is critical for investors to balance short-term performance-oriented enthusiasm with the sobriety of a longerterm perspective, performance per se is only one of the factors that make this sub-asset class attractive. International small-cap equities have provided attractive risk-adjusted returns, as can be seen in Figure 6, in which the data covers the five-year period ending September 2007.

Figure 5

Small-Cap And Large-Cap Long-Term Performance Comparison 650% 550% 450% 350% 250% 150% Jun 90

Dec 91

Jun 93

Dec 94

Jun 96

Dec 97

Jun 99

Dec 00

Jun 02

Dec 03

Jun 05

50%

Dec 06

■ S&P/C iti EMI ■ MSCI EAFE ■ Russell 2000 ■ S&P 500 Source: NTGI, Standard & Poor’s, MSCI, Russell Indexes

Figure 6

Favorable Correlations

Global Equity Sub-Asset Class Risk/Return Characteristics 45

✘ MSCIEM

40 35

▲ S&P/Citi EMI

30 25

■ MSCIEAFE

• 5

7

9

20 S&P 500

11

13

15 15

17

10

19

Annualized Risk Source: NTGI, Standard & Poor’s, MSCI, Russell Indexes

Figure 7

Three-Year Rolling Correlation Over Time S&P 500 vs. MSCI EAFE

A Note On Performance And Timing? Caveat Emptor Looking at performance, adding developed international small-cap and emerging markets to a well-structured portfolio would have also boosted returns over the past decade (Figure 9). Of course, a case can be made that these markets are no longer as compelling as they were in the early part of the decade, when valuations were significantly lower (the

Annualized Return %

U.S. investors have long looked to international equities to provide diversification within a portfolio. In Figure 7, we show how the correlations between the S&P 500 and the MSCI EAFE have changed over time. The correlation is far higher today than it was a decade ago, which is not surprising when one thinks about the global nature of today’s markets. International equities continue to provide some diversification, however small-cap companies provide more than large cap (Figure 8). Clearly, international small-cap adds diversification benefits, whether treated as a separate sub-asset class or integrated into the broader international equity asset class. This type of diversification is part of what has made foreign investing attractive to U.S. investors. With correlations rising among large-cap securities around the world (and especially among global “mega-cap” companies), developed international small-cap has a more important role to play than ever in helping build strong asset allocation portfolios.

Jan 74

Jan 77

Jan 80

Jan 83

Jan 86

Jan 89

Jan 92

Jan 95

Jan 98

Jan 01

Jan 04

Jan 07

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Source: NTGI, Standard & Poor’s, MSCI, Russell Indexes

Figure 8

Correlation Long-Term Correlations ’89-07 S&P 500 S&P 500

1

MSCI EAFE

Short-Term Correlations Sept ’04-Sept 07

S&P/Citi EMI

MSCI EM

S&P 500

0.65

0.53

0.62

1.00

MSCI EAFE

S&P/Citi EMI

MSCI EM

0.71

0.63

0.62

MSCI EAFE

1

0.93

0.63

1.00

0.94

0.84

S&P/Citi EMI

1

0.61

0.82

MSCI EM

1

1.00

Source: NTGI, MSCI, FactSet, Standard & Poor’s

www.indexuniverse.com/JOI

January/February 2008

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P/BV of international small cap was just over 1.1). This should be a cautionary indicator for investors who may not have a longerterm perspective.

The Challenge Of Defining The “Sub-Asset Class”

Figure 9

Comparative Returns And Valuations For U.S. And International Annualized Total Return

Current Valuations

5 Years

10 Years

15 Years

S&P 500

15.46

6.57

11.11

17.1

2.8

S&P 600

18.74

9.41

22.6

2.3

MSCI EAFE

23.32

9.61

10.28

PE

15.3

P/BV

2.4

Because international small-cap equiS&P/Citi EMI World x US 29.64 25.11 10.93 16.9 2.5 ties tend to “fall below” the standard Source: NTGI, Standard & Poor’s, MSCI. Data as of September 30, 2007. developed-international benchmarks, defining the sub-asset class has challenged and often confused many in the industry. Determining the correct benchmark for active managers and the best investment strategies to employ in this category has not been easy. Fortunately, this issue has recently been gaining long-overdue attention, and we believe that the industry is finally at the inflection point of shifting toward a more logical, holistic framework. In November 2006, MSCI announced that it would be updating its methodology to correct an overlap that had long existed between its dominant large/mid-cap indexes (like the MSCI EAFE) and its small-cap index series. Previously, the large/mid-cap indexes had a smattering of small-cap exposure; in the new version, the indexes are discrete. Provisional indexes were released with two scheduled transition dates: November 2007 and May 2008. Since the previous methodology built in an overlap of the index series, however, it was unclear to many MSCI users how to successfully incorporate small-cap securities within their existing portfolios. Moreover, the methodology fell short of a broad comprehensive representation of the sub-asset class. Fortunately, other global index providers have stepped up to offer a solution in this space, including the S&P/Citigroup EMI, S&P/Citigroup “Cap Range,” FTSE, Dow Jones Wilshire and Russell Global indexes. These index families offer coherent solutions for the small-cap market segment, but also offer a series of clearly defined, nonoverlapping indexes, providing broad exposure to international markets. MSCI EM

39.79

15.48

12.81

18.5

3.0

Gaining Efficient Exposure As the “sub-asset” class of international small-cap stocks has become more transparent, investors now have better options for integrating it into their portfolios. Still, getting efficient exposure with talented active managers can be a balancing act. Finding good international small-cap managers with sufficient capacity can be difficult. Though the number of strategies offered within this asset class has expanded, capacity constraints are a growing concern (as they are among top-quartile Emerging Market managers). In a 2006 survey of the 42 managers that offered dedicated international small-cap portfolios, 14 of them—most with above-median performance—were closed to new investors. The 14 managers represented 48 percent of the market cap of assets managed in this space, thereby highlighting the issue of limited capacity.8 And while active management has delivered strong returns historically, capacity constraints are increasingly reducing the availability of alpha. Thus, active management may not be the most effective and efficient way to acquire additional exposure today. One simple, cost-effective solution for investors is to utilize an index-based strategy in this space. Again, with the increased offering of comprehensive, investable indexes, index managers can now offer products to complement investors’ large-cap international strategies. 22

January/February 2008


A Complete Solution? Total International Equity Strategy (TIES) A dedicated international small-cap allocation is not the only approach, and may not be the best approach. Broad-based, all-inclusive benchmarks now exist that include small-cap stocks along with larger-cap issues and emerging markets. At Northern Trust, we call these complete strategies “Total International Equity Strategies,” or “TIES.” Choices of benchmarks include the MSCI Global Investable Market Index (GIMI), S&P/Citi Broad Market Index (BMI), FTSE All-Cap Indexes, Russell Global Indexes and, most comprehensive of all, the Dow Jones Wilshire Global Total Market indexes. These benchmarks can be used to integrate each segment of the international market into one broad-based portfolio. Since they include a broad array of issues across markets and market capitalizations, their adoption as policy benchmarks encourages managers to take positions in smaller-cap companies. Furthermore, adoption of “TIES” for the passive core of an international equity allocation enables investors to fill in gaps where they have not identified active managers, using, for example, an index-based developed-international large-cap value strategy while conducting a search for an active manager in this category. Just as many U.S. investors have implemented the comprehensive Russell 3000 and Dow Jones Wilshire 5000 as policy benchmarks for their U.S. equity allocations, we recommend that a similar approach be established for international allocations. As portrayed in Figure 10, the

www.indexuniverse.com/JOI

Figure 10

Global Benchmark Evolution – Investor Solutions “Total International Equity Strategy” TIES

Developed International Large / Mid Cap

Emerging Markets

Developed Intl Small Cap

Source: NTGI Global Quantitative Management

combination of the various sub-asset classes of International Equity into a single “Total International” benchmark (and allocation framework) for policy purposes and investment mandates (both active and passive) has a similar logic and elegance. We view adoption of this framework as the inevitable next phase of sophisticated asset allocation for international equities. Regardless of the benchmark or the investment style (traditional active, structured or index), investors should not ignore any of the subcomponents of the global markets. One can argue the merits of active versus passive, but as is often the case, simply “being there” is what matcontinued on page 48

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continued from page 23

ters the most. However the position is achieved, we would argue that ignoring international small-cap equities leaves the investor with an incomplete and inefficient global

equity allocation. Relying only on a developed-international large-cap benchmark like MSCI EAFE as one’s primary index for the asset class is outdated and inappropriate.

Endnotes 1We will emphasize throughout this article that International Small Cap, like Emerging Markets, should be considered a subcategory of International Equity, just as U.S. Small Cap

is a sub-asset class within U.S. Equities. 2According to a Pensions & Investments 2007 Survey of the Top 1000 Defined Benefit Plans, the average allocation to International Equities was 16.8 percent. 3It should be noted that the weights within the non-EAFE portion of the International Equity asset class have shifted, with Emerging Markets growing dramatically in the past several years,

but the overall percentage that has been “missing” (beyond EAFE) has been relatively stable this decade, ranging from 30 to 35 percent of the total universe of stocks outside the U.S. 4See pp. 38-39 of “Emerging Markets Investing, Efficiently Adding Emerging Market Equities to a Global Portfolio,” by Steven A. Schoenfeld and Alain Cubeles, Northern Trust, March

2007 (www.northerntrust.com). 5Some large pension funds even measure the extent of this “dabbling” as a way of both tracking and controlling their active managers’ out-of-benchmark allocations to

Emerging Markets and Small Cap. 6For more background on the various style indexes for international equities, see Chapter 9 of Active Index Investing: Maximizing Portfolio Performance and Minimizing Risk through Global

Index Strategies, (Wiley Finance, 2004), especially pp. 155-159. 7We use the S&P/Citigroup EMI to represent the Developed International Small Cap sub-asset class, as it has a longer history and a more stable composition than the MSCI’s cur-

rent International Small Cap indexes. The later has just undergone its phased transition to an improved construction methodology which better reflects the International Small-Cap category. From its introduction in December 1998 (data back to December 1992) until November 2007, MSCI’s International Small-Cap index series covered only about 40 percent of the universe, had overlap with its large-cap counterpart and exhibited very high turnover. This is discussed later in the paper. 8InterSec Research, “Implementation Challenges in International Small Cap,” February 2006

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January/February 2008


The Value Of Currencies New exchange-traded vehicles provide entry into the FX market

by Tom Haines

24

January/February 2008


T

he launch of the Rydex CurrencyShares Euro Trust (NYSE Arca: FXE) in December 2005 opened up the currency market to mainstream investors for the first time ever. The exchange-traded trust, which provides exposure to the euro and generates interest payments based on local (EU) bank rates, was an instant hit, rapidly gathering over $1 billion in assets. Noting the demand, Rydex quickly added to the CurrencyShares family, rolling out an additional seven trusts over the next 15 months. In May 2007, Barclays PLC joined the party, issuing three iPath currency exchange-traded notes (ETNs) designed to track the value of individual currencies. (PowerShares and other ETF providers have also launched currency-focused products recently; those funds, however, include multi-currency and currency-strategy ETFs, and are beyond the scope of this article.) The success of these new currency exchange-traded vehicles (ETVs) is no surprise. Prior to the CurrencyShares trusts and iPath currency ETNs, it was very difficult for individual investors to gain exposure to the foreign exchange market—ironic, considering that foreign exchange is the most liquid asset market in the world, with daily turnover of $3.2 trillion.1 Of course, it was possible for investors to tap into these markets before the launch of these new vehicles. Investors could open foreign currency bank accounts or tap in to the highly liquid currency futures markets. But each approach had its flaw. Few banks offer foreign currency accounts to individuals, and the Patriot Act requires U.S. citizens to disclose all foreign bank accounts with deposits above $10,000 to the Department of the Treasury. Meanwhile, foreign currency futures, though wildly successful with institutional investors, require margin accounts and demand that investors roll into

new contracts as the near-month contract expires, something many investors are uncomfortable doing. By contrast, these new ETVs offer clean, crisp exposure, all from the comfort of a regular equity brokerage account.

Hedging Portfolios While some investors have used these funds to speculate on currency movements, the most popular uses seem to be as a hedge against existing currency exposure or as a noncorrelated asset to add to a portfolio.

Correlations Among Currencies Individual-currency ETVs can be hedged against other individual-currency ETVs and other asset classes to help reduce market risk. Within the currency market, correlations exist between currencies within the same geographic region and between currencies from countries that depend on similar industries. Figures 3 and 4 show the correlation matrix for the CurrencyShares ETFs and iPath currency ETNs. They highlight the high level of correlation between the currencies in Europe (FXE, FXB, FXF and FXS), as well as the strong correlation (52 percent) between the CurrencyShares Australian Dollar Trust (FXA) and the CurrencyShares British Pound Trust (FXB). The latter can be attributed to the fact that the British and Australians both annually invest $35 billion (USD) in each other’s economy.2 The Japanese yen has a low or even inverse correlation with many other currencies. This could partially be attributed to the very low 50 basis point (0.50 percent) interest rate in Japan, as well as the fact that the yen is the only Asian currency in the matrix.

Figure 1

Individual Currency ETFs Trading Symbol FXA FXB FXC FXE FXF FXM FXS FXY

Fund Name

3-Month Average Daily Volume

CurrencyShares Australian Dollar Trust CurrencyShares British Pound Trust CurrencyShares Canadian Dollar Trust CurrencyShares Euro Trust CurrencyShares Swiss Franc Trust CurrencyShares Mexican Peso Trust CurrencyShares Swedish Krona Trust CurrencyShares Japanese Yen Trust

73,456 32,024 53,589 190,880 54,869 6,086 5,170 386,456

Assets ($US millions) 218.91 177.36 163.76 979.33 185.73 23.49 39.40 905.51

Source: NYSE ArcaVision and CurrencyShares.com. Data as of October 31, 2007.

Figure 2

Individual Currency ETNs Trading Symbol ERO GBB JYN

Fund Name

3-Month Average Daily Volume

Assets ($US millions)

iPath EUR/USD Exchange Rate ETN iPath GBP/USD Exchange Rate ETN iPath JPY/USD Exchange Rate ETN

18,186 1,527 21,097

83.36 5.31 66.26

Source: NYSE ArcaVision and iPathETNs.com. Data as of October 31, 2007.

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January/February 2008

25


Correlations With Equities It is interesting to analyze the positive correlation relationship between certain international equity ETFs and individual-currency ETVs, as it helps us understand the degree to which ETVs can serve as a hedging tool for institutional traders exposed to currency risk as a result of owning foreign equities. Figures 5 and 6 group the CurrencyShares and iPath Currency ETNs with an appropriate iShares international equity ETF and showcase the correlations between each. A onefactor regression was generated where the one-day return of each CurrencyShare or iPath ETN was the dependent variable and the one-day return of the related iShares international ETF was the independent variable. The results show that all of the iShares were positively correlated to their corresponding currency vehicles, and that they were statistically significant with a 99 percent degree of confidence. Interestingly, the results also show that the iShares equity index funds and the currency vehicles are not a perfect proxy for one another, since there is equity market risk with the index funds. The betas in Figure 5, for instance, suggest that for every 1 percent return in the iShares equity ETFs, the related CurrencyShares would return anywhere from 7 to 29 basis points (0.07 percent to 0.29 percent) in the same direction. The betas are much lower for the iPath currency

ETNs, most likely due to limited data. The in-sample single-factor regression model of the CurrencyShares Australian Dollar Trust using the iShares MSCI Australia Index Fund (Figure 7) provides a visual image showing that the foreign currency ETF is not a perfect hedge for the respective equity index, even though there is positive correlation. The relationship diverged, for instance, in August 2007, during the global credit crunch.3

Correlations With Gold It has been over 35 years since the collapse of the Bretton Woods Agreement and the end of the gold standard, but even in a free-float currency economy, there still remains a correlation between the foreign exchange market and the gold market. Figures 8 and 9 display the results of regressions for the one-day returns of the CurrencyShares and iPath Currency ETNs using the one-day returns of the streetTRACKS Gold Shares ETF (NYSE: GLD) as the independent variable. GLD has a statistically significant positive correlation to all the CurrencyShares except the CurrencyShares Japanese Yen Trust; however, the results also make clear that the correlations are not high enough to justify the idea that a GLD position creates exposure to currency markets.

Figure 3

CurrencyShares NAV Correlation Matrix June 2006 - September 2007, *FXY covers February 2007 – September 2007

FXA FXB FXC FXE FXF FXM FXS FXY*

FXA

FXB

FXC

FXE

FXF

FXM

FXS

FXY*

— 52% 48% 55% 22% 48% 45% -37%

52% — 33% 68% 44% 35% 58% -8%

48% 33% — 43% 23% 39% 39% -19%

55% 68% 43% — 82% 37% 82% 10%

22% 44% 23% 82% — 1% 64% 49%

48% 35% 39% 37% 1% — 36% -52%

45% 58% 39% 82% 64% 36% — 1%

-37% -8% -19% 10% 49% -52% 1% —

Source: CurrencyShares.com

Figure 4

iPath/CurrencyShares NAV Correlation Matrix May 2007 – September 2007

ERO GBB JYN

FXA

FXB

FXC

FXE

FXF

FXM

FXS

FXY

38% 33% -49%

53% 76% -9%

27% 20% -21%

78% 51% 3%

64% 39% 36%

41% 25% -44%

65% 44% 1%

2% 2% 81%

Source: CurrencyShares.com and iPathETN.com

26

January/February 2008


Figure 5

CurrencyShares NAV International / iShares NAV Regression Analysis June 2006 – September 2007

Ticker

CurrencyShares

iShares Equity Index Hedge

R2

Beta

T-Stat

FXS FXM FXA FXB FXE FXC FXF FXY

CurrencyShares Swedish Krona Trust CurrencyShares Mexican Peso Trust CurrencyShares Australian Dollar Trust CurrencyShares British Pound Trust CurrencyShares Euro Trust CurrencyShares Canadian Dollar Trust CurrencyShares Swiss Franc Trust CurrencyShares Japanese Yen Trust

iShares MSCI Sweden Index Fund iShares MSCI Mexico Index Fund iShares MSCI Australia Index Fund iShares MSCI United Kingdom Index Fund iShares S&P 350 Europe Index Fund iShares MSCI Canada Index Fund iShares MSCI Switzerland Index Fund iShares MSCI Japan Index Fund

0.26 0.30 0.43 0.19 0.16 0.23 0.10 0.02

0.20 0.15 0.29 0.18 0.16 0.21 0.17 0.07

10.49 11.74 15.43 8.55 7.82 9.63 6.09 1.88

Source: CurrencyShares.com and iShares.com

Figure 6

iPath Currency ETNs NAV International / iShares NAV Regression Analysis May 2007 – September 2007

Ticker

ERO GBB JPY

iPath Currency ETNs

iPath EUR/USD Exchange Rate ETN iPath GBP/USD Exchange Rate ETN iPath JPY/USD Exchange Rate ETN

iShares Equity Index Hedge

R2

Beta

T-Stat

iShares S&P 350 Europe Index Fund iShares MSCI United Kingdom Index Fund iShares MSCI Japan Index Fund

0.10 0.07 0.00

0.09 0.08 0.00

3.37 3.05 0.15

Source: iPathETN.com and iShares.com

Combining Asset Classes Multifactor regressions provide a tool for analyzing methods of combining asset classes for hedging exposure. The multifactor regression in Figure 10 models the CurrencyShares Swedish Krona Trust against the CurrencyShares Euro Trust and the iShares MSCI Sweden Index Fund. The results show that the regression has an adjusted R-squared of 71 percent, and that both variables were statistically signifi-

cant with a 99 percent degree of confidence. Figure 11 plots the return of the in-sample model against the return of the CurrencyShares Swedish Trust, and illustrates the view that the European currency markets have been highly correlated. Investors with a bullish view on the Swedish krona should consider their current portfolio exposure to European equities and other European currencies before making a final allocation.

Figure 7

Figure 8

CurrencyShares Australian Dollar Trust NAV Cumulative June 2006 - September 2007

CurrencyShares NAV/GLD Regression Analysis June 2006 – September 2007

25%

FXA.NV Regression Adjusted R2: .43 F-Statistic : 238.07 Beta NAV Ticker T-Stat EWA.NV 0.28 15.43

20% 15% 10% 5% 0%

6/22 '06

8/3 í06

9/14 10/26 12/7 1/18 í06 í06 í06 í07

3/1 í07

4/12 5/24 í07 í07

■ Model ■ FXA Source: CurrencyShares.com and iShares.com

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7/5 í07

8/16 9/27 í07 í07

-5%

CurrencyShares CurrencyShares Australian Dollar Trust CurrencyShares Swedish Krona Trust CurrencyShares Euro Trust CurrencyShares British Pound Trust CurrencyShares Swiss Franc Trust CurrencyShares Canadian Dollar Trust CurrencyShares Mexican Peso Trust CurrencyShares Japanese Yen Trust

R2

Beta

T-Stat

0.10 0.11 0.14 0.12 0.10 0.05 0.30 0.00

0.16 0.15 0.12 0.12 0.12 0.08 0.07 -0.03

5.91 6.38 7.05 6.47 6.01 4.10 3.72 -0.68

Source: streettracksgoldshares.com and CurrencyShares.com

January/February 2008

27


Figure 9

Figure 12

CurrencyShares Euro (FXE.NV) Regression Against streetTRACKS Gold (GLD.NV), iShares S&P 350 Euro (IEV/NV) and iShares Lehman 1-3 Year Bond (SHY/NV)

iPath Currency ETNs NAV/GLD Regression Analysis May 2007 – September 2007 CurrencyShares iPath EUR/USD Exchange Rate ETN iPath GBP/USD Exchange Rate ETN iPath JPY/USD Exchange Rate ETN

R2

Beta

T-Stat

0.22 0.14 0.00

0.16 0.13 -0.01

5.22 3.92 -0.13

Source: streettracksgoldshares.com and iPathETN.com

The second in-sample multifactor regression (shown in Figure 12) analyzes the CurrencyShares Euro Trust daily returns against the streetTRACKS Gold Shares, iShares S&P 350 Euro Index Fund (IEV) and the iShares Lehman 1-3 Year Bond Fund (SHY) daily returns. The purpose for including the iShares Lehman 1-3 Year Bond Fund was based upon the theory of interest rate parity, which states that the differential of short-term interest rates between two foreign countries should have a positive relationship on the valuation of their currency rate. The iShares S&P Lehman 1-3 Year Bond Fund is the closest ETV proxy for short-term interest rates.

