Indexing

[rffrydr]

To carry on a theme of mine the separation of value from what is valued: the full faith and credit in indexing is showing some fraying on the...core:

[rffrydr]

PetroChina achieves 1trillion market cap--at a cost:

[rffrydr]

Delusions of grandeur or a commodity-based world?


http://www.djindexes.com/mdsidx/?event=showIslamicOverView
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

The more things stay the same, the more they change:

http://ftalphaville.ft.com/blog/2007/10/05/7855/harvard-why-cdos-are-economic-catastophe-bonds/
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

From this week's HCM credit commentary in Mauldin:

[rffrydr]

[rffrydr]

Isn't an index, an average, supposed to be "more true"?

AHEAD OF THE TAPE



Complacency,
Panic Whipsaw
Credit Markets
By GREG IP
August 6, 2007; Page C1

Eight months ago, credit markets reflected dangerous complacency about the risk of default in the economy. Today, there are signs they've gone too far in the opposite direction.

Jim Bianco, president of Bianco Research LLC, says that's the case with the popular ABX indexes, which track subprime mortgages. Using J.P. Morgan's model to calculate the scenarios for home prices and defaults implied by the current level of ABX indexes, he found the current price of the AA portion, or tranche, is predicting a 27% decline in home prices over the next five years -- a drop he says has occurred nationally only in the Great Depression.


To be sure, the homes underlying the ABX are concentrated in California and Florida, and therefore might behave differently from the national average. But a 27% decline over five years seems a stretch.

Meantime, the triple-B-minus tranche -- the riskiest slice -- is predicting a drop of just 6% in home prices over the same period, an unusual discrepancy. Mr. Bianco says the divergence of scenarios suggests irrational pricing.

If so, how did the subprime indices become detached from reality?

Stock derivatives seldom wander far from fair value, because it's easy for arbitragers to trade the underlying stocks and bring the price of the derivatives and the underlying stock into alignment. By contrast, the assets underlying credit derivatives are relatively illiquid. The ABX indexes are derived from credit derivatives that are themselves derived from subprime-backed collateralized debt obligations that hold the actual mortgages. So, the index is several steps removed from the underlying assets.

At times of market stress, credit derivatives do often stray from fair value. After General Motors Corp.'s debt was downgraded to junk in early 2005, its credit derivatives at one point implied 100% odds of default in less than five years. Today, says Mr. Bianco, "it looks like that was the result of panic."

He sees a similar mispricing today in the Dow Jones CDX index, based on credit derivatives derived from 100 high-yield bonds. That index is now pricing in materially higher probability of default than the price of the underlying bonds themselves.

Dan Castro, managing director at GSC Group, a New York asset manager, sees a similar disconnect in trading in the LCDX credit-derivatives index, linked to the cost of bank loans used in leveraged buyouts. "That's crazy," he says. "There's just this huge disconnect between the fundamental value of the index and where things are trading."
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

[rffrydr]

Hedge Funds are not an asset class--but they get "indexed" like one:

Copyright 2007 The Financial Times Limited
Financial Times (London, England)

July 2, 2007 Monday

SECTION: FT REPORT - FT FUND MANAGEMENT; Pg. 14

LENGTH: 735 words

HEADLINE: The sector that arrived late to the party

BYLINE: By STEVE JOHNSON

BODY:


The concept of index investing may be old hat in most asset classes, but in the world of hedge funds it is still work in progress.

Hedge fund indices, have of course, been around for many years, but there is no simple underlying measure, such as a FTSE 100, to recreate.

Traditional investable hedge fund indices simply provide the post-fee performance of a basket of available hedge funds. But these indices suffer from negative selection bias - few of the better managers are interested in index money - as well as erosion from the industry's high fee structure. In short, they invariably provide sub-industry returns.

Non-investable indices, which merely aggregate and average out performance data, are more accurate, but of course offer no way of participating in the sector.

For the past few years, a select handful of academics on both sides of the Atlantic have been pondering an alternative notion - that of synthetic hedge fund replication models, which would serve as an investable index either for the broader hedge fund universe or a specific hedge fund strategy.