Adjusted R2: .30 F: 47.53 NAV Ticker GLD.NV IEV.NV SHY.NV

Beta

T-Stat

0.15 0.97 0.09

7.45 6.08 5.47

Source: CurrencyShares.com, streettracksgoldshares.com and iShares.com

Figure 13

CurrencyShares Euro Trust NAV Cumulative Return/In-Sample Model Return 14% 12% 10% 8% 6% 4% 2%

Figure 10

0%

CurrencyShares Swedish Krona (FXS.NV) Regression Against iShares Sweden (EWD.NV) and CurrencyShares Euro (FXE.NV)

6/22 7/22 8/22 9/22 10/22 11/22 12/22 1/22 2/22 3/22 4/22 5/22 6/22 7/22 8/22 9/22 '06 '06 '06 '06 '06 '06 '06 '07 '07 '07 '07 '07 '07 '07 '07 '07 ■ Model ■ FXE.NV

Adjusted R2: .71 F-Statistic : 401.55 NAV Ticker EWD.NV FXE.NV

Beta

T-Stat

0.08 1.02

6.56 22.69

Source: CurrencyShares.com and iShares.com

Figure 11

CurrencyShares Swedish Krona Trust NAV Cumulative Return/ In-Sample Model Return June 2006 - September 2007

6/22 7/22 8/22 9/22 10/22 11/22 12/22 1/22 2/22 3/22 4/22 5/22 6/22 7/22 8/22 9/22 '06 '06 '06 '06 '06 '06 '06 '07 '07 '07 '07 '07 '07 '07 '07 '07 ■ Model ■ FXS.NV Source: CurrencyShares.com and iShares.com

-2%

18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4%

As interest rates and bond prices have an inverse relationship, the regression supports the broad hypothesis and we observe that the return of the iShares Lehman Bond fund had a positive beta against the CurrencyShares Euro Trust return, holding all else equal. The three-factor model had an adjusted R-squared (or goodness of fit) of 30 percent. This relationship could weaken for many reasons, such as if the Euro Zone’s interest rate volatility increased, which is not a factor incorporated in the model. Figure 13 plots the return of the in-sample model against the return of the Euro Currency Trust.

Conclusion The results of this analysis show that single-currency exposure can be a useful hedging tool in a variety of situations. Global asset correlations are currently at their highest levels in years, putting a heightened value on unique asset classes that can be incorporated into portfolios. The launch of new ETVs like the CurrencyShares Trusts and iPath Currency ETNs has significantly opened up the foreign exchange market to all investors, who can now tap in to these assets as they build more sophisticated, institutional-caliber portfolios.

This article is for investment professionals only. Information in this newsletter is based on current public information (as of November 1, 2007) that we consider reliable, but we do not represent it as accurate or complete, and it should not be relied on as such. NYSE Euronext and its affiliates make no recommendation as to, and do not endorse or sponsor, any security mentioned in this article. This article is for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall trading or investment strategy. NYSE Euronext and its affiliates disclaim all liability for investment decisions of readers of this newsletter. Readers should seek professional advice, including tax advice in connection with any investment decisions or trading strategies. 28

January/February 2008


This article is not an offer to sell or the solicitation of an offer to buy any security. Investors interested in a particular security should contact their brokers or the issuer of the security for a prospectus outlining the risks, investment objectives and other information regarding that security. Past performance is not a guide to future performance; future returns are not guaranteed; and a loss of original capital may occur. Certain transactions, including those involving ETFs, futures, options and other derivatives, give rise to substantial risk and are not suitable for all investors. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments.

Endnotes R2: R-Squared is a statistical measure of how well a regression line approximates real data points. R-Squared is a descriptive measure between zero and one, an indication of how well the independent variable is predicting the dependent variable. An R-Squared of zero is low and an R2 of one is high. T-Statistic: After an estimation of a coefficient, the t-statistic for the coefficient is the ratio of coefficient to its standard error. That can be tested against a t distribution to determine how probable it is the true value of the coefficient is really zero. Beta: A mathematical measure of the sensitivity of rates of return on a portfolio or given stock compared with rates of return on the market as a whole. A beta of 1.0 indicates that an asset closely follows the market. A beta greater than 1.0 indicates greater volatility than the market.

References 1www.bis.org 2007 Triennial Survey 2Australian Government Department of Foreign Affairs and Trade

© 2007 NYSE Euronext. No part of this material may be (i) copied, photocopied or duplicated in any form by any means, or (ii) redistributed without the prior written consent of NYSE Euronext.

ETFR exchange-traded funds report

ETFR exchange-traded funds report

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The search for income

cuts of a few years ago. Many are still Dividends are one corner of the ETF uni- smarting from the recent bear market verse where investor enthusiasm is and demographics are beginning to take matching managers’ product develop- their toll as the first baby-boomers move ment. Investors can already choose from into the later parts of their investment seven ETFs offering exposure to different lives. Like many successful financial prodbaskets of dividend paying stocks, ucts, these dividend ETFs are shrewdly including one with an international answering a market need. But do investors know what they’re slant. Meanwhile, there are two products waiting in the wings. As ETFR goes to buying? The seven dividend ETFs currentpress, Vanguard’s Dividend VIPER was ly offer yields ranging between 3.6% and poised to launch on the American Stock 1.5%, and whether that dividend 10 Exchange and Dividend ETFs Nasdaq was seekFund Name Ticker 1Q'06 Launch ing a manager to iShares Select Dividend DVY 3.3 Nov-03 design an ETF S&P Dividend Aristocrats SDY 3.6 Nov-05 tracking its nascent Nasdaq Frist Trust Morningstar Dividend Leaders FDL Mar-06 Dividend index. PowerShares Dividend Achievers PFM 2.8 Sep-05 It’s no secret PowerShares Dividend Achievers (HiYield) PEY 1.4 Dec-04 that investors PowerShares Dividend Achievers (HiGr) PHJ 3.9 Sep-05 today are looking PowerShares Dividend Achievers (Int'l) PID 6.3 Sep-05 for yield, and diviVanguard Dividend VIPERs Will be launched shortly dends are “hot” again after the tax Nasdaq Dividend Achievers Has not yet been filed By Marsha Zapson

IN THIS ISSUE Every Jane and Joe can now take a direct bet on oil, easily and relatively cheaply. USO, the first ETF to track the price of crude, launched in April on the Amex. Like the Deutsche Bank Commodity ETF, USO invests in futures. Cover The QQQQ twist: Nasdaq now offers two new takes on QQQQ. QQEW is an equal weighted version of the Nasdaq-100, while QTEC is an equal weighted version of technology stocks in the Nasdaq-100. According to John Jacobs, Nasdaq’s executive vice president, the ETFs were launched due to investor demand. Page 3 ETFR’s Expert Portfolios have done well this quarter. At the end of March, the Tack 80 was up 4.4%, the PMMA was up 4.3%, INR was up 6.1%, and the Dawgs was up 7.2%. In comparison, the Diamonds was up 4.6%, the Nasdaq 100 was up 6.4%, and the SPDR was up 4.7%. Each portfolio manager explains how and why his portfolio did well. Page 7 Remember the largecap rally that never happened? ETFR looks at the 12 largecap ETFs in the market and finds that Rydex’s equal weighted version of the S&P 500 outperformed the others in the first quarter. Page 8 ETFR’s monthly databank includes ETFs from around the globe. Page 13

UPDATES

Crude realities Even though oil prices more than tripled since late 2001, most investors could watch but not partake. Gaining direct exposure to the commodity itself was a challenge for everyday investors who could not or did not want to trade futures. All that changed when the US Oil Fund LP (USO) began trading on the American Stock Exchange April 10, 2006. For the first time, every Jane and Joe in the US can make a bet on crude

oil easily and cheaply. Like the recently launched Deutsche Bank Commodity ETF (DBC), USO is not a 1940 act company. Rather it is a commodity pool registered with the Commodity Futures Trading Commission and Securities and Exchange Commission. USO, managed by California-based Victoria Bay Asset Management, buys futures to track the price movement of West Texas Intermediate light, sweet crude oil. WTI is the primary benchmark for oil in the US.

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Issue No. 66 May 2006

USO is an unlevered pool, “meaning if $100 million comes in, we buy $100 million of futures contracts,” said John Hyland, USO’s director of portfolio research. After the first month, the fund rolls the contracts forward, month after month, year after year. However, because the fund only has a small proportion to advance as margin, the balance of unused cash sits in short-term treasuries. “USO is calculated on a total return basis, which does not mean the price of the ETF equals the price of that 3

The equalweight trend

weighted S&P 500 ETF (RSP) so attracIt’s not a great surprise that cap- tive. It has also carved a niche in an weighted indexes and their respective increasingly crowded market for ETFs have lost some allure for investors PowerShares’ ETFs and a slew of equalduring the last five or six years. “If weighted ETFs, like the recently you’re looking for long term market launched equal-weighted version of exposure, market cap-weighting is the QQQQ (QQEW) and State 10 way to go,” says Srikant Dash, Standard & Poor’s index strategist. But, in this S&P 500 (April 2006) market, who wants market exposure? Cap Wt Equal Wt Just look at the S&P 500, the preYTD 5.61 7.37 mier tradable index with some $1.1 tril12 mo 15.42 22.42 lion tracking it and another $3 trillion 3 yrs 14.68 22.03 to $4 trillion benchmarked to it. For the 5 yrs 2.70 8.64 past five years, the cap-weighted ver10 yrs 8.94 11.69 sion of the 500 returned 14.7% annualSource: S&P ized while its equal-weighted sibling returned 22.0%. As mid- and small-caps out- Equal wt vs Cap wt vs perform large caps, equal- Modifed cap wt (as of April 2006) weighted and modified capQ1 '06 12 mo 3 yr weighted index-tracking ETFs RSP 2.76 22.13 20.90 have taken center stage. It’s SPY 2.69 15.58 14.13 an index methodology that PWC 1.02 23.44 21.39 has made Rydex’s equalBy Marsha Zapson

IN THIS ISSUE Finally, the iShares Silver Trust (SLV) is trading on the Amex after months of blocking and tackling by the Silver Users Association. SUA objected to the ETF because, or so the association heatedly claimed, SLV would corner the market and inflate the price of silver. It hasn’t so far: After a month of trading, the price of silver remains flat. Cover As investor appetite for dividend ETFs remains unabated, another such product began trading. There are now eight dividend ETF in the US Page 3 ETFR takes a look at the April returns for its four Expert Portfolios. Year to date, XTF 80 was up 9.8%, PMAA Momentum was up 7.3%, INR Moderate was up 6.9%, and Bobo’s Dawgs were up 9.9%. Looks like Bobo has done it again; but then, Bobo doesn’t have any clients. Page 4 This month we include a market commentary on Alpha Lost and Found by James F Peters, CEO of Tactical Allocation Group. Over the past six years, many investors have been left smarting in the wake of the bear market and, writes Peters, have been left frustrated and feeling betrayed. Yet most advisories go with the general market direction. Peters discusses the search for alpha in today’s market and explains how ETFs can be effective tools in tactical allocation strategies. Page 7 ETFR’s monthly databank looks at ETF performance from around the globe. Page 13

UPDATES

At long last, silver Almost one year to the day after Barclays Global Investors filed an application with the Securities and Exchange Commission for a silver ETF that tracks the price of silver, the product finally began trading on the American Stock Exchange at April’s close. Even though the Silver Trust (SLV) is based on a template introduced by the gold ETF in November 2004 and used by other products since, like Rydex’s Euro

Currency ETF (FXE), SLV had been mired for months in blocking and tackling strategies devised by the Silver Users Association. Simply put, SUA’s plaint has been that SLV will corner the market and drive up the price of silver. At the end of 2005 according to the London Bullion Market, an ounce of silver was worth about $88.30. At the end of April, when SLV launched, it was worth about $12.55, and on June 2, it closed at $12.15. On June 2, SLV was selling for $121.75 per share.

Each share of SLV is worth 10 oz of silver, and its price reflects the price of silver owned by the Trust less expenses and liabilities. SLV’s management fee is 50 basis points. (In comparison, the iShares COMEX Gold Trust (IAU) cost 40 basis points.) Because the shares mirror the price of silver held by trust, SLV’s market price will be as unpredictable as the price of silver has historically been. This has been the year of commodity ETFs. Three other commodity ETFs trade on the Amex, DB 3

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Gold investor’s choices widen By Marsha Zapson

With the gold rush now in its fifth year, the first US ETF to hold gold mining stocks (Canada has had one for three years) began trading on the American Stock Exchange May 22. While some investors lament that the ETF trading under ticker GDX made its appearance a year too late, it nonetheless allows them to buy a broad basket of 44 gold mining stocks (hedged and unhedged) for 55 basis points. And who better to design and manage such a fund than Van Eck Global? The New York-based boutique, which introduced the first gold-mining-oriented mutual fund in the US in 1968, has become known as one of the top money managers in precious metals since the 1970s when it made its name in that decade’s gold bull run. In addition, the shop also runs money in emerging markets, its smallest business, and in hard assets (like oil, natural gas, and timber), its largest.

One week after launch, GDX had attracted $54.9 million in assets— healthy perhaps for a nascent ETF but a mere pittance when compared with Van Eck’s gold mutual funds and managed accounts that total some $1 billion. Why would Van Eck want to launch a gold miners ETF? After all, GDX will directly compete with a Van Eck mutual fund that is also designed for US investors and that also invests in international gold mining stocks. “That’s the way the market is going,” says the firm’s gold strategist, Joe Foster, who also just happens to run its international gold miners mutual fund. “If we hadn’t done it, somebody else would have.”

Comparing indexes GDX tracks the Amex’s Gold Miners index, GDM, which was launched at the end of 2004 and designed specifically for the ETF. Like so many 10

UPDATES

A flurry of BRICs Emerging markets have not been immune to recent stock volatility, and their double-digit return hegemony of the past three years is now being challenged. While investors have been pouring money into emerging markets funds this year, advisors are saying that they may have just missed the rally. Returns for Brazil, Russia, India, and China, known as BRIC countries, have descended into negative territory during May. Despite

declines, investor interest in the BRICs is high, and an ETF offering exposure to this group would be a welcome addition to the relatively small number of US mutual funds in the space. ETF newcomer Claymore Advisors of Lisle, Illinois, filed an application with the Securities and Exchange Commission late May for a BRIC ETF. (Claymore, by the way, has plans to launch four additional ETFs, all of which are in registration; page 3.) The proposed BRIC ETF tracks the Bank of New

IN THIS ISSUE Thinking of investing in the BRICs? ETF newcomer, Claymore Advisors, filed with the SEC in late May for an ETF tracking BONY’s BRIC index, which holds 50 ADRs and GDRs. Claymore, by the way, has plans to launch four additional ETFs, all of which nudge the ETF industry one step closer to active management. Cover Our four ETFR expert portfolios hit their first negative month this May. All are down for the month, although Bobo, the Dart-Throwing Monkey, who is something of an anomaly in this august group, is still ahead of his mates. XTF 80 is down 3.6%, INR Moderate is down 3.3%, PMAA Momentum is down 3.2%, and Bobo’s Dawgs is down 2.9%. Page 4 After four years of wending their way through the SEC, PlusFunds’ eight leveraged and inverse ETFs finally began trading on the Amex June 21. These ETFs deliver double the daily performance—either long or short—of the S&P 500, Nasdaq-100, DJIA, and S&P MidCap. Page 7 PowerShares, the first ETF provider to offer enhanced indexes for its cadre of ETF, has filed for 31 (count ‘em) new ETFs including 10 RAFIbranded ETFs, 16 Intellidexes, and five standalones. Among the latter group, two are noteworthy: the much anticipated Nasdaq-100 dividend ETF and an India ETF. Page 8 ETFR’s monthly databank includes ETFs from around the globe. Page 13

York’s recently launched BRIC Select ADR index, which holds American and Global Depositary Receipts trading on the New York, American and Nasdaq stock exchanges. BONY’s BRIC index, which is modified cap weighted and a subset of the bank’s broader ADR index, holds 50 of the largest BRIC companies, including 15 each from Brazil, India and China, and five from Russia. No one stock can exceed 23%, and no one country can exceed 45% of the index. The index is continuously calculated 3

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January/February 2008

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China Forum A survey of leading experts in the field

Edited by Matthew Hougan

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China, China, China: It’s all investors want to talk about these days. And no surprise: The Chinese economy—and the Chinese stock market—are booming. GDP growth is humming along at 10+ percent a year, and Chinese equity indexes are rising faster than the Nasdaq in the days of eToys and Kozmo.com (except this time, the underlying companies are actually making profits). The China boom presents a unique challenge for indexers, and particularly for fans of market-cap-weighted indexing. China is now the fourth-largest economy in the world, but because the vast majority of Chinese equity shares are inaccessible to foreign investors, the country holds very little weight in free-float-adjusted market capitalization indexes: about 1-to-1.5 percent, depending on the index. That means investors who follow a free-float methodology are putting more money into Holland than they are into China. Does that make any sense? To find out, the Journal of Indexes’ editorial staff asked nine leading experts on China three questions: 1) Is China underweighted in global benchmarks, and should investors increase their exposure? 2) Is the Chinese equity market a bubble ... and will it pop? 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?

Rob Arnott, Chairman and Founder, Research Affiliates 1) Is China underweighted in global benchmarks, and should investors increase their exposure? Yes, it is underweighted in global benchmarks, but that does not necessarily mean that one should increase their allocation. I am not a believer in efficient markets, and China has become very expensive by world standards. So my personal view is that China is expensive; that it is not priced to have superior returns in the coming five years; but that as part of a benchmark, it is underweight because of the benchmark’s reliance on the market capitalization of stocks that one can buy as a foreign investor. The RAFI Fundamental Indexes weight stocks by their fundamental footprint in the world economy, not by the market capitalization that is available for foreign investors to buy. As a result, the Fundamental Index has been overweight China within emerging markets throughout its history. But interestingly, as Chinese stocks have soared recently, the Fundamental Index has been trimming back its allocation to China to return back to the fundamental footprint of those companies. At this point [November 15, 2007], the Fundamental Index is very close to the cap-weighted index for China. A year ago it was starkly overweight. 2) Is the Chinese equity market a bubble ... and will it pop? I’m very hesitant to label it a bubble. These are big, successful and profitable companies. China is a quintessential capitalist economy at this stage, albeit one with less rule of law. As a consequence, it has less protection for external investors than we might like. The prices at this stage relative to fundamental value are marginally above other emerging markets. I would not call it a bubble, but I would call it expensive. www.indexuniverse.com/JOI

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? The prospects relative to the rest of the emerging markets are probably slightly below average. The emerging markets in general are fairly expensive.

James Rogers, co-founder of the Quantum Fund and author of the forthcoming book, A Bull In China: Investing Profitably In The World’s Greatest Market 1) Is China underweighted in global benchmarks, and should investors increase their exposure? Of course. It is one of the largest economies and markets in the world. 2) Is the Chinese equity market a bubble ... and will it pop? It is an incipient bubble and will turn into one within a few months unless something causes a significant correction soon. 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? If a full-fledged bubble develops, it will be one of the worst. If something causes a significant correction, it will be one of the best.

John Prestbo, Editor and Executive Director, Dow Jones Indexes 1) Is China underweighted in global benchmarks, and should investors increase their exposure? I don’t think so. I think it’s weighted just about right. China is a funny situation because a lot of the stocks are in Hong Kong, listed as Red Chips or H Shares, so if you’re using a benchmark that includes Hong Kong and the Red Chips, you’re getting blue-chip exposure to China right there. 2) Is the Chinese equity market a bubble ... and will it pop? I wouldn’t call it a bubble necessarily, but I do think there’s a lot of Olympics enthusiasm in the market right now. Whether it pops or just deflates at some point remains to be seen. China is a developing, emerging market that is growing like the dickens, but it is still volatile. I think any investor wanting exposure to China has got to think “emerging markets” and not “developed markets.” No one should confuse China’s tremendous growth economically with economic stability. 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? I think stock markets always follow economic growth and strength, and there’s no end in sight for the growth of China’s economy and its influence in the world. So my feeling is that over the long haul, China’s market is going to be going up.

Mark Makepeace, Chief Executive, FTSE Group 1) Is China underweighted in global benchmarks, and should investors increase their exposure? It is true that today China only makes up 1 percent of global benchmarks. The reason for this is that the main bulk of Chinese companies are listed as A Shares on the Shanghai and Shenzhen stock exchanges. January/February 2008

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Include these companies at their full market weighting and China represents almost 5 percent of the FTSE All-World Index and 32 percent of emerging markets excluding Korea and Taiwan. But even this number under represents the importance of China, as today many large Chinese companies have yet to come to the market to make their initial public offering. But for now, exposure to the larger China A-Share market is restricted and likely to remain so, as long as capital controls and restrictions exist with regard to institutional investment in China. The only way for international investors to access this high-performing market is through a CSFA-run Qualified Foreign Institutional Investor (QFII) scheme. Currently there is an approximate $10 billion USD QFII quota, and reportedly, that number is soon to be increased to $30 billion. Until the quota is raised, and other issues are addressed (such as unrestricted or low restriction on foreign investment, free flow of foreign exchange into and out of China and other markets, regulatory and infrastructure issues), institutional investors will be unable to freely increase their direct exposure to the China A-Share market. So, in the meantime, increasing exposure to China is restricted. FTSE offers three routes: Invest in Hong Kong-listed Chinese companies through the iShares FTSE/Xinhua China 25 Index ETF; invest in the A-Share market through the iShares FTSE/Xinhua A50 Index ETF listed in Hong Kong; or use our FTSE All-World Watch List indexes, which include A Shares for those investors who can secure QFII allocations. 2) Is the Chinese equity market a bubble ... and will it pop? The A-Share market is today overvalued relative to Chinese shares listed outside of mainland China, and at some stage, this must change. But the relative overvaluation is largely a reflection of the investment controls in place, and as these are gradually removed, the valuations should realign themselves. However, the underlying China economic fundamentals appear to be strong. This includes a growing GDP for the last four years (10.4 percent this past year), approximately $2.5 trillion in savings and a large amount of foreign reserves ($1.3 trillion). China stocks, both international and domestic, are still rising. The FTSE China Index (comprising Red Chips and H Shares) was the best-performing country index in the FTSE Global Equity Index Series last month in both dollar and local currency, up 19.5 percent. The top-three-performing stocks from the 2,500 stock universe were also Chinese: China Eastern Airlines (H), Zijin Mining Group (H) and Hong Kong Exchanges and Clearing. The domestic A-Share market is also performing well, with new listings and continued growth. Mining, Mobile Telecommunications and Life Assurance were top-performing sectors in September, with individual companies showing very strong growth: Shanxi Meijin Energy up 261.92 percent, while China Eastern Airlines gained 91.15 percent. 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? Within the next 5-10 years, China will become one of the world’s most important markets. Investment controls will gradually be removed and Chinese companies will adopt international practices as they seek to attract foreign investment and grow their businesses outside of China. Today, within the global benchmark, there are already two 32

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Chinese companies (Petrochina “H” and China Mobile) in the top 10 companies ranked by market capitalization. If restrictions were relaxed and A-Shares were included in your global benchmark, the number of top-10 Chinese companies rises to six. In 10 years’ time, the vast majority of these top 10 will be Chinese!

Burton G. Malkiel, Chemical Bank Chairman’s Professor of Economics, Princeton University 1) Is China underweighted in global benchmarks, and should investors increase their exposure? Yes and yes. 2) Is the Chinese equity market a bubble ... and will it pop? The A-Share market is very richly valued. Indeed, the same companies, such as Sinopec and China Life, sell at higher prices in the A-Share market than in the H-Share Hong Kong market and in New York, where they trade as ADRs. When China relaxes currency and other restrictions, these differences will disappear. 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? I view the H-Share and N-Share (New York-listed Chinese companies) markets as attractive.

Roger Nusbaum, Financial Advisor, Your Source Financial 1) Is China underweighted in global benchmarks, and should investors increase their exposure? China is more and more becoming the straw that stirs the drink. China’s ascendancy/modernization is altering the supply and demand dynamics for many resources, including U.S. dollars. From an intuitive standpoint, China is underrepresented in many global benchmarks. Regardless of the pace of growth or what happens next in the Chinese capital markets, China will come to play an ever-larger role in the world economic order. 2) Is the Chinese equity market a bubble ... and will it pop? China is at least in an investment mania. People are very quick to label many investment themes as bubbles. I tend to think of bubbles as being all-encompassing macro events. The aftermath of the tech bubble was that many markets around the globe got cut in half. If a big decline in China has the same domino effect, then it will have turned out to have been a bubble. I don’t care about whether China is a bubble or not. For anyone with capital at risk, what matters is an assessment of the risks and rewards based on current information to make a forward-looking decision of how much, if any, exposure to have. I invested personally and for clients through Petrochina (PTR) early on and then with Sinopec (SNP) for several years, until selling in the second quarter of 2007 after what I thought was a huge run. Since that time, all things China have gone much higher; there have been many new IPOs; there are many Chinese stocks with huge market caps; and the recent decline does not seem to be worrying too many people. These are all indications of potential excess reminiscent of the tech bubble, so a sharp decline in China should not be a shock if it occurs.


Year-to-date the Shanghai Composite is up 100 percent and the Hang Seng Index is up 40 percent, while some of the bigger Chinese ADRs are up like amounts. As great as those numbers are, similar numbers have been available in other emerging markets that get far less attention; for example, the iShares MSCI Brazil ETF (EWZ) is up 80 percent year-to-date. Although China may be underrepresented in global benchmarks, that does not mean the shares are not overvalued. That so many Chinese companies have market caps greater than $100 billion is problematic. During the tech bubble, we saw the same thing; dozens of companies larger than $100 billion, many of which are now gone or have become micro-caps. For the time being, China is a market I want to avoid for a couple of years, until the current mania ends. 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? I have no doubt that China will become more important in every aspect we could think of. Over long periods of time, and into the future, there is no question that China will be an increasingly important investment destination. The notion of this being the China century rings very true to me. Just as the last century was the U.S.’ century, there were long periods of time where the best thing would have been to avoid U.S. equity exposure. It is only logical that now, in the China century, there will be periods of time where the best thing to do will be to avoid China for a couple of years. I believe this is one of those times.

George R. Hoguet, Global Investment Strategist, State Street Global Advisors 1) Is China underweighted in global benchmarks, and should investors increase their exposure? Investability is a key concept in benchmark construction and, in this sense, China’s current weight in most major benchmarks (roughly 1.5 percent) is appropriate, as it reflects what an investor can actually buy. So far, QFII allocations for access to the A-Share market have been modest. To the extent these increase significantly, index providers should consider methods to incorporate this development into their calculations. Investors should consider benchmark weights in a “greater China” context. Hong Kong, Taiwan and Singapore all benefit tremendously from China’s growth and are truly investable. China represents not just a global supply shock but also a global demand shock. The increasing importance of China, which in five years will surpass Japan as the world’s secondlargest economy, and the BRICs in general, gives additional impetus to considering adopting a global benchmark. A “world market weighting” in China — and greater China — is a good place to start thinking about one’s strategic allocation. China is the largest emerging market in terms of investable capitalization. Investors should consider investing in China both directly and indirectly through allocations to emerging markets and global multinationals. 2) Is the Chinese equity market a bubble ... and will it pop? One has to make a distinction between the A-Share market and the H-Share market. The former currently sells at 37 times www.indexuniverse.com/JOI

forward 12-month earnings and the latter at 24 times. A-Share earnings are growing at roughly 25 percent per annum; forecast 12-month earnings for investable China indexes, which include H-Shares, are growing at roughly 20 percent. A Shares represent a modest proportion of household wealth in China. Valuations in China are below the Nikkei in the 1980s and the Nasdaq in the 1990s. The A-Share market could be supported for some time by continued withdrawal by Chinese retail investors from banks. On the other hand, China continues to be in a tightening mode, and a greaterthan-anticipated slowdown could lead to a rapid change in sentiment and sharp decline. The H-Share market likely will be supported by capital outflows from China and appreciation of the Chinese renminbi, although of course global systematic factors will impact valuations. 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? Global investors need to reflect on China’s growing impact on the world economy and its implications for the structure of world output and investment returns. China faces enormous environmental, social and political challenges, and investors need to make a core judgment on whether they think globalization is irreversible. Over time, China will likely progressively dismantle capital controls, appreciate the renminbi and strengthen its institutions. Like Japan in the 1960s, the Chinese economy will likely grow at least in the high single digits for many years to come, and the stock market will become more of a “core holding” for global investors. China can offer diversification benefits to a global portfolio, and holds out the prospect of return enhancement based on continued strong earnings growth. However, investors need to pay careful attention to entry-point valuations and individual company earnings prospects.

Richard Gao, Portfolio Manager, Matthews China Fund 1) Is China underweighted in global benchmarks, and should investors increase their exposure? I think China is no doubt underweighted in global benchmarks, and this will change significantly in the next three-to-five years as the country’s stock market is expanding very rapidly. China accounts for more than 15 percent of the global economy on a purchasing-power-parity basis and has been one of the fastest-growing major economies in the world in the past decade. Investors with a long-term investment horizon should benefit from China’s growth. 2) Is the Chinese equity market a bubble ... and will it pop? I won’t describe the Chinese equity market as a “bubble,” but it definitely needs a correction and will be very volatile in the near term. China’s overall economy is still quite healthy, and corporate earnings growth has been strong. But the stock market has kept reaching historical high levels with record-high valuations. The domestic A-Share market was driven by huge liquidities and dominated by speculative retail investors. I continued on page 49 January/February 2008

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continued from page 33

won’t be surprised to see a sharp correction from here. 3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market? I am quite positive on China on a long-term prospective. Although China is already one of the largest economies in the world, it is still a poor country in terms of per capita income, and there are lots of investment opportunities as the country continues to grow rapidly and people’s living standards continue to improve. China has been consistently reforming itself and changing from a socialist economy to a market economy and has made impressive achievements. Going forward, China will be relying less on exports and investments and the economy will be more driven by domestic consumption.

Steven Schoenfeld, Chief Investment Officer, Global Quantitative Management, Northern Trust Global Investments 1) Is China underweighted in global benchmarks, and should investors increase their exposure? Global equity benchmarks are designed to present an accurate view of the investable universe, and thus cannot include the large segment of the Chinese market which is greatly restricted to foreign investors (the A Share market). Thus, the relatively low weighting reflects current realities, and will inevitably adjust as Chinese authorities open up their market. We have seen this before with both Korea and Taiwan, and will likely see it later this decade with Vietnam. Investors can consider a “tilt” in their weightings toward China, or could consider a portfolio of “China-linked” markets

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such as Hong Kong and Taiwan. Another way to approach the market is to look at the H-Share market in Hong Kong (which is highly represented in most China indexes), as this class of shares will ultimately converge with A-Share prices. A pure measure of this component of the Chinese market is the Hang Seng China Enterprises Index (HSCEI). 2) Is the Chinese equity market a bubble ... and will it pop? It has all the “necessary ingredients” of bubble–eye-popping valuations, huge public participation, a hot initial public offering market and a very powerful macro thesis on why the valuations and bull market are justified (not to mention the excitement of the upcoming 2008 Olympics as well). The challenge is that the economic fundamentals are genuinely strong, and like Japan and Taiwan in the 1980s and 1990s respectively, the economic achievements are real. But the signs of excess are unmistakable (including massive public speculation and excitement about the market). So the question really isn’t whether it’s a bubble, but “when will it pop?” This could even occur before the Olympics, as many local investors may anticipate a government tightening of monetary policy. 3) How do you view China’s prospectus over the next 5-10 years relative to the rest of the market? Despite the significant short- and medium-term risks of a major correction, after my most recent visit to China in October, I am convinced that the long-term macro economic basis of the bull run in Chinese equities is real, and that in the long term—say by 2020—China will have substantially outperformed major developed equity markets, and perhaps most emerging markets as well. It is not unreasonable to predict that a unified Chinese market (A+B+H Shares) will comprise more than 25 percent or more of the world equity benchmarks by that time.

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A Window On The Chinese Markets The Hang Seng Indexes And The Growth Of China By Heather Bell

In 1997, the United Kingdom transferred sovereignty of Hong Kong, which had been one of its colonies since 1842, back to the People’s Republic of China, thereby setting the stage for the development of an entirely unique and somewhat paradoxical relationship. The handover paired the world’s freest economy with one that numbered among the world’s most insulated and restricted. It also created an intriguing scenario in which an emerging market, for all intents and purposes, acquired a fully developed market. Hong Kong will operate with a large degree of independence from China as one of the country’s special administrative regions until its reintegration with the rest of China in 2047. As such, Hong Kong maintains its own legal and monetary systems, among its many other freedoms; the arrangement has been referred to as the “one country (China), two systems” policy. From a global investment perspective, however, the most important aspect of Hong Kong’s quasi-independent status is likely its largely independent stock market. And given the way the mainland’s stock markets are set up, Hong Kong’s market is no minor detail from China’s point of view either. Today, China is experiencing growth unprecedented at the global level. A huge population, rapid industrialization and cheap resources have all combined to send the country’s economy hurtling forward and bring it to a critical stage in its development. GDP growth has exceeded 10 percent for successive years, and everyone from leading investment banks to sophisticated pension plans are looking for ways to invest in that growth. China, however, is a difficult and complicated market in which to invest, and gauging its movements can be a highly nuanced task. For one thing, domestic and foreign investors are essentially trading in two parallel universes. In fact, most are quite literally trading in separate markets, with domestic investors restricted to the mainland stock markets and international investors limited to the Hong Kong exchange.

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At the heart of the matter lies China’s unique share structure, which has several types of shares that are available to different kinds of investors. A shares are traded in renminbi, China’s local currency, and are available almost exclusively to domestic investors; foreign investors, with few exceptions, cannot access these markets. B shares are traded on the domestic Shanghai and Shenzhen exchanges, but are traded in U.S. and Hong Kong dollars, respectively, and were originally designed for foreign investors. Still, these are not the preferred means of gaining exposure to China for most investors; there are only 110 B share stocks, and in the early days of trading, those stocks were small, thinly traded and subject to manipulation. H shares are traded in Hong Kong dollars, and are the shares most foreign investors use to gain exposure to China’s economy. H shares are shares in mainland China companies that trade on the Hong Kong stock exchange (HKSE). Among the advantages attributed to the H shares are that they trade on a developed market’s exchange, where they must meet stricter listing requirements than China’s B shares. Sometimes companies are dual-listed on both the Hong Kong exchange and a mainland China exchange, so that they have H and A shares. Although stocks in China also list on the New York and London stock exchanges, Hong Kong remains the main gateway to China’s markets for global investors. Opening China’s Markets A number of steps have been taken over the years by China toward integrating Hong Kong’s economy with its own and toward liberalizing its own economy. For example, in 2003, it introduced the Closer Economic Partnership Arrangement, which all but eliminated tariffs between Hong Kong and China, and moved toward liberalizing and promoting trade between them. Prior to that, in 2002, it introduced the Qualified Foreign Institutional Investor (QFII) program, which


ADVERTISEMENT allows foreign institutional investors licensed by the government to trade in the A shares market through special accounts. Although the QFII program is very limited in scope, it is a step toward more open markets and does provide some access to the actual mainland China stock market to foreign investors. The QFII program was followed up with the complementary Qualified Domestic Institutional Investor (QDII) program in 2006, which allows domestic investors to gain exposure to certain foreign investments through accounts with certain commercial banks in China. In August 2007, the Chinese government announced plans for a pilot program that would allow investors in the Tianjian Binhai New Area—one of China’s designated special economic zones, where the government sometimes tests experimental reforms—to invest in H shares through special accounts. The announcement helped push Hong Kong’s Hang Seng Index up nearly 50 percent in the following months, as investors anticipated an influx of new money from the mainland. However, the Chinese government began backing away from the plan early on. By November, China’s Premier Wen Jiabao announced that the program would be delayed until certain conditions could be met. The reasons behind the delay appear to have been: the success of the QDII program; concerns about how an overheated Hong Kong stock market would react to the influx of mainland investors; and concerns about the relative inexperience of mainland investors with regard to global stock markets. Regardless of the reasoning, however, the news was a shock to international and Hong Kong investors, and helped kick off a 5 percent drop in the Hang Seng Index, its worst one-day decline since the days following the September 11 attacks. Despite these delays, however, one thing is clear: Hong Kong and China are inextricably linked. As more and more

H shares list on Hong Kong’s stock market, it is easy to see China’s growing influence on Hong Kong. But Hong Kong is undoubtedly having a different but equally important effect on China, providing both a template and a mechanism for the liberalization of China’s markets. The special region remains the gateway to China for most foreign investors, and it is increasingly a gateway to the world for Chinese companies (and possibly Chinese investors as well). Many changes seem likely in the coming years as China’s unprecedented growth continues and it flirts with world power status; its relationship with Hong Kong will be a key factor in its economic development.

“As China flirts with world power status, its relationship with Hong Kong will be a key factor in its economic development.” A Window On The Market Hang Seng Indexes Company Limited (HSI) a Hong Kongbased index provider that is a subsidiary of Hang Seng Bank, has a front-row seat to history as it is being made. It has developed a broad family of indexes to chart the performance of both Hong Kong and mainland China’s markets. With its multiple types of shares, its complicated relationship with Hong Kong and its exuberant growth, China can be a bit of a muddle to would-be investors. However, HSI has devoted itself to teasing out the knots to uncover the threads underlying the economies of both markets. Not only does it provide benchmark, blue-chip, size and sector indexes for the Hong Kong market, it also offers separate indexes for H shares and for mainland China’s markets.

Hang Seng Index - Top Ten Components Year-End 1997 Company HSBC Holdings HK Telecom Hutchison Hang Seng Bank SHK Properties Cheung Kong China Light CITIC Pacific Henderson Land HK Electric

Sector FIN UTI COM FIN PROP PROP UTI COM PROP UTI

Effective 12/10/2007* Weighting (%)

Company

Sector

Weighting (%)

24.80 9.20 9.13 6.98 6.26 5.66 5.19 3.18 3.07 2.89

HSBC Holdings China Mobile PetroChina China Life HKEx CCB ICBC CNOOC Cheung Kong Hutchison

FIN COM COM FIN FIN FIN FIN COM PROP COM

15.00 13.07 5.84 5.47 4.09 4.01 3.74 3.52 3.07 2.85

*Weights for rebalanced index are based on November 5, 2007 values.

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ADVERTISEMENT HSI’s flagship index is the blue-chip Hang Seng Index, which has tracked the Hong Kong stock market since 1969. Among the other offerings in its index family is the Hang Seng China Enterprises Index, which tracks H shares on the Hong Kong stock market, and the Hang Seng China AH Premium Index, which tracks the spread between the prices of A and H shares for companies with both types of shares on the market. Taken together, this sample of three of HSI’s indexes can be used to paint an interesting picture of the developing relationship between Hong Kong and China, and of the growth of China’s economy in general.

today. And although the number of components included in the Hang Seng Index has been expanded from 33 over the years to 43 as of December 10, 2007, the number of property companies has fallen from 12 in 1997 to just six today. Part of this evolution is fairly recent and has to do with the inclusion of H shares in the index starting in 2006. With the increasing interaction between the two economies, it made less sense to exclude the H shares from the Hang Seng Index than it did to include them. In 2005, prior to the inclusion of H shares, the commerce and industry sector represented nearly 45 percent of the index, while financials were just 38 percent. Property companies and utilities also The Hang Seng Index had slightly higher weightings. However, based on the most recent rebalance, there will be nine H shares in the Hang Seng Index, and six of them in the financials sector. A look at the top 10 components of the Hang Seng Index in 1997 versus today offers an interesting comparison. Three of the companies are still the same, which is somewhat amazing given the changes that have taken place in the last decade: HSBC Holdings, Hutchison Whampoa, and Cheung Kong Group continue to hold strong positions in the index. Half of the top 10 components currently in the Hang Seng are financial companies, whereas in 1997, only The Hang Seng Index, one of the world’s best-known and two of them were. And there are no longer any utilities most widely quoted stock indexes, is nearing 40 years of companies in the top 10 components; in 1997, there were age. It is a blue-chip index with components selected based three. However, mobile phone operator China Mobile is the on size, turnover, sector representation and financial per- index’s second-largest component at 13.07 percent of the formance. Lately, the Hang Seng has been hitting new highs, index. Other companies currently in the top 10 include two and it cracked the 30,000 milestone in late-October. It has oil companies, a life insurance provider and the Hong Kong also undergone a few changes over the years, such as a Stock Exchange. The components from 1997 that are no bump in the maximum number of components to 50 this longer in the top 10 include the three utilities, a conglomyear and, in 2006, the application of free-float market capi- erate, two property companies and a bank. Four of the top talization weighting and a 15 percent cap on the weights of 10 components—PetroChina, China Life, CCB and ICBC— individual components at rebalancing. The 2007 rebalanc- are H shares, and three of those are financial companies. ing was completed on November 7 and was scheduled to By including the H shares in the Hang Seng Index, HSI take effect on December 10. has changed the index from a blue-chip index representing Since 1997, the year of the handover, the Hang Seng has Hong Kong to a blue-chip index that offers a fuller reprerisen roughly 130 percent. In that time, the index has sentation of a foreign investor’s opportunity set in both evolved into one that has a stronger financial sector— mainland China and the Hong Kong marketplace. The index roughly 43 percent of the represents one of the most index, based on the rebalviable ways to gain expoHang Seng Index vs. Hang Seng China Enterprises Index anced component list, versure to China, both 1997–2007 sus 33 percent in 1997— through the Hong Kong 500 and a larger commerce equities, which are seeing 450 and industry sector that increasing influence from 400 now represents 43 percent China thanks to measures 350 300 of the index, up from less like CEPA, and through the 250 than 25 percent in 1997. inclusion of the H shares, 200 Property companies have which comprise slightly 150 100 seen their weight in the more than 31 percent of 50 index fall by more than the index. The Hang Seng 0 half, dropping from roughIndex is positioned per1/2 1/2 1/2 1/2 1/2 1/2 1/2 1/2 1/2 1/2 1/2 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 ly 23 percent of the index fectly to capture the evolu■ Hang Seng Index ■ Hang Seng China Enterprises Index to less than 10 percent tion of China’s stock mar-

“The Hang Seng China Enterprises Index offers the best way for foreign investors to capture the performance of China’s extraordinary growth ...”