In the past year, this concept has finally seeped out of the realms of academia. Banks such as Goldman Sachs, Merrill Lynch, JPMorgan, Bear Stearns and Deutsche Bank have unveiled commercial products that aim to produce market-like returns at a fraction of the price, in the manner of a passive index-tracking equity fund.

The late arrival of the hedge fund sector to the indexing party is understandable. The key problem is that hedge funds are not really an asset class. Although high net worth and institutional investors increasingly allocate assets to hedge funds, what they are really getting is a series of exposures to underlying asset classes, from equities to volatility. This led many to conclude that hedge fund returns were essentially pure alpha, ie dependent on the intrinsic skill of the manager.

But the academic work suggested that returns were often more to do with movements of underlying markets than manager skill. For some trading strategies at least, this suggested that similar returns could be generated mechanically.

The commercial strategies unveiled so far broadly fall into factor-based and pay-off distribution approaches. Most investment banks have opted for factor-based models, which rely on proprietary algorithms thatdetermine the net exposure of the industry to a basket of liquid factors, such as the S&P 500 and US dollar.

"If broad-based passive exposure is what investors are looking for, perhaps they can get that more cheaply by replicating the broad underlying investments of hedge funds. If you can get that right with a reasonable degree of accuracy, you can then replicate the aggregate impact of their trading strategies, without management fees," says Edgar Senior, executive director in the fund derivatives structuring team at Goldman Sachs, which launched an Absolute Return Tracker Index in December.

Others, such as Harry Kat, professor of risk management at London's Cass Business School, have opted for the pay-off distribution approach. This aims to use a dynamic basket of futures to replicate the distribution of hedge fund returns, in terms of correlation with assets and level of volatility. However, returns in any given month may differ significantly from those of the industry.

Having analysed 2,000 hedge funds, Mr Kat believes he can replicate all but 17 per cent, where the manager has "so much skill and so many tricks in his bag that he can add so much value that he can more than offset the fees".

However, not everyone is convinced that these replication strategies will be so successful. Jack Schwager, an author and fund manager at Fortune, part of Close Brothers, likens them to bad systematic hedge funds with lower fees. "They are a hedge fund in disguise," he says. "I think they will wither and die."

Edhec, the French business school, pictured below, also concluded in a recent report that none of the replication strategies unveiled thus far was capable of accurately recreating hedge fund returns.

Backtesting of factor-based models produced results that were "bad to acceptable" in replicating hedge fund returns. Edhec was more upbeat about the pay-off distribution approaches but cautioned that, as monthly returns can vary significantly from those of the underlying hedge fund industry, it would take years for an investor to know whether the strategy had succeeded.

LOAD-DATE: July 1, 2007
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

Indexing THE index:

Although the price-weighted Dow Jones Industrial Average approached its all-time high in early May, the large capitalization-weighted indexes -- such as the S&P 500 or the Russell 3000 -- in which most investors hold their "indexed" investments are still substantially below their tech-bloated peaks reached in March 2000. Those of us who have linked our portfolio returns to these popular indexes wonder whether there is a better way to capture the market's return without enduring the wild swings that characterized the last bubble.

Don't get me wrong. Capitalization-weighted indexation has been one of the great innovations in the last quarter-century. It has allowed millions of investors to capture the return on the market at a very small cost, and has outperformed most actively managed mutual funds. The $5 trillion invested in portfolios tracking cap-weighted indexes speaks to its popularity.

But we are on the verge of a revolution: New research demonstrates that it is possible to construct broad-based indexes offering investors better returns and lower volatility than capitalization- weighted indexes. These indexes are weighted by fundamental measures of firm value, such as sales or dividends, instead of allowing the market price alone to dictate how much of each firm should be included in the index.

The vast majority of indexes, with the exception of the Dow Jones Averages, are capitalization-weighted. This means that the weight of each stock in the index is proportional to the total market value of its shares. This methodology has strong appeal since the return on these indexes represents the aggregate or "average" return to all shareholders.

Strong support for these indexes also emanates from the academic community. The philosophical foundation of these indexes is the "efficient market hypothesis," which assumes that the price of each stock at every point in time represents the best, unbiased estimate of the true underlying value of the firm.

The efficient market hypothesis does not say a stock's price is always equal to its fundamental value. But the theory implies it is impossible to tell which stocks are undervalued and which are overvalued without either costly analysis or an innate skill possessed only by a chosen few, such as Warren Buffett, Peter Lynch or Bill Miller.