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ADVERTISEMENT

Hang Seng China Enterprises Index - Top Ten Components December 31, 1997 Company Beijing Datang Qingling Motors Guangdong Kelon Guangshen Rail Shanghai Pechem China South Air Zhenhai Refining Zhejiang Express SH Haixing Shipping China East Air

Weighting (%) 10.45 7.66 7.51 6.03 5.80 4.83 4.77 4.63 4.40 4.03

September 30, 2007 Sector* Utility Industrial Consumer Goods Transportation Energy/Oil Transportation Energy/Oil Transportation Transportation Transportation

Company China Life PetroChina CCB ICBC Sinopec Corp. China Shenua Ping An BankComm Bank of China CM Bank

Weighting (%) 11.32 10.60 8.14 6.94 5.55 5.41 5.16 4.79 4.31 3.10

Sector* Financial Energy/Oil Financial Financial Energy/Oil Energy/Oil Financial Financial Financial Financial

*Sectors do not reflect HSI’s sector classification system.

ket as the trade barriers and other divisions between emerging China and established Hong Kong fall.

the start of 2005, but the China Enterprises Index was up 320 percent over that time period. In the first 10 months of 2007, the China Enterprises Index was up 94 percent versus a stillHang Seng China Enterprises Index impressive 57 percent increase in the Hang Seng Index. The Hang Seng Index is complemented by the Hang Seng One of the most interesting aspects of the Hang Seng China Enterprises Index, which tracks the H shares listed on China Enterprises Index is the way the top 10 components the HKSE; it comprises all 43 H shares included in the broad- have changed over the years. Unlike the Hang Seng Index, er Hang Seng Composite Index, and serves as a proxy for none of the top 10 components from 1997 are currently the actual mainland China stock market. included in the top 10. In 1997, many of the companies From many perspectives, the China Enterprises Index were transportation-related, with three airlines, a railroad actually presents a more realistic picture of the mainland and a shipping company. Those five companies together stock market than the mainland indexes themselves, as for- represented roughly 24 percent of the total index. The obvieign investors can move freely in and out of H shares. In ous explanation for their strong presence was that manucontrast, stocks traded only on China’s mainland exchanges facturers exporting goods from China were heavily reliant are in such demand by domestic investors (who are limited on transportation companies. In addition, another three as to where they can invest their money) that they have companies in the top 10 were energy- and power-related; become rather inflated and disconnected from the global they represent a total of roughly 21 percent of the index. market … and perhaps from fair value. Again, their presence is not surprising, as they were likely If the Hang Seng Index is positioned to track the conver- fueling China’s burgeoning industries. gence of the Hong Kong and mainland China stock markets, As of the end of the third quarter, 2007, the seven finanthe China Enterprises Index offers the best way for foreign cial companies in the top 10 components of the China investors to capture the performance of China’s extraordinary Enterprises Index represented approximately 44 percent of growth as an emerging marthe total index. This trend ket that is well on its way to was hinted at in the Hang Hang Seng China AH Premium Index developing into a world Seng Index, where H shares 200 superpower. financial companies have a 180 And while the Hang strong presence. With 160 Seng Index’s growth has China’s economy having been respectable, the China undergone a relatively long 140 Enterprises Index’s rise has period of sustained devel120 been rather breathtaking, opment, it makes sense 100 particularly in recent that financial companies 80 months. As of the end of would come to represent a 2/3 4/3 6/3 8/3 10/3 12/3 2/3 4/3 6/3 8/3 10/3 October, the Hang Seng larger part of the market; 2006 2006 2006 2006 2006 2006 2007 2007 2007 2007 2007 was up 120 percent since as wealth is generated, the

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January/February 2008

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ADVERTISEMENT need for financial services to support the growth of industry increases. The three remaining companies in the current top 10 are involved in oil and coal mining and power generation, reflecting China’s continued reliance on natural resources and fossil fuels. Both the domestic and international sides of mainland China’s stock market have seen prices boom, but the China Enterprises Index’s rate of growth has been more realistic, reflecting China’s stupendous economic growth in the context of the global economy. Hang Seng China AH Premium Index If there were any doubts about a bubble in the A shares market, HSI’s recently introduced AH Premium Index effectively put them to rest. The AH Premium Index measures the spread between the A and H shares of companies with dual listings on the HKSE and one of the mainland exchanges. Currently, the index has just 34 components. An index level above 100 indicates an A shares premium, while an index level below 100 indicates an H shares premium. Although there is not much calculated back history, data going back to just 2006 shows a paradigm shift in the index’s behavior recently. In 2006, the index indicated an H shares premium for 43 percent of all trading days. However, in 2007, there have been no such days so far, and as of the end of October, the index was indicating an A shares premium of roughly 54 percent. While this recent level may seem extreme— remember, this is the valuation premium for the same companies’ shares trading in the two markets—consider that the premium index went so far as to indicate an almost 84 percent premium on A shares in mid-August. On that same day, the index hit an intraday high of 197.82, indicating an A shares premium of almost 98 percent. Coincidentally or not, the mainland government announced its plan to begin allowing mainland Chinese to invest in the H shares market just as the index hit its peak, and the index began trending mainly downward after that. This isn’t really surprising: Should mainland investors be allowed to invest in H shares, it would be like the loosening of a pressure valve; mainland investors would have more outlets for their investable dollars. When the government announced the suspension of this program, however, the AH Premium Index indicated that the A shares premium jumped to a little over 60 percent in reaction, from just under 56 percent the previous trading day. It settled down to a 54 percent premium by the next day, but the premium remains. Even with the A shares’ premium shrinking, however, the AH Premium Index tracks a disturbing trend. The H shares as a whole are trading way above the Hang Seng Index, which is not at all alarming: China has experienced strong growth as an emerging market, while Hong Kong’s blue chips are displaying the steadier, more sedate performance of a developed market. However, pile another 54 percent

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onto H share prices, and what was considered a remarkable growth story suddenly begins to ominously resemble a bubble. How China handles the opening of its markets and its economic policies in the future will help determine whether that bubble pops or deflates slowly. As China’s growth continues and it takes further steps to open its markets, it is growing closer and closer to merging its economy with that of Hong Kong. The “one country, two systems” policy is going to be in place for another 40 years, but it is doubtful that China’s government wants to wait that long to bring the two markets into line with each other. The AH Premium Index gives both domestic Chinese and foreign investors a way to chart the eventual convergence of the two markets. Hang Seng Indexes Company Limited As the primary local index provider, HSI has demonstrated its expertise in monitoring and creating indexes capturing the economic opportunities that have been created by

“How China handles the opening of its markets and its economic policies in the future will help determine whether the A-share bubble pops or deflates slowly.” China’s development and its critical relationship with Hong Kong. Although larger global index providers offer indexes covering Hong Kong and China, the firm is uniquely positioned with a front-seat view of one of the world’s most unusual and exciting economic stories. When considered as a group, the Hang Seng Index, Hang Seng China Enterprises Index and Hang Seng China AH Premium Index represent three key segments of that story. The Hang Seng is one of the world’s best-known blue-chip indexes, and it provides a window on the ways Hong Kong’s market is changing. The China Enterprises Index is important because it provides a more realistic measure of the value of mainland China’s stocks and provides a more detailed glimpse of what is becoming a more and more significant part of Hong Kong’s stock market. The AH Premium Index, by contrast, is not tracking a section of the market but a trend: Should the index stay close to 100 for an extended period, it is likely that the barriers separating the A shares and the H shares—and mainland China’s stock markets from the global economy—have been dissolved. Eventually, Hong Kong and China’s “two systems” will be merged—with most of the merging likely to occur well before that 40-years-off deadline—and as the two markets delve into the uncharted territory before them, HSI is providing quantitative ways to track their progress.


Talking Indexes

Liquidity

Gauging the trade-off between liquidity and complete market coverage.

By David M. Blitzer

M

ost of the indexes discussed in the Journal of Indexes are stock indexes constructed with prices from recognized exchanges, all delivered via one of a handful of global data vendors. Investors rarely worry over what the prices represent if trades can be executed at these prices. For index providers, equities are easy: One computer connects to another, reliable prices flow in and the indexes flow out. However, neither all indexes nor all markets are so easy. The turmoil seen in commercial paper, mortgages and mortgage securities over the summer is a reminder that markets can be messy. There are moments—occasionally very long moments—when prices and even whole markets vanish. Moreover, while the details vary from market to market, no market is immune from these troubles. Reliable and consistent price data may seem further away in real estate than stocks or bonds, but prices can become meaningless in any asset class. This has implications for indexes and index construction—if the prices aren’t real or trades can’t be completed because markets aren’t liquid, index tracking becomes very difficult. At that point, an index may be an interesting sentiment indicator but it certainly can’t support financial instruments or investment products. Even when stock prices reflect actual transactions (or at least the bids and asks), liquidity questions are usually close by. Practically speaking, liquidity means you can execute your trade quickly at a price close to the last one quoted. For a few hundred shares of a popular stock, this is rarely an issue. However, if the market is obscure, the

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stock is not widely followed or the trade is for several thousand shares, liquidity can fade away. Those who believe liquidity is never a worry in a major developed market like New York or London should consider adjustments in major indexes. The “index effect” or “index pop” when a stock is added to the S&P 500 is proof that liquidity can be a factor in any market. S&P responds to this by providing ample notice of index changes, reviewing liquidity when selecting stocks, sometimes avoiding dates when liquidity is known to be poor and by using closing prices for adjustments and calculations. Liquidity may be easy to define, but it is difficult to measure objectively. One approach is days-to-trade: how many days are needed to establish or liquidate a position given daily trading volume and position size. This is often measured to gauge the difficulty in tracking any index through adjustments or stock additions and deletions. This gives you an idea of how much can be traded without moving the price too far under normal conditions. Other measures look at bid-ask spreads or at the book of bids and asks, if such a book is available. Still other measures may examine selected trades and see if they generated something like an index effect. None of these measures tell the whole story, however, and all depend on “normal” trading conditions. In the real world, conditions aren’t always normal—unexpected market events may disrupt the best of plans. The lesson is that even in the most liquid of markets, and even when dealing with headline indexes and major stocks, things don’t always work out. And of course, as we move further from equities and away from deep markets, the challenges grow.


Various factors contribute to liquidity: normal market conditions, deep developed markets and stocks that are widely followed and traded continuously. Sometimes an index can boost liquidity. With the S&P 500 there is a “list effect”—stocks on the S&P 500 list sometimes seem to get more attention or trade more often than similar stocks not in the index. However, the reward for this attention may be ending up on someone else’s takeover target list. Most indexes don’t boost the liquidity of included stocks, so the index construction process must face concerns about low liquidity. Ignoring liquidity means that it will be more difficult to manage a portfolio tracking the index. Futures markets show that other important contributors to liquidity are standardization and credit reliability. Futures trading—whether agricultural products, metals or financial futures such as index futures on the S&P 500—depend on standardization. Stock index futures are defined by the particular index being tracked. That way, one S&P 500 trade involves the same underlying instrument as another S&P 500 trade, and there is no confusion about which stocks are being represented. In futures, one buys or sells a contract—a promise to deliver or receive a standardized item at a future date. Unlike stocks or bonds where the buyer can take possession of the instrument, in futures, all the buyer has is someone else’s promise. Since this may sound risky, the exchange steps in and guarantees the counterparty performance through its clearinghouse and its mark-to-market rules. Stock indexes ignore liquidity at their own risk. At the same time, when the factors that create liquidity are understood, the stock indexes can become more powerful financial tools, even creating liquidity and markets where none existed before. One current example is real estate indexes, such as S&P/Case-Shiller indexes covering residential properties and S&P/GRA Commercial Real Estate Indices (S&P/GRA CREX) covering commercial properties. Both of these support futures contracts. Real estate is a classic case of a liquidity-constrained market: Transaction volume is limited, there is no standardization and the search for buyers or sellers can take days, weeks or months. Short-term investments or hedges are difficult or impossible in these markets. In addition, transactions are lumpy: It is hard to buy or sell 20 percent of a house just because you only want to invest a small part of your portfolio in real estate. Successful indexes need prices, but the illiquidity and bumpiness of real estate transactions makes it hard gathering reliable price data. An index built on an alternative price collection methodology may surmount these concerns. In the case of the S&P/Case-Shiller real estate indexes, repeat sales methods are applied to accommodate home prices idiosyncrasies. In the S&P/GRA CREX indexes, data on the outstanding stock of different kinds of commercial real estate is combined with transaction prices to develop the index. These indexes bring liquidity to real estate by creating an

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alternative investment approach that benefits from the liquidity enhancements of standardization and credit assurance, as well as specialized approaches to price discovery. S&P’s Total Market Index (TMI) includes over 4,500 stocks, some with as little as 10 percent of their shares publicly held. (There is no minimum size requirement.) While this is a good measure of the complete U.S. equity market, it is not something you want to trade in and out of daily—too many stocks, including too many that are illiquid. In other words, because it is comprehensive, the TMI is a good benchmark. But because it is comprehensive, it is not easily tradable. Compare the TMI with the S&P MidCap 400, however. The MidCap 400 has just 400 stocks with explicit liquidity rules governing their selection, but it does not offer total coverage of U.S. mid-cap stocks. Here, the reverse is true: A portfolio can reliably track the index holding all 400 stocks in the prescribed proportions, making it easily tradable; however, it is not comprehensive. In both the MidCap 400 and the TMI, the index makes trade-offs to accommodate the reality of liquidity. Liquidity concerns apply to indexes as well as individual stocks. When it is difficult to add funds to an index portfolio without moving markets or to make adjustments in the portfolio to reflect changes in the index, the index itself is not sufficiently liquid. If the index is large compared with the markets it represents—either in terms of the number of stocks or the market cap of the index—illiquidity may be a concern even though each stock appears to be reasonably liquid. Index designers need to consider at least two aspects of index-level liquidity—at the stock level and again at the index level. In the latter case, a simple issue is the number of stocks included. The more stocks being traded in a short period of time, the greater the demands being placed on those market participants who provide liquidity. In a similar manner, an index that includes 95 percent or more of a market’s total value may be comprehensive, but is not likely to be overly liquid. Can one index be both a comprehensive benchmark and highly liquid? Generally, no. Some people suggest the S&P 500 manages to be both, and it is often cited as a benchmark for large-cap U.S. equities; however, it is not a comprehensive measure of U.S. equities. Liquidity concerns mean we can’t have our cake and eat it too—there are trade-offs between comprehensive coverage and adequate liquidity. Though these trade-offs are unavoidable, they can be managed. Investors and other index users need to choose indexes that meet their most important needs. If investment products—futures, options, ETFs, funds, structured products and so forth—are the goal of an index, then liquidity is crucial. This means fewer stocks and probably an explicit goal of adequate liquidity. If, however, comprehensive measurement—for asset allocation, portfolio strategy development or market evaluations—is most important, then sacrificing liquidity for complete coverage makes sense.

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Benchmarks For Fiduciaries Creating real benchmarks for real-world portfolio possibilities

by Brian J. Jacobsen

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I

ndexes are designed to point out the performance of certain segments of the financial markets (just like an index finger points). Today, stock and bond indexes are a fixture of the evening news—and rightfully so. More and more households have their wealth tied to the performance of the various financial markets, and financial indexes are designed to be broadbased measures of the performance of these markets. An index, though, is not a good benchmark for portfolio management performance measurement. The reasoning for this claim is similar to why the Consumer Price Index (CPI) is adequate as a measure of the changes in the overall costs of living for a nation, but is not a good measure for any individual’s cost of living change. The popular Consumer Price Index for All Urban Consumers is designed to measure the change in prices paid by urban consumers for representative baskets of goods. This cookie-cutter index is not appropriate for measuring the cost of living for an individual, a family of two, a retiree, etc. Nobody is the statistical average. Similarly, why would an index, which is appropriate for measuring the performance of a market segment, be appropriate for measuring the performance of an individual’s portfolio? It is informationally efficient to use an index, but it must be used with care—it should be used as a very rough indicator of market performance, but not necessarily for benchmarking portfolio performance. A benchmark is ordinarily thought of as a bogey portfolio against which a portfolio’s performance should be measured. What I show in this paper is that it is better to create a bogey distribution of possible portfolios and to see how a particular portfolio’s performance stacks up against the entire universe of feasible portfolios. Using an index instead of a true benchmark means: (1) an investor may not have realistic expectations of portfolio performance; and, (2) a portfolio manager’s performance cannot be accurately measured. In this paper, I illustrate how to create a set of benchmarks—call them Fiduciary Benchmarks—from not only a universe of underlying assets, but also a universe of underlying allocations. The resulting set of benchmarks means: (1) an investor can better understand what possible outcomes were available, given the constraints they imposed on the portfolio; and, (2) if a manager is given discretion in selecting allocations within a particular band, then his or her discretion can be assessed. This paper is especially relevant to measuring the performance of a mutual fund or another managed account where the manager acts in a fiduciary capacity. The Investment Company Act of 1940 section 5(b)(2) sets limits on concentrated positions in diversified portfolios.1 Indexes may not always violate these limits, but they are not constructed in cognizance of these limits. Fiduciary Benchmarks would be an ideal addition to the index universe where the indexes are constructed according to the same limits fiduciaries face.

Indexes Typically, an index focuses on defining a set of rules for selecting the assets that can comprise a portfolio. Those assets are then combined by following a predefined allocation strategy to divide the portfolio among various assets (e.g., free-float market weighted, fundamentally weighted, etc.). Some more recent indexes impose nonfinancial constraints www.indexuniverse.com/JOI

on the allowable assets—socially or biblically responsible investing; sector indexes; etc. Some indexes have even begun to represent different allocations and trading strategies: For example, a market-cap-weighted index is equivalent to a passive trading strategy; fundamentally weighted and fixedweighted indexes are equivalent to contrarian strategies; and a price-weighted index is equivalent to a momentum trading strategy. Contrast this to most investment policy statements and model portfolios, which are stated in terms of investment bands, where a range of allocations are possible. Sharpe (1992) listed some characteristics of good indexes—they should be mutually exclusive, exhaustive and have returns that “differ”—but scant has been written about how the investable universe should be partitioned into indexes. Fama and French (1992) set in motion the construction of numerous stock market indicators that purport to represent certain “asset classes.” Most asset classes are defined according to Fama and French’s three-factor model, which sets out to explain the cross section of security returns by three factors: the market-value-to-book ratio of a company (i.e., the value-growth dichotomy); the market value of the company (i.e., whether the company is large cap, mid cap, or small cap); and the returns on a broad market index. The first factor has inspired the distinction between value and growth firms in the investing community, with value companies having lower market-to-book values than growth companies. The second factor suggests that firm size matters in investing, with smaller companies garnering larger returns over time than their larger counterparts. The third factor suggests that the beta (the sensitivity of a security’s risk premium to the market risk premium) is an important determinant of the cross section of returns. From the Fama and French study, equities have been partitioned in a two-dimensional matrix: value-growth and smallmid-large capitalization.2 These metrics have formed the basis for defining asset classes, and indexes have been constructed to represent the performance of these different asset classes. Many index providers partition the world into boxes (foreign/domestic, value/growth and large/mid/small). This classification system has become so popular that mutual funds and investment managers are often stereotyped into individual “style boxes.” Sortino (2005) said that indexes should indicate the performance of a particular segment of the market. However, not only does the available set of securities have to be divvied up, but so too does the set of available allocations. It is this latter dimension that indexes fail to represent, rendering them ineffective in benchmarking, because a portfolio is not just a list of securities, but also a specification of the allocations and rebalancing rules. To represent a passive portfolio, an index should use a market-value weighting scheme because then an investor can just “buy and hold” a set of securities. Some of the more recent “fundamentally weighted” indexes are actually a great addition to the performance measurement arena, since a fundamentally weighted index represents a contrarian investment strategy (just like a price-weighted index represents a momentum strategy). For example, if the fundamental factor that determines the weighting of a security is operating cash flow, which is only reported quarterly, then as the stock price January/February 2008

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rises relative to operating cash flow, a smaller position must be taken in that security. As the stock price falls, a larger position should be taken. To develop a benchmark, instead of an index, a simulation should be used to generate the set of feasible portfolios and the resulting returns. When all the constraints are taken into consideration—constraints on the allowable securities and allocation rules—the result is not a single reference number, but rather, a distribution of feasible returns. This is a much fairer way to measure a portfolio manager’s performance, provided the portfolio manager adheres to the investment mandate.3 Because of how computationally intensive this method of constructing a benchmark is, it may be tempting to employ “Monte Carlo” methods to generate the feasible set of portfolios. True Monte Carlo methods are probably inadequate to handle this type of modeling problem, however, and instead, a bootstrapping technique should be employed.

Monte Carlo Vs. Bootstrapping Monte Carlo methods were developed by a community of mathematicians and physicists employed at the Los Alamos Scientific Laboratory while working on the atomic bomb design using the newly born Electronic Numerical Integrator and Computer (ENIAC) (Gass and Assad, 2005). Some of the notable individuals in this community were Stanislaw Ulam, John von Neumann, Nicholas Metropolis, Enrico Fermi,

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Richard Feynman, Robert Richtmyer and Edward Teller. While recovering from a brain operation in January 1946, Ulam thought of the method while playing solitaire. This could explain why the first appearance of this method (though not yet called “Monte Carlo”) was in a 1947 article by Ulam and von Neumann in which they analogized the method to playing a series of solitaire card games. Metropolis coined the term “Monte Carlo,” and used it in a paper in 1949 (Metropolis and Ulam, 1949). Emilio Segrè (who won the Nobel Prize in Physics), a student of Enrico Fermi, claims that Fermi actually developed the method prior to 1938 (when Fermi won the Nobel Prize). Regardless of the origin of the method, it is a brilliant, but oft-misunderstood, method. Monte Carlo methods, as originally developed, relied on modeling a process where the parts interacted with known probability distributions. Originally, the uniform distribution was the most commonly used distribution, but von Neumann, out of necessity, developed a method for converting a uniform distribution to an exponential distribution, which was much more appropriate for modeling the processes related to neutron diffusion. Von Neumann’s method generates nonuniform random variates, with the well-known inverse transform method that uses the inverse of the cumulative distribution function to convert uniformly distributed random numbers to those following the nonuniform distribution. He also developed a second procedure called the acceptance-rejection method.


Figure 1

Cumulative Distribution Of One-Day Returns For Asset Allocation Funds With Similar Constraints 1

0.6 0.4 0.2 -0.1

-0.08

-0.08

-0.08

-0.08 0 0.02 0.04 0.06 0.08 One-Day Return 1,000 samples ■ 10,000 samples ▲ 65,536 samples

0.1

Cumulative Fraction

0.8

0

The key elements in the Monte Carlo method are to set up the process and define the theoretical distributions from which the random variates come (Williams, 2004). Then, the process is run many times to develop a distribution of the end result. This needs to be contrasted with a method called “bootstrapping,” first described by Efron and Tibshirani (1979), in which the distribution, instead of being theoretical, is the empirical distribution of the variates. The difference is significant: Monte Carlo methods assume the process follows a particular theoretical distribution (e.g., a normal distribution), while the bootstrapping method assumes the process follows the empirical distribution of the process. In financial applications, bootstrapping is much more appropriate than the Monte Carlo method because the bootstrapping method is not based on any assumption about the behavior of the returns, whereas Monte Carlo methods often assume returns are independent or log-normally distributed (Ruiz and Pascual, 2002). The power of the bootstrap technique is its ability to estimate parameters and confidence intervals from small samples without having to place restrictive assumptions on the distribution of the underlying process.

Building Benchmarks With Simulations To illustrate how this simulation-based method of building a benchmark works, I will walk through an illustration based on evaluating the one-day performance of a hypothetical asset allocation fund on June 29, 2007. Imagine that the fund’s principal strategy includes investing between 60 and 70 percent of the fund’s assets in large, dividend-paying U.S. equity securities; the remaining funds are invested in intermediate-term U.S. Treasuries. If a stock is included in the portfolio, it cannot be less than 1 percent of the fund assets or more than 5 percent of the fund assets. To operationally define these terms, a “large” stock is one where the issuer has an enterprise value (market value of equity plus debt) of at least $10 billion, and “intermediate-term” means five to 10 years. To make this computationally feasible, it has to be assumed that the allocations are chosen at the beginning of every evaluation period and change only as a result of changes in market values. In other words, if a manager is allowed to change the asset allocations throughout the eval-

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uation period (in this case, one day), the dimensionality of the problem becomes too great to handle with modern computational capabilities. To generate the set of allowable securities, a screening tool needs to be employed (for this I used Reuters Knowledge). Based on the criteria above, as of June 28, 2007, there were 291 allowable stocks. I used a single Treasury vehicle, the Lehman U.S. Intermediate Treasury Index. To evaluate the one-day performance of the fund, the oneday return on all possible portfolios needs to be generated. To represent these possible portfolios, the allocations need to be made discrete, so I will assume that the allocations can range from 1 to 5 percent, in increments of 1 percent. With 291 stocks, any individual stock can have one of six allocations, ranging from 0 to 5 percent. The sum of all the allocations to stocks cannot be less than 60 percent of fund assets or more than 70 percent of fund assets. Once the total allocation to the stocks is determined, the allocation to the fixed income portion is automatically determined. An exhaustive enumeration of all the possible portfolios would require representing 1.7861x10291 portfolios. Because this is practically impossible, random sampling from these portfolios is necessary to create the distribution of possible returns. The empirical cumulative distributions in Figure 1 are from samples with replacement sizes of 1,000, 10,000 and 65,536 (the maximum number of rows on one Excel spreadsheet). To evaluate the performance of a particular fund, you can ask what is the probability that the returns would have been lower given the cumulative distribution. The higher the probability, the more likely it is that the portfolio manager wisely exercised discretion. This method of evaluation is similar to assigning a grade to a manager, but the peer group is the set of all possible portfolios that could have been invested in, given the constraints imposed by the investment policy statement. Because of the similarity of the cumulative distribution functions implied by the various sample sizes, a relatively small sample size (circa 10,000 random portfolios) should be sufficient to capture the richness of the distribution.

Conclusion An index is not necessarily a benchmark, especially for fiduciaries who need to invest subject to a number of constraints. A benchmark for a portfolio should reflect the investment policy of the investor, which imposes constraints on the feasible set of portfolios. Indexes typically only focus on defining the population of assets that can comprise a portfolio, but it is also possible, through simulation, to define the population of allocations that can be used. You get better and fairer benchmarks through simulation. This means comparing a portfolio’s performance with a distribution of feasible returns, instead of a single data point defined by an index. The shortcoming of constructing benchmarks from the set of feasible securities and allocations is in the computational complexity of constructing the feasible distribution of returns. This is exacerbated for an actively managed portfolio where the portfolio can be reconstituted at arbitrary time intervals. To assess a manager’s performance in the

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actively managed scenario, the feasible return distribution needs to be generated for each time step. At each time step, the manager’s performance can be compared with the feasible return distribution. For the next time step, the selected

portfolio serves as the starting point for generating the feasible return distribution. In this sense, the proposed methodology is only applicable for the ex post analysis of a manager’s performance.

References Cooper, Michael J., Huseyin Gulen, and P. Raghavendra Rau, 2005, “Changing Names with Style: Mutual Fund Name Changes and Their Effects on Fund Flows,” The Journal of Finance LX (6): 2825-2858. Dickey, David A., and Wayne A. Fuller, “Distribution of the Estimators for Autoregressive Time Series with a Unit Root,” Journal of the American Statistical Association (June 1979), pp. 423-31. Downs, Thomas and Robert Ingram, 2000, “Beta, Size, Risk, and Return,” The Journal of Financial Research XXIII (3): 245-260. Efron, B., and R. Tibshirani, 1979, “Bootstrap Methods: Another Look at the Jackknife,” Annals of Statistics, 7: 1-26. Fama, Eugene and Kenneth French, 1992, “The Cross Section of Expected Return,” Journal of Finance, Vol. 47, No. 2: 427-465. Fortune, Peter, 1998, A Primer on U.S. Stock Price Indexes, New England Economic Review November/December: 25-40. Gass, Saul and Arjang Assad, 2005, “Model World: Tales from the Time Line–The Definition of OR and the Origins of Monte Carlo Simulation,” Interfaces, 35(5): 429-435. Grinblatt, Mark and Bing Han, 2005, “Prospect theory, mental accounting, and momentum,” Journal of Financial Economics, 78: 311-339. Hanna, J. Douglas and Mark J. Ready, 2005, “Profitable predictability in the cross section of stock returns,” Journal of Financial Economics, 78: 463-505. Haugen, Robert and Nardin Baker, 1996, “Commonality in the Determinants of Expected Stock Returns,” The Journal of Financial Economics 41: 401-439. Hong, Harrison, Jeffrey D. Kubik, and Jeremy C. Stein, 2005, “Thy Neighbor’s Portfolio: Word-of-Mouth Effects in the Holdings and Trades of Money Managers,” The Journal of Finance LX (6): 2801-2824. Ivkovic, Zoran, James Poterba, and Scott Weisbenner, 2005, “Tax-Motivated Trading by Individual Investors,” The American Economic Review 95 (5): 1605-1630. Jostova, Gergana and Alexander Philipov, 2005, “Bayesian Analysis of Stochastic Betas,” Journal of Financial and Quantitative Analysis 40 (4): 747-778. Lettau, Martin and Sydney Ludvigson, 2001, “Resurrecting the (C)CAPM: A Cross-Sectional Test When Risk Premia Are Time-Varying,” The Journal of Political Economy 109 (6): 1238-1287. Metropolis, N., S. Ulam, 1949, “The Monte Carlo Method,” Journal of American Statistical Association, 44(B):s 335-341. Nagel, Stefan, 2005, “Short sales, institutional investors and the cross-section of stock returns,” Journal of Financial Economics 78: 277-309. Ruiz, Esther and Lorenzo Pascual, 2002, “Bootstrapping Financial Time Series,” Journal of Economic Surveys, 16(3): 271-300. Scruggs, John T. and Paskalis Glabadanidis, 2003, “Risk Premia and the Dynamic covariance between Stock and Bond Returns,” Journal of Financial and Quantitative Analysis 38 (2): 295-316. Sharpe, William, 1992, “Asset Allocation: Management Style and Performance Measurement,” Journal of Portfolio Management: 7-19. Simons, Katerina, 1998, “Risk-Adjusted Performance of Mutual Funds,” New England Economic Review, September/October: 33-45. Ulam, S.M., J. von Neumann, 1947, “On the Combination of Stochastic and Deterministic Processes: Preliminary Report, Bulletin of the American Mathematical Society, 53: 1120. Williams, Terry, 2004, “Why Monte Carlo Simulations of Project Networks Can Mislead,” Project Management Journal.

Endnotes 1 To qualify as a Diversified Company, as opposed to a Non-Diversified Company, no more than 5 percent of the portfolio can be invested in any one issuer. A further constraint is

that a fund cannot invest in more than 10 percent of the voting securities of any given issuer. There may be additional concentration limits (at the industry, sector or country level) if specified in the registration statement of the fund. The investment policy can only be changed with a majority vote of voting shareholders. 2 For more issues, see Fortune (1998), who explained that in the absence of taxes, indexes should measure total returns; Lettau and Ludvigson (2001), who show the dominance of

the Fama and French model; Hanna and Ready (2005), who integrate transaction costs; Haugen and Baker (1996), who construct a 50-factor model; Downs and Ingram (2000), who examine the effects of censoring extreme monthly security returns on the importance of the Fama and French factors; Nagel (2005) and Hong, Kubik and Stein (2005), who looked at the impact of institutional ownership on the importance of different factors; Cooper, Gulen and Rau (2005), who support the idea that past returns may also increase individual demand for securities, along with institutional ownership; Jostova and Philipov (2005), who looked at the importance of past behavior in predicting future correlations; and Scruggs and Glabadanidis (2003), who showed that the covariance matrix between stock and bond returns should not be taken as a constant. 3 If the portfolio manager does not adhere to the investment mandate, the manager’s performance can still be measured using this method, provided we can ascertain from which

sets of assets and strategies the manager drew his or her portfolio.

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News Muni Bond Melee The normally quiet muni bond sector got very noisy this fall, as four exchange-traded fund (ETF) firms jockeyed for position to launch the first muni bond ETF. Barclays Global Investors (BGI) captured the roses, launching its iShares S&P National Municipal Bond Fund (MUB) on September 10. But as BGI was celebrating, State Street Global Advisors (SSgA) crashed the party by announcing its own muni bond ETF launch, just three days later. Worse, SSgA undercut BGI on price, charging just 0.20 percent in annual expenses for its SPDR Lehman Municipal Bond ETF (TFI) compared with 0.25 percent for MUB. PowerShares—which now offers over 100 ETFs—joined the fun in October, launching a family of muni bond ETFs including the PowerShares Insured National Municipal Bond ETF (PZA). PZA charges 0.28 percent in expenses. PowerShares, SSgA and BGI also offer New York- and California-specific muni bond funds, while SSgA also offers a short-term muni bond fund covering the national market. Van Eck Global also has five muni bond ETFs in registration at the Securities and Exchange Commission (SEC). Investors may be overwhelmed by the array of choices, but there are important differences between the funds. Among the national funds, the PowerShares offering gives you the highest credit quality (AAA) but the lowest average coupon (4.80 percent at press time). The SSgA fund has the second-highest credit quality (AA1) and a higher average coupon (4.96 percent at press time). BGI also has an average credit score of AA1 (albeit at a slightly lower mix

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than SSgA’s fund), but had the highest average coupon at press time (4.99 percent). Importantly, the three funds also have very different underlying structures and investment processes, which could have a major impact on performance down the road. The municipal bond market is notoriously illiquid, and is plagued by high spreads and low trading volumes. Many investors are taking a “wait and see” attitude and watching how these funds perform for the first few months before investing.

whatever company divisions they fall under. Renaissance Capital said that MSCI showcased a steady historical compound annual growth rate of 14 percent (which has recently risen to 17 percent due to ETF licenses and the Barra analytics operations), a 93 percent customer retention rate and strong recurring revenue. The company has very high operating profits at 35 percent and low capital expenditures. Sales are running at $360 million, while earnings are expected to be 75 cents per share.

MSCI Goes Public

A Hedge Fund Index Fund?

MSCI successfully executed its initial public offering (IPO) on November 15. The expected price range for the deal was raised from $14-$16 to $16$18 prior to the IPO due to high demand, and the stock eventually priced at the very top of the range. The deal valued the company at roughly $2 billion, including debt “That tells you there is some interest in it, even though it’s a shaky time in the market,” said Kathleen Smith, a principal at Renaissance Capital, a research firm based in Greenwich, Connecticut, specializing in IPOs. “They’re probably pricing it pretty close to its fair value,” she added. Smith described MSCI as a highly profitable and stable business that has done well even in tough markets. The IPO is a first for the index industry, and was widely anticipated, as it means industry watchers will finally get a comprehensive look at the profitability and business challenges of the index business, thanks to disclosure requirements. Index providers are usually small parts of much larger companies, so their financial information is usually buried within the financial results of

Goldman Sachs has filed papers with the SEC for a fund designed to mimic the returns of a hedge fund index. The Goldman Sachs Absolute Return Tracker Index (GS-ART) is one of the first of a new class of “hedge fund replication” strategies to be developed over the past few years. These products are designed to mimic the returns and performance characteristics of hedge fund indexes—without investing in hedge funds at all. The GS-ART fund, for instance, will use futures, swaps, commoditystructured notes, ETFs and fixedincome securities to replicate the performance of a broad-based hedge fund index created by Goldman Sachs. The fund relies on correlation analysis to approximate the index’s return. Interestingly, according to the prospectus, although some index information and data about components and their relative weightings in the index will be shared with the fund manager for the sake of the fund’s management, the index will not be completely transparent.


PowerShares Looks To Europe PowerShares is headed overseas. The fast-growing ETF company was expected to start launching its funds in the United Kingdom, Germany and Italy in November. According to an article in Fund Action, the firm’s intentions to expand internationally were one of the reasons it was sold to INVESCO, which has global distribution capabilities. So far, reports suggest that PowerShares will launch a broad suite of ETFs, rather than tiptoeing into European waters carefully (then again, when did PowerShares ever do anything halfway?). Among the funds expected to launch were fundamentally weighted ETFs, ETFs tied to the Intellidex indexes and a number of stand-alone specialty ETFs. BGI is already a major player in the European market, but PowerShares’ effort could lay the groundwork for further transatlantic ETF efforts.

Feds Consider ETN Tax Treatment

investors will only pay taxes when they sell or when the notes reach their 30-year maturity. By comparison, a commodity ETF like the iShares GSCI Commodity ETF (GSG) or the PowerShares DB Commodity ETF (DBC) gets hit with a double-whammy on the tax front: First, any interest income in the fund is paid out and taxed as regular income; Second, the funds are “marked-to-market” at the end of the year, meaning the IRS treats the funds as if you sold them on December 31 ... even if you didn’t. If the fund is up, you pay capital gains taxes, with 60 percent treated as longterm gains and 40 percent treated as short-term gains. Similar—and indeed more favorable—treatments apply to the currency ETNs. Some argue that this amounts to a tax dodge, and that regulators should crack down and put the notes on par with ETFs on the tax front. Others note that the fact that ETNs have credit risk show that they are truly

different products, and deserve different tax treatment There was no official report coming out of the meeting. INDEXING DEVELOPMENTS

Israel Upgraded To Developed Status FTSE announced the results of its annual review of its country classifications in September, and it had good news for Israel: The country is being upgraded to developed markets status as of June 2008. FTSE uses a three-tiered classification system, with countries falling under Developed, Advanced Emerging and Secondary Emerging designations. FTSE also updated its Watch List, which tracks countries that have a reasonable likelihood of a status change. In addition to the Israel news, Hungary and Poland have both been upgraded to Advanced Emerging markets. Pakistan is being removed

Representatives of the Internal Revenue Service (IRS) and the Department of the Treasury met in October to discuss the issue of how exchange-traded notes (ETNs) should be taxed. Most ETN providers have so far argued that ETNs should be treated like risksensitive structured products, which would give them a significant tax advantage over ETFs. For instance, the prospectus for the iPath Dow Jones AIG Commodity Index Total Return ETN (NYSE: DJP) states that the note should be treated as a prepaid contract with respect to its underlying index. That means that all the interest income and spot return on the index will be rolled up into the value of the note, and

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News from the FTSE GEIS entirely because it no longer meets the minimum requirements with regard to the quality of its markets. Greece will remain on FTSE’s Watch List and could be downgraded from Developed to Advanced Emerging status at the next review. Taiwan and South Korea will also remain on FTSE’s Watch List for possible promotion to Developed status from the Advanced Emerging category, despite the fact that many had thought they would be promoted this year. The major criteria used to evaluate countries in the FTSE indexes include economic size, wealth, market quality, and market depth and breadth. Ultimately, the resulting assessment reflects the country’s level of investability for foreign investors.

A New Way To Gauge Volatility Morningstar has launched a new set of volatility indexes that compete directly with the Chicago Board Options Exchange’s (CBOE’s) popular volatility benchmarks. The CBOE indexes have a popular suite of futures and options contracts tied to them and dominant mindshare in the industry. However, the Morningstar’s indexes take a completely different approach to calculating volatility, and at the very least, they offer an interesting new tool for investors. The CBOE volatility indexes base volatility readings on the spreads of options contracts tied to each index; i.e., the CBOE VIX Volatility Index is based on options on the S&P 500. In contrast, the Morningstar indexes use the combined volatility of the component stocks. The main upshot to the differences in methodology for Morningstar is flexibility. CBOE needs a liquid index option to calculate a volatility index. With Morningstar’s approach, it could calculate an inde-

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pendent volatility index based on any slice of the market.

S&P Enters Muni Market With all the attention paid to the many muni bond ETFs that launched this fall, one important fact got overlooked: The index underlying the first of those ETFs—the aforementioned iShares S&P National Municipal Bond Index Fund (MUB)—was created by S&P. Why is that interesting? Because it was S&P’s first-ever municipal bond index. The S&P index covers about 3,000 municipal bonds rated BBBor higher by S&P or Fitch, or rated Baa3 or higher by Moody’s. The minimum par amount for individual components is $50 million. Components are selected from the S&P/Investortools Municipal Bond Index, and the index is reviewed and rebalanced once a month. The index’s total market value as of September 4 was roughly $305 billion. It has two state-level subindexes, covering California and New York, two of the largest markets for muni bonds. Nearly 50 percent of the index is insured municipal bonds. Another 18.5 percent are pre-refunded or escrowed to maturity, while nearly 14 percent are uninsured state and local general obligation bonds. The remaining categories represent less than 5 percent each of the index. According to S&P, the index was designed to be investable rather than a benchmark.