It can be shown that under standard portfolio models, if stocks are priced according to the efficient market hypothesis, then capitalization-weighted indexes offer investors the best risk-return combination. And there is no doubt that capitalization-weighted portfolios have performed very well for investors. Research conducted by Jack Bogle, Charles Ellis, Burton Malkiel and myself has undeniably shown that active mutual fund managers fail, after fees, to keep pace with the market indexes.

But as indexed investing gained adherents, cracks were found in the efficient market hypothesis. In the early 1980s, Rolf Banz and Don Keim showed that small stocks earned an outsized return compared to their risks. And, earlier, Sanjoy Basu and David Dreman discovered that stocks with low price-to-earnings ratios had significantly higher returns than stocks with high P/E ratios; small stocks with low P/E ratios (small value stocks) enjoyed particularly outstanding returns. The magnitude of these size- and value-based returns could not be rationalized using the standard asset pricing models of the efficient market hypothesis.

This caused schizophrenia in the financial community. Efficient- market believers still dominate the field of financial research, but many practitioners, including moonlighting academics, recommend that investors overweight value and small stocks in their portfolios. Eugene Fama from the University of Chicago and Ken French from Dartmouth's Tuck School built a very successful investment firm based on slicing the universe of stocks into value- and size-based sectors to market to large individual and institutional investors.

Since the 1980s, the finance profession has searched in vain for the reason why small and value stocks outperformed the market. Efficient- market diehards maintain these stocks contain deeply buried risk hidden in the historical data. They predict that one day, when a crisis hits and investors critically need to liquidate their portfolios, small and value-based stocks will crumble while large growth stocks will shine.

But if this is true, the data are unfortunately moving in the wrong direction. In the past decade we witnessed a huge tech bubble, 9/11, a recession, major corporate scandals and wars in Afghanistan and Iraq -- yet not only did small and value stocks survive, they outperformed the big cap, high-priced stocks by wider margins than they had in the past.

Current attempts to explain the hidden risks in value stocks remind me of the astronomers in the 16th century who attempted to save the earth-centered Ptolemaic view of the universe. They were forced to add complicated "epicycles" to the orbits of the planets to rationalize their movements in the evening sky; the model collapsed when Copernicus showed that a simple sun-centered solar system was an easier explanation. As with Copernicus, there is now a new paradigm for understanding how markets work that can explain why small stocks and value stocks outperform capitalization-weighted indexes.

This new paradigm claims that the prices of securities are not always the best estimate of the true underlying value of the firm. It argues that prices can be influenced by speculators and momentum traders, as well as by insiders and institutions that often buy and sell stocks for reasons unrelated to fundamental value, such as for diversification, liquidity and taxes. In other words, prices of securities are subject to temporary shocks that I call "noise" that obscures their true value. These temporary shocks may last for days or for years, and their unpredictability makes it difficult to design a trading strategy that consistently produces superior returns. To distinguish this paradigm from the reigning efficient market hypothesis, I call it the "noisy market hypothesis."

---

The noisy market hypothesis easily explains the size and value anomalies. If a stock price falls for reasons unrelated to the changes in the fundamental value, then it is likely -- but not certain -- that overweighting such a stock will yield better than normal returns. On the other hand, stocks that rise in price more than their fundamentals become "large stocks" with high P/E ratios that are likely to underperform.

These discrepancies are not easy to arbitrage away on a stock-by- stock basis. The noisy market hypothesis does not say that every stock that changes price does so by more than what is justified by fundamentals. Any particular stock may still be undervalued when it moves up in price or overvalued when it moves down.

New research indicates that there is a simple way that investors can capture these mispricings and achieve returns superior to capitalization-weighted indexes. This is through a strategy called "fundamental indexation." Fundamental indexation means that each stock in a portfolio is weighted not by its market capitalization, but by some fundamental metric, such as aggregate sales or aggregate dividends. Like capitalization-weighted indexes, fundamental indexes involve no security analysis but must be rebalanced periodically by purchasing more shares of firms whose price has gone down more than a fundamental metric, such as sales, and selling shares in those firms whose price has risen more than the fundamental metric.