MSCI Examines The Frontier In August, MSCI issued a consultation paper asking for opinions on the creation of frontier market indexes. Frontier markets have become popular among investors as they continue to search for noncorrelated returns. The proposal says that all countries that MSCI does not currently cover would be considered for inclusion in its frontier markets

indexes, as long as they have a total market capitalization of more than $1 billion, “relative market openness” and a market that could be the basis for an investable index. Among other requirements, countries must have at least three viable index constituents and be free of “extreme economic and political strife.” Twelve countries from the resulting list would be selected for inclusion in MSCI’s frontier market indexes. The frontier market family would also comprise certain countries already covered by the MSCI indexes: Sri Lanka, Venezuela, Bahrain, Oman, Qatar, United Arab Emirates and Kuwait.

S&P Launches New Frontier Index In October, S&P rolled out the S&P Select Frontier Index, which appears to be an investable subset of its S&P/IFCG Extended Frontier 150 Index. The new index includes 30 of the largest and most liquid components of the broader benchmark. It has a total market capitalization of $46.9 billion, and individual components must have market capitalizations of at least $100 million; their weights are capped at 10 percent of the index. Components must also meet certain liquidity requirements. The weight of individual countries is capped at 30 percent of the index, and no country can be represented by more than five companies. The index includes nine countries, most of which are not included in other index providers’ families at all. Pakistan has the heaviest weighting in the index at 28.97. The Middle East—including Pakistan, United Arab Emirates, Jordan and Kazakhstan—represents about 72 percent of the index; Asia represents 12.55 percent; South America 13.98 percent; and Europe, represented by Bulgaria, 1.05 percent.


News Sustainable And Sector-Neutral KLD, arguably the best-known provider of ethical indexes, recently launched its own family of global sustainability indexes. The new benchmark index, the KLD Global Sustainability Index, is a sector-neutral global benchmark. It relies on environmental, social and corporate governance screens to rank components within each market sector, and then selects companies in each sector with the highest “sustainability” ratings. “Sustainability,” according to KLD’s Web site, “refers to the degree to which companies address the social and environmental needs of the present without compromising the quality of life of future generations.” Socially responsible indexes have suffered recently due to their tendency to underweight sectors like Energy. Index providers have felt pressure from shareholders and institutions to limit that tracking error. By moving to a sector-neutral process that looks for “best-ofbreed companies” rather than excluding entire industry segments, this index moves down that path. Components in the index are rated according to 14 different socially responsible criteria and then ranked within their regional sector peer group. Twenty-three developed markets are included in the indexes, and the benchmark index had 686 components at launch. Country indexes are not calculated, but the index family does include four regional subindexes: Asia-Pacific, Europe, North America and the world ex-U.S.

HSBC’s Climate Change Index HSBC has released what is probably the most comprehensive index covering companies that are wellpositioned to benefit from efforts to prevent or slow climate change. The HSBC Global Climate Change Benchmark Index covers roughly 300 stocks from 34 countries, and comes

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with four pure-play subindexes. Companies involved in low-carbon energy production represent 52.3 percent of the index, while companies involved in energy efficiency and energy management are 24.1 percent. Water waste and pollution control companies represent 23.4 percent of the index, and the financials sector is only about 0.3 percent. To be included in the benchmark, companies must derive more than 10 percent of their annual revenues from climate-change-related business activities. The minimum market capitalization is currently set at $500 million. Components are weighted based on a combination of free-float market capitalization and their exposure to climatechange-related activities. Europe represents 55 percent of the index, followed by North America at 27 percent, Asia Pacific at 16 percent and Latin America at 2 percent.

Morningstar Launches Commodity Indexes Morningstar launched its own family of commodity indexes in September. The Morningstar Commodity indexes take a different approach

from most popular commodity futures indexes in that they come in five unique flavors: long only, short only, long/short, long/flat and short/flat. The long- and short-only indexes are exactly what they sound like: They take long and short positions, respectively, in each of the 20 commodities that are included in the indexes. The short index is the first major index to track the performance of a short strategy in the commodities setting. The most interesting new indexes, however, are the split indexes. The long/short index uses a momentum rule to determine on a monthly basis if it will hold long, short or flat positions in each commodity. The long/flat index doesn’t go short, while the short/flat index doesn’t go long. These more closely replicate the strategies of sophisticated commodity traders, rather than taking a blanket long or short approach to the market. The indexes cover 20 different commodities. There is no word yet on when and if investable products tied to these benchmarks will launch.

Schwab Expands Fundamental Charles Schwab has filed for two more index mutual funds based on FTSE RAFI indexes, adding to its fundamental indexing suite of products. The Schwab Fundamental Emerging Markets Index Fund will track the FTSE RAFI Emerging Index, while the Schwab Fundamental International Small-Mid Company Index Fund will track the FTSE RAFI Developed Markets Ex-U.S. Mid Small 1500 Index. Schwab already offers FTSE RAFIbased U.S. funds covering the small/mid and large-cap segments of the market, as well as a FTSE RAFI-based international large-company fund. Expense ratios on the funds range from 0.35 percent for institutional shares to 0.59 percent

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News for investor shares. PowerShares already offers ETFs on the same indexes, but it charges more for the privilege, with expense ratios ranging from 0.75 to 0.85 percent.

DFA Adds R Shares Dimensional Fund Advisors (DFA) recently announced the addition of two retirement share classes to its funds. The firm had not offered retirement shares previously, which made it difficult for plan sponsors to have DFA funds added to service provider platforms. Retirement shares pay fees to plan service providers, and the fees go to cover the added costs those service providers face in adding new funds. Without them, plan service providers have little incentive to add funds to their platforms. DFA’s R1 and R2 shares will pay plan service providers fees of 10 and 25 basis points, respectively; they do not contain 12b-1 or distribution fees.

Dividends Decline S&P says that only 439 of the 7,000 U.S. companies for which it tracks dividends increased their payouts for the third quarter, a 7.6 percent decline from the 475 companies that did so for the prior-year period. The number of dividend extras, which was up for the first half of the year, was down 6.8 percent in the third quarter to 82. S&P Senior Index Analyst Howard Silverblatt says fewer companies are making forward commitments to dividends and that S&P believes the increase in corporate buyback activity is to blame. However, the number of dividend payouts is still increasing, up 3.2 percent in the third quarter and 3.0 percent year-to-date. And the number of negative dividend actions— or the number of companies moving to reduce their dividends—was actually lower in the third quarter of 2007 than it was in 2006.

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Home Prices Plummet The S&P/Case-Shiller Home Price Indexes experienced yet another significant decline in August. The 10-city composite index recorded an annual decline for August of 5.0 percent, its biggest drop since June 1991 and not far from April 1991’s record decline of 6.3 percent. Meanwhile, the 20-city composite was down 4.4 percent on an annual basis. August represents the 21st consecutive month of decelerating annual returns and the eighth month of negative annual returns. MacroMarkets LLC Chief Economist Robert Shiller, one of the creators of the indexes, said that there was no sign of a turnaround or a slowdown in the declines.

ering inflation-linked government bonds in October. The series is the first of its kind: There are other emerging markets bond indexes out there, but they do not cover inflation-linked debt. The new index has three tiers— individual country indexes, regional indexes and the broad Barclays Emerging Markets Government Inflation-Linked Bond benchmark index. The benchmark index currently includes 43 bonds from Argentina, Brazil, Chile, Colombia, Mexico, Poland, South Korea, Turkey and South Africa. Latin America is the biggest region, representing roughly 90 percent of the index, while Brazil is the largest country, at approximately 66 percent of the index.

S&P Highlights Southeast Asia

FTSE RAFI A Hit In South Africa

S&P’s new S&P Southeast Asia 40 Index holds 40 companies from the fast-growing markets of the Philippines, Indonesia, Malaysia and Thailand. The index was up nearly 30 percent for the first nine months of 2007 and 46 percent for the preceding 12-month period. The S&P index has a modified market-capitalization-weighting scheme which limits individual stocks to 10 percent of the index and individual countries to 40 percent of the index; each country must be represented by at least four components. Malaysia is the largest country at 35 percent of the index, while Thailand is about 30 percent and Indonesia is nearly 26 percent. The Philippines makes up more than 9 percent of the index. Components must have a floatadjusted market capitalization of $500 million and a three-month average daily value traded of at least $1 million.

FTSE recently introduced its first fundamental index in South Africa, and already it’s a hit: At its launch, there were already three products based on the index in development, among them an ETF. The FTSE/JSE RAFI 40 Index is a fundamentally weighted index of 40 South African stocks. It contrasts with the FTSE/JSE Top 40, which tracks the country’s 40 largest companies by market capitalization and is one of the country’s most widely quoted indexes. Satrix Managers (Pty) Ltd., which already has several ETFs trading on the Johannesburg Stock Exchange, is planning to launch an ETF based on the FTSE/JSE RAFI 40 Index in the coming months. Plexus Asset Management is operating an active fund based on the index, and Umbono Fund Managers will launch an index fund.

Emerging TIPS Barclays Capital launched an emerging markets index series cov-

A Second IPO Index Renaissance Capital LLC, a research and investment services provider that focuses on IPOs, has created its own IPO benchmark index. The Renaissance IPO Index includes all U.S.-listed, institutional-


News ly investable IPOs for a two-year period beginning on their first day of trading. Renaissance says the index captures about 95 percent of the total market value of all IPOs. The index is weighted by floatadjusted market capitalization and requires that components have a float-adjusted market cap of at least $50 million. As of the end of September, the index had 300 components ranging from $46 million to $10.5 billion in size. Competing and more-established indexes from IPOX Schuster have a four-year holding period, among other methodological differences.

NASDAQ Neurotech Index The NASDAQ Stock Market entered a new index niche with the release of the NASDAQ NeuroInsights Neurotech Index, which covers the neurotechnology industry. It partnered with NeuroInsights to create the index, which includes companies involved in the research, development, manufacture and marketing of drugs, treatments, medical devices and diagnostics for the brain and nervous system. It’s a field that’s likely to thrive as the baby boom generation ages, as many of the ailments addressed by neurotechnology are age-related. The new index is part of the growing field of thematic indexes, which aim to capture discrete investment or societal trends. The index has 32 components. To be eligible for inclusion, a company must qualify as a pure-play neurotechnology company in the opinion of NeuroInsights. AROUND THE WORLD OF ETFS

Small-Cap Emerging Markets With investors searching high and low for noncorrelated assets, the new WisdomTree Emerging Markets SmallCap Dividend ETF (DGS) is attracting a lot of attention.

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Launched this fall, DGS is the first small-cap emerging markets ETF. Investors upset with the growing correlation between international and domestic (U.S.) large-cap companies are turning toward international small-caps on the theory that those companies should be more closely tied to local economies. That should be even more the case in emerging markets. The WisdomTree Emerging Markets SmallCap Dividend Index has 363 components drawn from 14 countries and a total market capitalization of $550 billion, meaning the average component market capitalization is $1.5 billion. The ETF has an annual expense ratio of 0.63 percent.

Vanguard Goes MegaCap Vanguard submitted a filing to the SEC in September for three “mega-cap” index funds, designed to track the MSCI U.S. Large-Cap 300 Index (which covers the 300 largest stocks in the investable U.S. market) and its growth and value subindexes. The fund provider already offers a fund called the Vanguard LargeCap Index Fund, but that is really a large/mid-blend fund; it includes both the Large-Cap 300 and the Mid-Cap 450 indexes. Vanguard separately offers a fund tied to the MSCI U.S. Mid-Cap 450 Index, as well as the distinct MSCI U.S. SmallCap 1750 Index. With the addition of the mega-cap funds, investors will have an entire suite of nonoverlapping large-, mid- and small-cap funds, as well as growth and value subsegments, to use for asset allocation purposes. The new funds will be available as ETFs and as Institutional and Investor shares. The Investor shares will have the highest expense ratio at 0.20 percent, followed by the ETF shares at 0.13 percent. The Institutional shares, not surprisingly, will have the lowest expense ratio, at 0.08 percent.

ProShares Goes International In a well-timed move, ProShares has gone international, launching six new ETFs that could help investors hedge against a downturn in global markets. The new funds are ProShares’ first international funds, and come in two flavors: Short and UltraShort. The “Short” ETFs deliver the inverse of the daily return of the underlying index, while the “UltraShort” ETFs offer 200 percent of the inverse returns of the underlying index. The funds are: • Short (EFZ) and UltraShort (EFU) MSCI EAFE • Short (EUM) and UltraShort (EEV) MSCI Emerging Markets • UltraShort MSCI Japan (EWV) • UltraShort FTSE/Xinhua China 25 (FXP) As with all ProShares ETFs, the funds carry an expense ratio of 0.95 percent.

ProShares Plans Commodities, Currency ETFs Meanwhile, the company is looking to extend its empire to commodities and currencies. The company recently filed papers with the SEC for the right to launch 48 new ETFs tied to those alternative asset markets. The commodity funds will be linked to the Dow Jones-AIG Commodity Index and related subindexes, and will look to provide 200%, -100% and -200% of the daily return of those indexes. In the currency market, ProShares has targeted the euro, Australian dollar, British pound, Canadian dollar, Japanese yen, Mexican peso, Swedish krona and Swiss franc with a similar slate of leveraged, inverse and inverseleveraged funds.

iPaths Get Daily Redemption In October, Barclays Bank changed the policy on its iPath

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News ETNs to allow daily redemptions at net asset value (NAV), rather than weekly, as was originally the case. The move to daily redemption is an important one because it shortens the window of credit exposure for large investors; it also improves transparency and liquidity. Now, an investor holding 50,000 shares of an ETN is guaranteed daily liquidity at NAV. The daily liquidity should also help arbitrageurs keep the ETNs closely priced to their NAV on an intraday basis. The move brings the iPaths ETNs’ features closer into line with those of ETFs, which can also be redeemed daily.

one of the best-known commodity indexes. The fund will track the CRB Index as it existed prior to a 2005 reformulation, when the benchmark was rebranded the Reuters/Jefferies CRB Index and underwent a major design overhaul. Prior to the overhaul, the CRB was an equally weighted index of 17 commodities. During the 2005 rebranding, the CRB adopted a new methodology that more closely mimics the S&P GSCI and DJAIG commodity indexes.

iPaths Add More Commodities The iPath family of ETNs literally doubled overnight this fall, as Barclays Bank launched eight new ETNs on October 24 on the NYSE Arca exchange. The iPaths already included eight ETNs, holding approximately $3.6 billion in assets. The new ETNs are linked to eight subindexes of the Dow Jones-AIG Commodity Index, covering the Agriculture (JJA), Copper (JJC), Grains (JJG), Energy (JJE), Industrial Metals (JJM), Livestock (COW), Natural Gas (GAZ) and Nickel (JJN) markets. The bulk ($2.3 billion) of the existing iPaths assets are located in the broad-based iPath Dow JonesAIG Commodity Index Total Return ETN (NYSE: DJP). The notes each carry an annual investor fee of 0.75 percent and have a 30-year maturity.

New “Old” CRB ETF Greenhaven Commodity Services has filed papers with the SEC for the right to launch an ETF tied to an old iteration of the popular CRB Commodity Index. The Atlanta-based firm said it would launch the ETF on the American Stock Exchange (Amex), charging 0.85 percent in annual fees. The CRB was the first and is still

56

January/February 2008

XShares Launches Lifecycle ETFs In one of the more interesting ETF launches to hit the market of late, XShares launched the first-ever family of lifecycle ETFs in October in partnership with TD Ameritrade. The new TDAX Independence ETFs are also the first ETFs to combine stocks and bonds in the same portfolio. The funds hold a portfolio of stocks and fixed-income securities designed to track the Zacks Lifecycle Indexes. Four of the five funds have target dates set at 10-year intervals for the years 2010 (TDD), 2020

(TDH), 2030 (TDN) and 2040 (TDV). The fifth fund is the “in target” fund (TDX), which means its target date is set at inception. All of the funds trade on the NYSE Arca and carry an expense ratio of 0.65 percent.

Chinese Real Estate China is hot, and real estate is hot: Put them together and you have an ETF filing that is catching some buzz. Claymore filed papers with the SEC for the Claymore/Alphashares China Real Estate ETF, which will invest in Chinese companies that derive the bulk of their revenues from real estate development and property management in China, Hong Kong and Macau. The fund will hold both ADRs and local shares (Hong Kong H Shares and China B and N shares). The underlying index is a free-float adjusted modified market cap index, with a 5 percent cap on component weights. The index also has a minimumcomponent-weighting requirement of 0.35 percent, and a minimummarket-cap requirement of $250 million. These requirements are a two-sided coin in a market like China. Potential investors may feel that smaller, potentially highgrowth companies—and the returns they could contribute to the index— are being excluded. Others might see the exclusion of small, illiquid shares as a way to cut down on expenses, figuring that these smaller companies would likely not make a meaningful contribution to the index’s performance anyway.

MarketGrader ETFs Debut SPA International has launched ETFs based on six indexes from MarketGrader.com. The fund launches took place on both sides of the Atlantic, with listings on both the Amex and the London Stock Exchange. The funds track the MarketGrader 40, MarketGrader 100, MarketGrader 200, MarketGrader


News Small Cap, MarketGrader Mid Cap and Market Grader Large Cap indexes. MarketGrader.com is a U.S.based research firm that grades stocks on a scale of 0 to 100 based on 24 quantitative indicators, roughly divided into four buckets: growth, value, profitability and cash flow. Each index is equal-weighted and selects the companies with the best scores that meet certain sector and market capitalization requirements. The SPA ETFs charge 0.85 percent in expenses. The key difference between these and other fundamentally weighted ETFs is that the MarketGrader products are very focused, almost acting like actively managed portfolios. The flagship MarketGrader 40 rebalances quarterly and has significant portfolio turnover, although it has delivered strong results since inception in 2003.

PowerShares International Four new PowerShares FTSE RAFI ETFs began trading on the Amex in late September, along with a new international private equity ETF. Three of the FTSE RAFI funds cover the small/midsize market segments of global regions. They include the PowerShares FTSE RAFI Asia-Pacific Ex-Japan Small-Mid Portfolio (PDQ), the PowerShares FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio (PDN) and the PowerShares FTSE RAFI Europe Small-Mid Portfolio (PWD). The three funds complement existing PowerShares ETFs covering the large-cap segments of those same markets. PWD and PDN have expense ratios of 0.75 percent, while PDQ’s expense ratio is 0.80 percent. Options contracts will be available for all three funds. The fourth FTSE RAFI-based ETF is the PowerShares FTSE RAFI Emerging Markets Portfolio (PXH), which tracks the largest stocks in the emerging markets region. It has an expense ratio of 0.85 percent.

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Meanwhile, the PowerShares International Listed Private Equity Portfolio (PFP) will track the Red Rocks International Listed Private Equity Index. The fund has an expense ratio of 0.75 percent. Private equity has fallen off the investing map recently, but history suggests it will have its day in the sun again.

PowerShares Fixed-Income ETFs In addition to the muni bond ETFs mentioned earlier, PowerShares launched two additional fixed-income ETFs in early October. The PowerShares 1-30 Laddered Treasury Portfolio (PLW) is the first Treasury ETF to use a laddering strategy. It has an expense ratio of 0.25 percent. The PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) is the first ETF to focus exclusively on emerging market sovereign debt. Its expense ratio is 0.50 percent.

International Treasury ETF SSgA’s new SPDR Lehman International Treasury Bond ETF (BWX) is the first-ever international bond ETF. The fund began trading on the Amex in early October and is based on the Lehman Brothers Global Treasury Ex-US Capped Index, which tracks fixed-rate sovereign debt denominated in local currency. The index covers 18 investment-grade countries and includes more than 670 issues, although the ETF only holds about 62 in its optimized portfolio. The fund charges 0.50 percent in annual expenses.

Claymore’s Dividend Rotation ETF A new ETF from Claymore Securities tracks the Zacks Dividend Rotation Index, a domestic index designed to maximize dividend income at the lowest possible tax rate. The index’s 100 components are divided into two subindexes of 50 components, weighted by yield and liquidi-

ty, which are rebalanced monthly on an alternating basis to maximize the broad index’s dividend income. Eligible stocks are evaluated using a quantitative method designed by Zacks to select those with the greatest yield potential. The Claymore/Zacks Dividend Rotation ETF began trading in late October under the symbol IRO. It trades on the Amex and carries an expense ratio of 0.60 percent.

Adelante! In early October, XShares Advisors launched the Adelante Shares Real Estate ETFs on the NYSE Arca exchange. The seven new funds are the first real estate ETFs to be based on equal-weighted indexes. Each ETF tracks a different section of the real estate market. The funds include the Adelante Shares RE Classics ETF (ACK), the Adelante Shares RE Kings ETF (AKB), the Adelante Shares RE Shelter ETF (AQS), the Adelante Shares RE Yield Plus ETF (ATY), the Adelante Shares RE Growth ETF (AGV), the Adelante Shares RE Value ETF (AVU) and the Adelante Shares RE Composite ETF (ACB). Each has an expense ratio of 0.58 percent.

Wide Moat ETN Deutsche Bank ushered a new ETN to market in October. The ELEMENTS Wide Moat Focus ETN (WMW) tracks the Morningstar Wide Moat Focus Total Return Index and trades on the NYSE Arca platform. The index was launched in April and was inspired by a phrase from Warren Buffett, who used the term “wide moat” to describe companies with sustainable competitive advantages. Morningstar’s methodology identifies about 10 percent of the companies in its broad U.S. index as “wide moat” companies. The Morningstar Wide Moat Focus Total Return Index selects twenty of these companies with the best Morningstar price/fair value ratios, a measure that compares the differ-

January/February 2008

57


News ential between a company’s trading price and its “fair value” based on a discounted cash flow model. WMW has an annual expense ratio of 0.75 percent.

WisdomTree Launches 401(k) Platform WisdomTree announced the launch of a new 401(k) platform in October, making it perhaps the only ETF company offering its own platform allowing investors to put their retirement dollars into ETFs. The open-architecture platform features 11 funds from WisdomTree’s own family of ETFs, as well as select fixed-income ETFs from iShares and Vanguard. A few open-end, no-load, actively managed mutual funds are also included in the offerings. ETFs have been slow to take off in the 401(k) market for a number of reasons, mainly related to costs and record-keeping. For smaller plans that lack economies of scale, however, the cost advantages of ETFs may overweight these concerns, which can be mitigated through omnibus trades and software solutions. WisdomTree is targeting 401(k) plans with less than $50 million in assets. Its “Model Plan” allows investors their choice of six predetermined plans designed to meet different desired risk levels or retirement dates. The firm says that fees for its plans can be as low as 65 to 70 basis points (0.65 percent to 0.75 percent) per year, including everything except the advisor’s fee.

New Commodities ETFs Debut In Europe ETF Securities’ latest group of “exchange-traded commodities” began trading on the London Stock Exchange (LSE) in October. The new ETFs track “three-monthforward” versions of the Dow Jones-AIG Commodity Indexes. As the name suggests, these funds invest in futures contracts dated

58

January/February 2008

out three months; i.e., the fund buys the March oil contract today rather than the January. The strategy is designed to mitigate the impact of “contango.” There are nine new funds: one tracking the broad-based DJ-AIG and eight tracking the Agriculture, Energy, Ex-Energy, Grains, Industrial Metals, Livestock, Petroleum and Softs subindexes.

INTO THE FUTURES

Emerging E-Minis The Chicago Mercantile Exchange (CME) launched new E-mini futures contracts on the MSCI Emerging Markets Index on October 22. The contracts, the first of their kind, should help investors hedge their exposures to the volatile movements of the emerging markets. The launch follows the March 2006 launch of E-Mini contracts on the MSCI EAFE index, which covers developed markets ex-U.S. The CME expects the Emerging Markets contracts to attract more interest than the EAFE contracts, as speculators and traders are attracted to the volatile emerging markets space. The contracts have a notional value close to $40,000. ON THE MOVE

Fleites Out At IndexIQ

KNOW YOUR OPTIONS The Chicago Board Options Exchange (CBOE) added to its popular lineup of volatility indexes by launching a handful of new indexes in early November. The most interesting of the new indexes is the CBOE S&P 500 3-Month Volatility Index, which measures the market’s expectations of future volatility by looking out at three-month S&P 500 options. The standard CBOE VIX Volatility Index considers one-month contracts.

Agustin “Gus” Fleites has resigned from his position as president of IndexIQ, just two short months after joining the firm in September 2007. There was no specific reason given for the departure. The only official communication was a brief note from IndexIQ, stating: “We can confirm that Gus Fleites is no longer with IndexIQ. The parting was an amicable one and we wish Gus the best in his future endeavors.” This marks the second rapid departure for Fleites in recent years. Before joining IndexIQ, Fleites spent one year as chief investment officer of ProShares, where he oversaw the launch of the first ProShares ETFs. But he left that company in October 2006, just three months after the products came to market. Prior to that, Fleites spent 18 years at SSgA, where he was instrumental in the development of the company's ETF business.


Global Index Data Selected Major Indexes

Sorted by YTD Returns

January/February 2008

Total Return %

Index Name MSCI Brazil MSCI Turkey MSCI EM Latin America MSCI World/Metals&Mining MSCI AC Far East Ex Japan MSCI EM BSE SENSEX LCL India MSCI Hong Kong Goldman Sachs Nat'l Res GSCI AMEX Composite Mstar Manfct Super Sec MSCI EAFE Growth DJ Utilities MSCI Europe MSCI World Ex US S&P Mid 400 Grwth NASDAQ Composite MSCI EAFE Mstar Inform Super Sec Russell 1000 Growth Russell 3000 Growth MSCI AC World NYSE Arca Tech 100 S&P Small 600 Grwth DJ-AIG Commodity Russell 2000 Growth S&P Midcap 400 MSCI EAFE Value Dow Jones Industrial MSCI EAFE Small Cap S&P 500 Growth NYSE Composite DJ Wilshire 4500 DJ Wilshire 5000 Russell 1000 S&P 100 S&P 500 Russell 3000 S&P Mid 400 Value S&P 500 Value DJ Transportation S&P SmallCap 600 LB Global Aggregate LB US Treasury US TIPS Russell 2000 Russell 1000 Value Russell 3000 Value LB US Aggregate CSFB Credit Suisse HY S&P Small 600 Value CPI LB Municipal Mstar Services Super Sec MSCI Japan Russell 2000 Value DJ Wilshire REIT DJ US Financial JSE Gold USD South Africa MSCI Ireland

Annualized Return %

YTD

2006

2005

2004

2003

2002

2001

3-Yr

5-Yr

10-Yr

15-Yr

79.50 78.81 54.10 53.22 49.44 46.57 43.89 42.94 34.00 30.26 23.05 22.15 21.48 19.86 19.73 19.26 18.48 18.38 17.60 16.72 16.51 16.31 16.27 16.07 15.14 14.68 14.27 13.93 13.77 13.74 13.26 12.90 12.83 12.80 11.42 11.21 11.61 10.87 10.77 9.46 8.92 8.57 8.56 7.75 7.55 6.12 5.98 5.31 4.78 4.55 2.73 2.71 2.42 1.86 1.58 -1.64 -6.19 -6.54 -7.85 -9.56

40.52 -9.22 39.34 34.56 28.47 29.18 46.70 26.27 16.82 -15.09 16.90 19.95 22.33 16.63 33.72 25.71 5.81 9.52 26.34 16.90 9.07 9.46 18.78 4.68 10.54 2.07 13.35 10.32 30.38 19.05 19.31 11.01 17.86 16.07 15.88 15.46 18.47 15.79 15.72 14.62 20.80 9.81 15.12 6.64 0.41 18.37 22.25 22.34 4.33 11.93 19.57 2.58 4.84 14.98 6.24 23.48 36.15 19.42 5.54 43.86

49.96 51.60 44.92 33.66 17.86 30.31 42.34 4.79 36.48 25.55 22.64 11.24 13.28 25.14 9.42 14.47 14.42 1.37 13.54 -1.79 5.26 5.17 8.83 7.36 7.07 21.36 4.15 12.56 13.80 1.72 26.19 1.14 6.95 10.27 6.32 6.27 1.17 4.91 6.12 10.77 8.71 11.65 7.68 -4.49 2.84 4.55 7.05 6.85 2.43 2.26 8.36 3.40 3.51 7.17 25.52 4.71 13.99 6.46 43.34 -4.74

30.49 38.46 34.77 13.88 14.23 22.45 13.08 20.79 24.57 17.28 22.22 20.26 16.12 30.24 20.88 20.38 15.78 8.59 20.25 3.57 6.30 6.93 13.30 11.73 24.29 9.15 14.31 16.48 24.33 5.31 30.78 6.97 12.16 18.57 12.62 11.41 6.43 10.88 11.95 17.18 15.03 27.73 22.65 9.27 8.46 18.33 16.49 16.94 4.34 11.96 21.09 3.30 4.48 11.89 15.86 22.25 33.18 13.39 -27.75 39.16

102.85 122.40 67.06 64.33 40.77 51.59 72.89 32.47 34.01 20.72 42.36 28.15 31.99 29.39 38.54 39.42 37.32 50.01 38.59 39.79 29.75 30.97 31.62 52.14 38.50 23.93 48.54 35.62 45.30 28.28 61.35 27.08 29.28 43.72 31.64 29.89 26.25 28.69 31.06 33.80 30.36 31.84 38.79 12.51 8.40 47.25 30.03 31.14 4.10 27.93 39.20 1.87 5.31 28.43 35.91 46.03 36.18 32.23 11.47 39.43

-33.78 -36.49 -24.79 -4.28 -11.05 -7.97 3.52 -20.63 -13.26 32.07 -2.74 -15.56 -16.02 -23.38 -18.38 -15.80 -19.67 -31.53 -15.94 -36.74 -27.88 -28.04 -20.51 -33.33 -16.57 25.91 -30.26 -14.53 -15.91 -15.01 -7.82 -28.10 -19.83 -17.81 -20.86 -21.65 -22.59 -22.10 -21.54 -9.43 -16.59 -11.48 -14.63 16.52 16.57 -20.48 -15.52 -15.18 10.26 3.11 -12.93 2.42 9.61 -17.77 -10.28 -11.43 3.58 -12.35 130.33 -28.07

-21.75 -33.55 -4.25 1.10 -4.14 -4.69 -17.87 -21.20 -15.59 -31.93 -5.59 -9.10 -24.58 -26.27 -19.90 -21.40 -2.55 -21.05 -21.44 -24.17 -20.42 -19.63 -17.23 -15.59 3.00 -19.51 -9.23 -0.61 -18.52 -5.44 -16.12 -10.21 -9.30 -10.97 -12.45 -13.81 -11.89 -11.46 1.43 -8.18 -9.30 6.54 1.58 7.90 2.49 -5.59 -4.33 8.44 5.78 9.52 1.60 5.13 -4.87 -29.40 14.02 12.35 -6.38 29.65 -4.01

65.79 43.66 53.78 44.45 36.06 41.29 51.79 28.10 30.64 5.95 24.50 20.89 23.32 23.53 25.14 24.02 16.65 13.12 23.44 13.25 12.87 13.05 17.98 12.57 14.62 10.10 14.87 16.02 23.51 14.15 24.35 10.67 15.50 17.18 14.19 13.82 12.63 13.16 13.81 15.25 15.69 13.16 14.29 4.58 4.07 13.69 14.62 14.42 3.88 7.15 14.03 2.97 3.72 10.78 14.29 12.34 22.29 8.60 7.15 12.53

61.38 50.31 49.09 40.82 28.86 36.41 46.41 24.23 30.24 16.32 25.31 20.75 21.01 26.46 24.29 23.86 18.10 16.55 23.21 14.20 12.61 13.04 17.56 17.70 18.94 15.12 18.57 17.78 25.36 13.17 29.43 11.10 15.58 20.30 15.31 14.54 12.20 13.88 14.83 17.36 16.79 18.10 18.42 7.08 6.16 18.67 16.39 16.54 4.42 12.81 17.97 2.83 4.46 12.23 16.68 18.60 19.26 12.05 7.24 18.46

16.24 12.46 15.85 15.80 9.74 12.31 17.96 8.37 10.53 7.25 14.10 9.83 12.28 10.66 9.62 14.69 6.02 9.26 4.53 4.81 4.75 6.78 12.92 9.86 7.95 4.76 12.38 8.60 5.37 7.32 8.83 7.44 7.40 6.96 7.10 7.39 10.15 8.12 6.04 10.10 5.88 7.07 8.01 9.11 9.16 5.91 6.46 10.15 2.58 5.29 8.30 3.84 10.49 13.93 8.31 7.58 5.30

20.06 6.89 10.26 8.05 7.67 13.44 12.25 10.85 13.23 10.37 10.91 10.08 10.38 9.15 9.02 8.78 17.83 9.02 8.36 14.43 12.63 10.09 11.93 11.31 11.35 11.40 11.20 11.29 10.42 6.53 11.46 12.93 12.95 6.44 8.30 2.60 6.03 11.99 3.38 13.89 14.84 13.84 2.03 10.59

Sharpe Std Dev 1.73 1.10 1.84 1.65 1.83 1.82 1.84 1.45 1.29 0.18 1.53 1.72 1.79 1.54 1.91 1.85 1.08 0.73 1.83 0.81 0.97 0.95 1.50 0.70 0.86 0.45 0.74 1.07 1.82 1.16 1.56 0.80 1.31 1.15 1.16 1.18 1.09 1.12 1.13 1.02 1.39 0.61 0.81 0.08 -0.04 0.71 1.24 1.19 -0.14 0.67 0.75 -0.98 -0.21 0.78 0.83 0.64 1.12 0.47 0.25 0.58

29.72 35.60 22.78 21.42 15.32 17.77 20.77 15.08 19.01 22.63 12.12 8.87 9.68 11.46 9.89 9.67 10.86 12.11 9.51 10.96 8.53 8.87 8.47 12.00 11.83 14.16 14.43 10.42 9.58 8.11 11.74 7.76 8.04 10.64 8.08 7.68 7.34 7.53 8.02 10.27 7.70 15.41 12.26 4.61 4.13 13.34 7.84 8.09 2.78 4.13 12.94 1.28 2.54 8.16 11.80 12.74 15.67 9.64 39.59 15.03

*Source: Morningstar. Data as of 10/31/07. All returns are in dollars, unless noted. YTD is year-to-date. 3-, 5-, 10- and 15-year returns are annualized. Sharpe is Sharpe ratio. Std Dev is 3-year standard deviation.

www.indexuniverse.com/JOI

January/February 2008

59


Global Index Data Largest U.S. Index Mutual Funds Sorted by Total Net Assets in $US Millions $US Millions

Fund Name Vanguard 500 Index Vanguard Tot Stk Vanguard Inst Idx Vanguard 500 Idx Adm Vanguard Total Intl Stk Vanguard Total Bd Idx Vanguard Tot Stk Adm Vanguard Inst Idx InstPl Vanguard Eur Stk Idx Fidelity Spar US EqIx Vanguard Em Mkt Idx Vanguard Tot Stk Inst Vanguard Pac Stk Idx T. Rowe Price Eq Idx 500 Vanguard 500 Index Signal Fidelity Spar 500 Adv Vanguard Total Bd Idx Ad Vanguard Tot Stk InstPls Vanguard Total Bd Idx In Vanguard Mid Cap Idx Dimensional Intl SmCpVal Fidelity Spar 500 Idx Fidelity U.S. Bond Index Dimensional US LgCpVal Vanguard Inst Tot Bd Idx Vanguard Gr Idx Vanguard SmCp Idx Dimens. EmergMrktsVal Fidelity Spar US Eq Adv Fidelity 100 Index Vanguard Mid Cap Idx Ins Dimensional Intl Val Vanguard ExtMktIdx Dimensional Intl Small Co VALIC I Stock Vanguard Eur Stk Idx Ins Vanguard Inst DevMktsIdx Fidelity Spar Intl Index Fidelity Spar Tot Mkt Ix Vanguard REIT Index Dimensional US Micro Cp Vanguard Mid Cap Idx Adm Vanguard Val Idx Schwab S&P 500 In Sel Gateway Vanguard SmCp Vl Idx Vanguard Dev Mkts Idx Schwab 1000 In Inv Schwab S&P 500 In Inv Vanguard Bal Idx Vanguard SmCp Idx Ins Dreyfus S&P 500 Index Fidelity Spar Tot Mkt Adv Dimensional USLgCo Vanguard EmgMkts Admr Vanguard Tx-Mgd App Adm Dimensional US Sm Cp Vanguard SmCp Idx Adm Schwab 1000 In Sel Dimens. TaxMgUSSmCpVl

Ticker VFINX VTSMX VINIX VFIAX VGTSX VBMFX VTSAX VIIIX VEURX FUSEX VEIEX VITSX VPACX PREIX VIFSX FSMAX VBTLX VITPX VBTIX VIMSX DISVX FSMKX FBIDX DFLVX VITBX VIGRX NAESX DFEVX FUSVX FOHIX VMCIX DFIVX VEXMX DFISX VSTIX VESIX VIDMX FSIIX FSTMX VGSIX DFSCX VIMAX VIVAX SWPPX GATEX VISVX VDMIX SNXFX SWPIX VBINX VSCIX PEOPX FSTVX DFLCX VEMAX VTCLX DFSTX VSMAX SNXSX DTMVX

Assets 68,416.8 50,929.4 47,686.8 38,945.9 29,724.6 28,961.1 28,739.5 26,330.3 26,187.5 24,106.9 14,149.8 14,060.3 11,280.7 10,268.0 10,061.1 10,004.5 9,419.5 9,003.3 8,871.1 8,699.9 8,642.4 8,475.4 7,863.0 7,704.5 7,607.2 7,479.0 7,021.4 6,800.0 6,785.9 6,516.4 6,236.8 5,805.9 5,759.0 5,663.0 5,287.5 5,263.3 5,111.4 4,990.3 4,980.2 4,958.4 4,938.2 4,793.9 4,660.3 4,349.8 4,206.4 4,076.6 3,976.4 3,976.3 3,949.4 3,838.8 3,787.1 3,784.0 3,721.2 3,531.4 3,513.9 3,417.3 3,395.4 3,379.9 3,311.6 3,290.6

January/February 2008

Annualized Return %

Total Return %

ER

3-Mo

YTD

2006

3-Yr

5-Yr

10-Yr

15-Yr

0.18 0.19 0.05 0.09 0.32 0.20 0.09 0.03 0.27 0.10 0.45 0.06 0.32 0.35 0.09 0.07 0.11 0.03 0.07 0.22 0.75 0.10 0.32 0.30 0.05 0.22 0.23 0.70 0.07 0.20 0.08 0.48 0.25 0.64 0.36 0.12 0.12 0.10 0.10 0.21 0.55 0.13 0.21 0.19 0.95 0.23 0.27 0.50 0.37 0.20 0.08 0.50 0.07 0.15 0.30 0.10 0.40 0.13 0.35 0.55

6.94 7.04 6.96 6.96 11.86 3.02 7.03 6.96 10.26 6.96 23.22 7.06 7.26 6.90 6.96 6.96 3.04 7.05 3.05 5.09 1.22 6.94 1.90 -3.95 3.00 9.44 6.23 15.89 6.97 7.75 5.12 -0.21 6.73 1.92 6.89 10.29 9.31 8.66 7.08 12.37 -3.88 5.12 4.89 6.91 4.51 3.74 9.31 7.01 6.85 5.45 6.28 6.87 7.10 6.94 23.27 6.94 -3.54 6.25 7.03 -5.19

10.77 11.12 10.85 10.85 23.88 4.69 11.18 10.87 20.54 10.83 51.55 11.20 14.16 10.60 10.85 10.84 4.77 11.24 4.80 11.71 13.67 10.81 3.64 2.14 4.78 16.25 9.31 34.41 10.85 11.83 10.08 11.52 13.87 10.56 20.63 18.61 18.04 11.19 -2.92 -0.81 11.83 6.84 10.87 9.27 1.07 18.52 11.14 10.67 8.60 9.43 10.46 11.22 10.77 51.75 11.58 0.24 9.37 11.26 -0.67

15.64 15.51 15.79 15.75 26.64 4.27 15.63 15.81 33.42 15.72 29.39 15.69 11.99 15.41 15.66 15.75 4.36 15.76 4.40 13.60 28.39 15.71 4.33 20.18 4.30 9.01 15.66 37.93 15.75 13.78 34.15 14.27 24.88 15.41 33.64 26.34 26.15 15.73 35.07 16.16 13.69 22.15 15.67 10.14 19.24 26.18 15.20 15.48 11.02 15.82 15.24 15.77 15.71 29.48 14.44 16.61 15.78 15.36 18.85

13.02 13.85 13.15 13.12 26.63 3.82 13.94 13.18 25.26 13.10 44.30 13.98 20.12 12.83 13.06 13.11 3.91 14.04 3.95 17.26 30.20 13.09 3.46 16.07 3.88 12.78 14.80 48.63 13.12 17.43 27.68 16.16 27.56 12.79 25.43 23.81 23.39 14.07 17.00 13.48 17.38 14.80 13.07 9.00 12.49 23.60 13.53 12.87 9.88 14.97 12.63 14.09 13.07 44.39 14.27 13.71 14.92 13.71 15.08

13.73 15.03 13.87 13.83 25.48 4.34 15.12 13.90 24.38 13.77 39.76 15.15 21.05 13.53 13.75 13.78 4.43 15.29 4.47 18.80 30.96 13.77 4.39 15.58 4.41 12.00 19.49 41.82 13.78 18.97 25.17 19.61 27.63 13.49 24.56 23.50 23.14 15.06 22.34 17.98 18.90 16.66 13.76 8.84 17.31 23.33 14.07 13.55 10.78 19.68 13.35 15.07 13.76 39.82 15.14 16.95 19.61 14.24 18.53

7.02 7.33 7.15 7.08 10.17 5.64 7.39 7.18 10.81 6.96 16.06 7.45 6.39 6.81 7.03 6.97 5.69 5.76 14.45 6.97 5.81 9.49 6.14 8.72 6.97 11.51 8.57 12.15 6.75 10.92 12.37 11.73 7.99 6.95 6.95 7.23 6.77 7.04 8.88 6.57 6.96 16.08 7.59 9.93 8.79 7.38 -

11.10 11.11 11.23 11.14 6.23 11.15 11.25 13.37 11.02 11.20 5.51 10.86 11.11 10.99 6.27 6.33 10.99 6.36 12.23 11.03 11.92 10.81 13.45 14.87 7.45 11.01 12.34 10.63 11.01 12.80 12.28 11.11 -

Mkt Cap 55,204 29,353 55,200 55,204 30,267 29,353 55,200 45,619 57,483 14,444 29,353 19,352 57,429 55,204 57,483 29,380 6,970 944 57,483 18,911 37,852 1,699 3,269 57,483 122,204 6,970 26,887 2,449 914 55,055 45,619 35,161 37,192 30,611 5,526 431 6,970 56,628 55,218 48,635 1,639 35,164 41,091 55,218 29,567 1,699 55,171 30,611 55,115 14,444 36,239 833 1,699 41,091 861

P/E

Std Dev Yield

17.1 17.5 17.1 17.1 15.5 17.5 17.1 14.2 17.0 16.1 17.5 18.7 17.0 17.1 17.0 17.5 19.1 14.1 17.0 13.6 21.6 19.7 11.4 17.0 16.5 19.1 13.4 20.3 17.2 16.4 14.2 15.3 14.8 17.5 31.1 19.2 19.1 14.5 16.3 16.6 16.9 15.3 16.6 16.3 17.6 19.7 16.5 17.5 17.1 16.1 17.7 19.2 19.7 16.6 15.9

7.52 8.06 7.52 7.52 10.38 2.85 8.07 7.52 9.88 7.52 18.13 8.06 10.93 7.52 7.52 7.52 2.85 8.08 2.85 10.32 10.01 7.52 2.66 9.64 2.83 8.53 12.08 16.77 7.52 10.34 9.75 11.05 9.89 7.51 9.90 9.49 9.39 8.04 15.74 13.76 10.34 7.68 7.49 2.94 11.44 9.48 7.61 7.50 4.86 12.08 7.52 8.04 7.50 18.14 8.05 13.54 12.10 7.61 13.62

*Source: Morningstar. Data as of October 31, 2007. ER is expense ratio. YTD is year-to-date. Mkt Cap is geometric average market capitalization in $US millions. Std Dev is 3-year standard deviation. Yield is 12-month.