Robert Arnott, editor of the Financial Analysts Journal and chairman of Research Affiliates, LLC, has published research documenting both the theoretical and historical superiority of fundamentally weighted indexes. It can be rigorously proved that if stock prices are subject to noise, then capitalization-weighted indexes will offer investors risk-and-return characteristics that are inferior to those of fundamentally weighted indexes.

I have long advocated the use of dividends in evaluating stocks. Dividends are the only fundamental variable that is completely objective, transparent and unable to be manipulated by managers who tinker with accounting assumptions. (In the interest of full disclosure, I am an adviser to a company that develops and sponsors dividend-based indexes and products.)

According to my research, dividend-weighted indexes outperform capitalization-weighted indexes and are particularly valuable at withstanding bear markets. For example, the Russell 3000 Index lost almost 50% of its value between the bull market peak of March 2000 and the October 2002 low. Over this same period, a comparable total market dividend-weighted index was virtually unchanged. A dividend weighted index did have a bear market, but it only corrected by 20%. Moreover, the dividend-weighted index bear market didn't start until March 2002, and it lasted only six months (compared to 24 months for the cap- weighted index). The dividend-weighted index is now about 40% above its March 2000 close, whereas the S&P 500 and Russell 3000 are still not yet back to even. A similar performance occurred in other bear markets.

The historical data make an extremely persuasive case for fundamental indexing. From 1964 through 2005, a total market dividend- weighted index of all U.S. stocks outperformed a capitalization- weighted total market index by 123 basis points a year and did so with lower volatility. The data indicate that the outperformance by fundamentally weighted indexes during the same period is even greater among mid-sized and small stocks.

Furthermore, dividend-weighted indexes had better risk and return characteristics than capitalization weighted indexes in each industrial sector and each country that I analyzed. Dividend-weighted indexes even outperformed "value cuts" of the popular capitalization- weighted indexes such as the Russell Value and Barra-S&P Value that attempt to choose those stocks whose prices are low relative to fundamentals.

With the advent of fundamental indexes, we're at the brink of a huge paradigm shift. The chinks in the armor of the efficient market hypothesis have grown too large to be ignored. No longer can advisers claim that capitalization-weighted indexes afford investors the best risk and return tradeoff. The noisy market hypothesis, which makes the simple yet convincing claim that the prices of securities often change in ways that are unrelated to fundamentals, is a much better description of reality and offers a simple explanation for why value- based investing beats the market.

If you are a fan of indexing, as I and so many other investors are, you are no longer trapped in capitalization-weighted indexes which overweight overvalued stocks and underweight undervalued stocks. Devotees of value investing who are searching for a simple, low-cost indexed portfolio in which to hold their stocks need wait no longer. Fundamentally weighted indexes are the next wave of investing.
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

The one-and-only SPDR, first in 1992, turned on it's head in turnover:

[rffrydr]

Live by the index, die by the index:

[HenryTo]

Re: the Alan Newman post.

At a recent talk at a CFA LA Society lunch, John Bogle stated that all the growth in indexing since the beginning of 2000 has occured in ETFs, as opposed to investing in low-cost index funds such as Vanguard mutual funds. My point is that looking at mutual fund cash reserves aren't too relevant anymore, given the rise of hedge funds (although the fact that equity holdings of hedge funds is now at a two-month high should give us pause) and given that equity holdings of U.S. households is at about the average we have seen over the last 50 years.

Combined with the fact that most of the mutual fund inflows have gone into international/EM stocks over the last few years, one can probably conclude that the S&P 500 is still nowhere close to a secular top here.

[rffrydr]

Crude-rated beta of SP is....positve:

http://www.thestreet.com/p/_rms/rmoney/energy/10343920.html
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

This guy's been reading my posts--but's loosing alot more money than I am thanks to the marketthoughts team:

http://www.decisionpoint.com/TAC/NEWMAN.html

Someone estimated at current rate of equity takeoff we'll cut the US supply by 1 trillion in an 11 trillion market.
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

A good primer on the current state of derivatives, from what they derive, what they leave behind--and what they create anew.

http://economist.com/business/displaystory.cfm?story_id=9033348
_________________
Today is the Tomorrow you worried about Yesterday!