60

January/February 2008

1.67 1.56 1.75 1.75 1.84 4.99 1.64 1.77 2.13 1.71 1.08 1.66 1.88 1.56 1.73 1.53 5.08 1.59 5.11 1.14 2.16 1.50 4.83 1.36 5.09 0.78 1.01 1.63 1.74 1.26 3.07 1.04 1.97 0.75 2.23 2.14 1.61 1.18 4.33 1.98 1.22 2.37 1.52 2.22 1.82 2.00 1.13 1.38 2.82 1.13 1.23 1.21 1.67 1.10 1.32 1.82 1.09 1.28 0.80


Morningstar U.S. Style Overview Jan. 1 – Oct. 31, 2007 Trailing Returns %

Morningstar Market Barometer YTD Return % 3-Month

YTD

1-Yr

3-Yr

5-Yr

10-Yr

US Market

7.11

11.50

15.31

14.16

15.08

7.30

Large Cap Mid Cap Small Cap

7.85 4.66

11.93 11.40

15.72 15.63

13.42 16.66

13.39 19.50

6.31 9.75

6.19

6.89

9.83

13.85

19.41

8.81

US Value US Core US Growth

3.42 6.86

4.20 11.12

9.30 14.31

14.64 13.91

16.82 15.05

9.16 8.37

11.04

19.79

22.68

13.51

13.19

3.46

Large Value Large Core Large Growth

4.18 8.03 11.43

5.53 12.17 18.70

10.75 15.17 21.57

15.06 13.43 11.15

16.00 13.56 10.34

8.39 7.47 1.98

Mid Value Mid Core Mid Growth

0.11 3.78 9.70

1.04 9.63 23.88

6.06 13.63 27.33

13.68 15.56 20.47

18.68 18.79 20.65

11.09 10.32 7.10

Small Value Small Core

4.48 2.57

–1.81 4.05

2.19 7.14

11.43 14.19

18.53 19.72

10.89 11.62

10.95

17.92

19.37

15.34

19.57

4.17

Value

Core

Growth

Small Growth Sector Index YTD Return %

Industry Leaders & Laggards YTD Return %

Energy

31.87

82.27 80.71

Hardware

24.69

Engineering & Construction

Industrial

23.10

Education

73.93 72.27

19.14

Mining (Nonferrous &

Software

18.66

Agricultural Machinery

Utilities

16.99

Metal Products

15.72

60.88

Publishing

11.12

19.79

Large Cap

11.93

5.53

12.17

18.70

Mid Cap

11.40

1.04

9.63

23.88

6.89

–1.81

4.05

17.92

–8.00

–4.00

0.00

11.83

–22.55

Hospitals

Healthcare

10.35

–22.90

Real Estate

Consumer Services

–32.42

1.32

–4.88

Media

–6.75

Financial Services

23.88

Mid Growth Juniper Networks Inc. Intuitive Surgical Inc. Fluor Corp.

2.19

7.14

19.37

–10

0

+10

+20

15.06

13.43

11.15

13.68

15.56

20.47

11.43

14.19

15.34

–20

–10

0

+10

+20

Value Large Cap

27.33

Growth

Mid Cap

13.63

Core

Small Cap

6.06

Large Cap

21.57

Mid Cap

15.17

76.01 87.07

0.92 0.75

–75.75 –70.61

0.55 0.57

–47.27 –43.66 –45.78

0.74 0.68 0.65

5-Year

Value

Small Cap

Large Cap Mid Cap Small Cap

Growth

10.75

–20

Collective Brands Inc. Rent-A-Center Inc.

3-Year Core

1.20 0.40 0.79

Home Building

1-Year Value

90.07 240.84 94.61

–1.81

Beazer Homes USA Inc. RAIT Financial Trust Ryland Group Inc.

Savings & Loans

–49.58

Core

Growth

16.00

13.56

10.34

18.68

18.79

20.65

18.53

19.72

19.57

–20

–10

Notes and Disclaimer: ©2006 Morningstar, Inc. All Rights Reserved. Unless otherwise noted, all data is as of most recent month end. Multi-year returns are annualized. NA: Not Available. Biggest Influence on Index Performance lists are calculated by multiplying stock returns for the period by their respective weights in the index as of the start of the period. Sector and Industry Indexes are based on Morningstar's proprietary sector classifications. The information contained herein is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

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Constituent Weight %

Worst Performing Index

Insurance (Title)

–33.02

+8.00

YTD Return %

Small Value Consumer Goods

+4.00

Best Performing Index

Express Scripts Inc. MEMC Electronic Materials Inc.

51.98

–21.60

4.20

Biggest Influence on Style Index Performance

Agrochemical

Business Services

US Market 11.50

Small Cap

Morningstar Indexes

January/February 2008

0

+10

+20

? 61


Dow Jones U.S. Economic Sector Overview HISTORICAL PERFORMANCE RETURNS Industry

Total Return (%) 3-Month YTD

1-Month

Basic Materials Consumer Goods Consumer Services Financials Health Care Industrials Oil & Gas Technology Telecommunications Utilities

8.86 4.20 0.39 2.40 3.28 3.97 8.06 3.81 4.36 3.54

6.06 2.92 -3.42 -4.27 2.08 3.45 9.23 6.10 2.23 1.35

27.25 8.92 0.93 -5.11 8.10 17.59 29.20 16.04 17.93 10.35

2006

1-Year

Annualized Total Return (%) 3-Year 5-Year 10-Year Since Inception

17.63 14.91 14.36 19.43 6.88 13.87 22.77 10.10 36.83 21.28

42.02 15.70 9.35 1.50 9.95 25.59 43.66 23.28 28.01 20.56

19.06 12.32 8.73 9.54 9.85 15.70 30.62 14.81 18.79 20.03

21.61 12.62 11.14 14.07 10.30 18.65 30.70 20.04 21.86 20.13

7.28 6.44 6.77 8.27 7.78 6.26 13.90 4.32 3.68 9.63

9.69 9.73 9.49 14.17 10.06 10.35 15.46 13.18 7.38 9.16

DOW JONES U.S. INDUSTRY REPRESENTATION Market Cap (USD Billions)

Industry Basic Materials Consumer Goods Consumer Services Financials Health Care Industrials Oil & Gas Technology Telecommunications Utilities

Weight in U.S. TMI

557.70 1,387.19 1,810.57 3,085.66 1,790.25 2,156.95 1,720.34 2,317.48 559.14 617.47

3.49% 8.67% 11.31% 19.28% 11.19% 13.48% 10.75% 14.48% 3.49% 3.86%

Utilities 3.86%

Telecom. 3.49% Technology 14.48%

Basic Materials 3.49% Consumer Goods 8.67% Consumer Services 11.31%

Oil & Gas 10.75% Financials 19.28% Industrials 13.48%

Health Care 11.19%

CORRELATION COEFFICIENTS Industry Basic Materials Consumer Goods Consumer Services Financials Health Care Industrials Oil & Gas Technology Telecommunications Utilities

1000

3000

5000

8000

4000

2000

0001

9000

6000

7000

1.0000 0.5098 0.5149 0.3867 0.1984 0.7529 0.6414 0.5658 0.3998 0.1469

1.0000 0.6331 0.6790 0.6951 0.5750 0.2386 0.6170 0.4543 0.4400

1.0000 0.6650 0.3373 0.7665 0.0584 0.7602 0.5711 0.1346

1.0000 0.5784 0.5219 0.0544 0.5253 0.5855 0.2622

1.0000 0.2713 0.1210 0.3602 0.4701 0.4094

1.0000 0.2494 0.7738 0.5367 0.0062

1.0000 0.2736 0.1125 0.3567

1.0000 0.4685 0.0882

1.0000 0.1872

1.0000

HISTORICAL DOW JONES U.S. INDUSTRY REPRESENTATIONS (%) Industry

2007 Q3

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

Basic Materials Consumer Goods Consumer Services Financials Health Care Industrials Oil & Gas Technology Telecommunications Utilities

3.49 8.67 11.31 19.28 11.19 13.48 10.75 14.48 3.49 3.86

3.02 8.63 12.32 22.12 11.43 12.62 9.29 13.58 3.21 3.76

2.95 9.17 13.99 21.25 12.17 12.64 7.10 14.50 3.00 3.24

2.74 9.40 13.43 21.01 13.33 11.87 6.05 16.10 3.09 2.98

2.67 10.22 12.97 21.08 14.56 11.68 6.32 13.53 3.81 3.15

2.28 8.44 12.84 19.04 14.28 12.07 5.88 17.12 5.03 3.02

1.98 8.14 10.45 18.02 14.23 12.54 6.00 19.89 5.19 3.56

2.47 8.34 14.49 14.11 9.21 11.98 4.51 25.59 6.96 2.34

2.34 11.63 12.57 16.92 12.44 11.89 5.46 16.43 7.20 3.12

3.53 13.79 10.51 19.31 11.35 13.47 7.17 11.78 5.67 3.43

4.31 14.72 9.59 16.89 11.08 14.35 7.88 12.25 5.36 3.57

5.02 15.09 10.09 15.11 11.11 14.39 7.45 9.99 7.29 4.45

6.28 15.62 11.45 13.51 9.90 14.50 7.91 8.76 7.24 4.82

Source: Dow Jones Indexes. Data is based on total return index values as of 8/30/2007.

62

January/February 2008


Exchange-Traded Funds Corner Largest New ETFs Sorted by Total Net Assets in $US Millions

Selected ETFs In Registration

Covers ETFs launched from November 1, 2006, through October 31, 2007.

AirShares EU Carbon Allowance Fund

Fund Name

Ticker

3-Mo

YTD

streetTRACKS DJ Int RlEst Vanguard FTSE All-W ex-US iPath MSCI India Index UltraShort Financials ProShares PowerShares DB Agriculture Fund Vanguard Ttl Bnd Mkt ETF CurrencyShares Japan Yen United States Natural Gas ProShares UltraShort Russell 2000 UltraShort Real Estate ProShares Vanguard Europe Pacific iShares Lehman Short Treas Market Vectors Russia Market Vectors Agribusiness ETF Vanguard Sht-Term Bnd ETF Claymore S&P Global Water SPDR S&P BRIC 40 streetTRACKS Rus/Nom PRJp SPDR S&P China

RWX VEU INP SKF DBA BND FXY UNG TWM SRS VEA SHV RSX MOO BSV CGW BIK JPP GXC

5.98 12.73 33.66 -5.34 12.25 2.99 3.30 9.04 -12.34 -15.52 9.33 1.37 19.95 2.26 6.58 39.45 -1.05 49.21

4.91 63.40 0.86 -

Launch Date 12.19.06 03.08.07 12.19.06 01.30.07 01.05.07 04.03.07 02.12.07 04.18.07 01.23.07 01.30.07 07.20.07 01.05.07 04.24.07 08.31.07 04.03.07 05.14.07 06.19.07 11.09.06 03.19.07

Assets 1,151.6 1,068.4 975.0 782.0 721.7 659.9 650.1 580.1 553.3 452.5 449.8 439.2 435.7 350.2 319.9 315.7 269.0 268.0 264.5

ER 0.60% 0.25% 0.89% 0.95% 0.91% 0.11% 0.40% 0.60% 0.95% 0.95% 0.00% 0.15% 0.69% 0.65% 0.11% 0.65% 0.40% 0.51% 0.60%

*Source: Morningstar. Data as of 10/31/2007. ER is expense ratio. 3-Mo is 3-month. YTD is year-to-date. Assets are total net assets in $US millions.

iShares JPM USD EM Bond Bear Stearns Current Yield Fund Claymore/Dorchester US-1 Cap Mkts First Trust DJ Global Select Dividend Greenhaven Continuous Commodity IndexIQ Cust. Loyalty Large MyShares ISE SINdex NETS DJW Global Total Market Powershares FTSE RAFI China ProShares Ultra Gold ProShares Ultra Euro Rydex Dynamic Inverse Energy StateShares New York 50 SPDR Barclays Global TIPS Market Vectors - Coal Vanguard Mega Cap 300 United States 12 Month Oil Fund Wilder China WisdomTree REIT Source: ETF Watch.

Largest U.S.-listed ETFs Sorted by Total Net Assets in $US Millions $US Millions

Fund Name

Annualized Return %

Total Return %

Ticker

Assets

ER

3-Mo

YTD

2006

2005

3-Yr

5-Yr

Mkt Cap

P/E

Sharpe Std Dev

Yield

SPDRs (S&P 500) SPY iShares MSCI EAFE EFA iShares MSCI Emerg Mkts EEM iShares S&P 500 IVV PowerShares QQQQ QQQQ streetTRACKS Gold Shares GLD iShares R1000 Growth IWF iShares Russell 2000 IWM iShares Japan EWJ MidCap SPDR (S&P 400) MDY Vanguard Total Stock Market VTI iShares R1000 Value IWD DIAMONDS Trust DIA iShares FTSE/Xinhua China FXI iShares Lehman 1-3 Treas SHY iShares Brazil EWZ iShares DJ Sel Dividend DVY iShares Lehman Aggregate AGG Vanguard Emerging Markets VWO iShares S&P 500 Growth IVW Energy SPDR XLE iShares S&P 400 MidCap IJH iShares Lehman TIPS Bond TIP iShares MSCI ex-Japan EPP

73,767.6 51,282.4 28,487.7 22,761.9 21,608.0 15,162.1 14,765.2 12,576.6 11,591.8 9,887.6 9,745.8 9,681.8 9,284.2 9,161.7 8,918.1 7,671.8 7,656.4 7,237.6 6,274.8 6,194.8 5,379.2 5,189.7 4,757.4 4,698.9

0.10 0.36 0.77 0.10 0.20 0.40 0.20 0.20 0.57 0.25 0.07 0.20 0.18 0.74 0.15 0.74 0.40 0.20 0.30 0.18 0.26 0.20 0.20 0.50

6.94 7.59 21.97 6.94 15.95 18.47 9.37 6.99 -1.24 6.20 7.04 4.55 5.98 51.13 2.16 34.58 3.45 2.90 23.26 8.33 10.94 6.21 3.38 21.15

10.78 17.40 44.50 10.80 27.75 23.78 16.32 6.22 1.42 13.64 11.18 5.86 13.59 91.70 5.22 82.08 0.66 4.47 51.71 12.72 31.45 13.64 7.40 43.10

15.69 26.00 30.71 15.70 7.03 23.44 8.86 18.17 5.49 10.05 15.66 22.00 18.81 83.19 3.83 44.27 19.41 4.13 29.53 10.81 18.40 10.14 0.29 32.07

4.79 13.39 33.78 4.83 1.64 16.65 5.08 4.46 24.65 12.18 6.10 6.92 2.40 14.15 1.48 52.46 2.98 2.16 3.81 40.20 12.48 2.65 14.03

13.04 23.13 42.59 13.07 14.87 12.65 13.61 13.68 15.57 13.97 14.43 14.26 62.68 3.40 68.96 9.52 3.60 11.47 31.26 15.82 3.91 34.14

13.73 22.93 13.77 17.91 12.39 18.54 16.02 17.37 15.12 16.17 13.16 2.73 66.04 11.04 30.78 17.58 32.01

57,526 38,972 24,689 58,584 34,813 37,923 1,147 19,586 3,588 29,353 50,540 116,604 104,489 32,424 15,250 14,444 65,709 77,193 3,760 22,813

17.0 15.2 18.8 17.1 28.6 21.7 19.1 18.0 18.5 17.5 13.9 16.9 27.6 6.4 14.3 16.1 18.9 13.3 19.5 17.5

1.11 1.81 1.83 1.12 0.78 0.95 0.71 0.79 1.04 1.14 1.23 1.19 1.99 -0.79 1.82 0.70 -0.24 0.89 1.26 1.06 -0.08 1.89

1.76 1.79 0.95 1.74 0.26 0.00 0.85 1.01 0.69 1.20 1.65 2.27 1.94 0.61 4.28 1.10 3.26 4.87 1.15 1.15 1.01 1.25 3.68 2.91

7.51 9.46 18.25 7.51 13.61 8.51 13.31 11.78 10.39 8.06 7.82 7.98 24.17 1.24 29.34 7.40 2.78 7.81 19.82 10.43 4.15 13.94

*Source: Morningstar. Data as of 10/31/07. Assets are total net assets in $US millions. ER is expense ratio. 3-Mo is 3-month. YTD is year-to-date. Mkt Cap is geometric average market capitalization. P/E is price-to-earnings ratio. Sharpe is Sharpe ratio. Std Dev is 3-year standard deviation. Yield is 12-month.

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January/February 2008

63


The Curmudgeon H U M O R

The Great Wheel of China What goes ‘round, comes ‘round By Brad Zigler

Answering a reader on China

A columnist checks mail with the same trepidation as when overturning a garden rock. One never knows if a struggling shoot or a creepy spider will be found. The Curmudgeon’s mailbag, as usual, is brimming over with slams and swipes for columns past. Does that trouble this back-page sophist? Nah. Ignorance is bliss, at least until the editor threatens termination again. Let’s instead look forward and pull out the letters that have the greatest import for readers of this august publication. Ah, here’s one … “You may already be a winner! Mail your sweepstakes entry TODAY!” Oops. Sorry. This one’s from Dave in New York City: Dear Curmudgeon – Your columns lately seem to focus on spurious indicators and benchmarks such as the porn index (“Marrying Vice and Virtue,” November/December 2007) and a baseball performance index (“Dear Retiree,” May/June 2007). We in the investment trenches need insight into real-world markets. Can’t you

Beijing Great Wheel of Excess, a bid to outdo itself as the home of the world’s tallest Ferris wheel. On the exact day construction commenced, the FTSE/Xinhua China 25 stock index swooned more than 6 percent, setting up a slide of more than 7 percent in the ensuing two weeks. Coincidence? I think not. So much financial controversy swirled ’round the erection of London’s 443-foot Millennium Wheel, and its successor to the “world’s tallest” title, the 525-foot Star of Nanchang, that Ferris wheel construction has become a bellwether of irrational exuberance. Is the Chinese stock market, which has been growing at a compound annual rate better than 50 percent over the past three years, itself suffering from preposterous prodigality? Could be. But then, think about this, Dave: You’re seeking investment advice from a humorist. As for commodities, it’s undeniable that Chinese demand has been a driver of basic materials prices. The country’s impact in the metals space, in particular, is huge. China accounted for about half the new demand for steel, copper and aluminum this decade, and virtually all the new demand for lead, zinc, nickel and tin.

“After all, China’s looked toppy since construction began in November on the $99 million, 680-foot-tall, Beijing Great Wheel of Excess, a bid to outdo itself as the home of the world’s tallest Ferris wheel.” devote your numeracy to analyzing important markets like China? Should we still be buyers of Chinese equities or has the tiger finally turned tail? Is Chinese demand for basic materials going to continue to propel commodity prices higher? Dear Dave – You’re right, of course, to be concerned about the continuing strength of the Chinese market. After all, China’s looked toppy since construction began in November on the $99 million, 680-foot-tall,

64

January/February 2008

According to the International Monetary Fund, China’s taste for lead alone more than doubled global demand for the metal. The United States has been feeding the trend, too. American exports of lead scrap grew 634 percent year-overyear in the first three quarters of 2007. While Chinese officials try to deflect blame for the upswell in lead costs, a rise in export taxes could push prices even higher. The only export likely to escape the reverse tariff would be the lead in toys China ships to the States.


Journal of Indexes Jan-Feb 2008