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Hands off My Cash, Monty

Edward TalisseJuly 21, 2014

Always Read the Label

Index investing is all about capturing the market's beta (systematic risk) premium in a particular assetclass. Pioneered by legendary investor John C. Bogle, founder of the Vanguard Group, indexinvesting is a low cost replication strategy for those, like me, who generally believe that securityselection is a mug's game. Today there is no shortage of low fee Index ETFs and ETNs that matchthe overall performance of an asset class, with little or no tracking error. That's the good news. Thebad news is that many of the most popular index products, such as the Barclays Aggregate BondIndex, which is designed to track the performance of the US Investment Gradebond universe, involve

some fairly complicated index construction nuances. For example, as of QI 2014, Mortgage BackedSecurities (MBS) and other Asset Backed Securities (ABS) constituted close to 20% of theoutstanding U.S.Bond Market Debt (Source: SIFMA Research Statistics). So the Barclays Index will ofcourse mirror the composition of the overall debt markets and have an MBS/ABS weight of around20% too. For sure, most investment professionals know all about negativity convexity associated withMBS and other path dependent securities. If and when interest rates rise, MBS duration will actuallyextend - meaning their prices become more sensitive to rate changes. If you want exposure to aproduct that is negatively convex like MBS, then the Barclays Aggregate Bond Index is perfect. If youdon't, then you should look at a more targeted index product.

Here is another example. Many investors want exposure to commodity indices due to their perceivedcorrelation and inflation hedge benefits. According toetfdb.com,an online database of ETF factoids,the ETF DBCis the largest (as measured by asset size) Commodity Index Trading Fund. This ETF is

very liquid, and according to NASDAQ, it trades on average more than 2 million shares per day.However, on closer inspection, this particular ETF, which is advertised as representative of a broadbasket of commodities, is currently running more than 50% its exposure to one commodity - OIL anda full 20% of the fund is invested in US Treasury Bills. Now, there is absolutely nothing wrong withthat allocation - it may in fact turn out to be very fortuitous and is certainly within the manager'smandate. However, I bet that very few individual investors that hold DBC are aware that they arebasically long a combination of Oil futures and T-bills.

What about equities? The S&P 500 index is weighted by market capitalization. If you own the index,SPX via the popular ETF SPY, then you are by definition a momentum trader - your allocation to thewinners automatically goes up and your share of the losers goes down. Market capitalization indices,like SPY, are great when the market is trending strongly in one direction - you are always with themove so to speak. However, when the trend changes, you will be left holding an outsized portion ofthe biggest winners and you will be underweight the laggards.

Final example: Let's say you are like me and you own U.S. Treasury Inflation Protected Securities.What do you really own? Well you own a nominal claim on the U.S. Treasury for the initial principalplus you own a strip of cap and floor options on the Consumer Price Index (CPI). If the CPI setshigher, your cash flow improves and if it sets lower, well then you lose out. The point is that it isextremely difficult to price the strip of options, although there is certainly a surplus of sophisticatedmodels than can help. I find it surprising that U.S. and international accounting standards set by theFASB and IFRS, respectively, permit holders of these securities to value the notes using traditionalmethods such as mark to market or amortized cost. The embedded derivatives (options) should beextracted from the nominal claim and valued separately. As of June 2014, there is about one trilliondollars of US TIPS outstanding (source: Treasury Direct), which also means that there are a lot of 3embedded derivatives attached to these securities as well. Who knows what those derivatives arereally worth, say in a hyperinflationary or deflationary environment? CPI has been well behaved, at

least statistically for the past 15 years, so valuation has not been a problem. That may all change if

http://r20.rs6.net/tn.jsp?f=001xIjx96CUPcGA-y_kb4p1SyumUsB7ffIFfAqBZmpto4VhUK_UgqJ_odzSioJXnDjpl0Y-JhBamfn3P7wMYD_AldIfcZBLpkN-3QtLWLhb-z9OowI9CfI1SwZrbpT-GfGxtMoejc61aEo7liwZoaa_2l1LBqdMaSblqndKQ3OTo5xeN0hiF5OQQfloUkkSYuT5zEVCSmmHPBM=&c=ooeVFTt6H4jTqP8vHNnbm9N5XOnH_Wp9nb8Ji-Ac_hStC0jpojnMfw==&ch=CHElpzQIrizr5D1ADF6Sfng46C2oqWF2d5XgG81auUnH9GaWQUozog==http://r20.rs6.net/tn.jsp?f=001xIjx96CUPcGA-y_kb4p1SyumUsB7ffIFfAqBZmpto4VhUK_UgqJ_odzSioJXnDjpl0Y-JhBamfn3P7wMYD_AldIfcZBLpkN-3QtLWLhb-z9OowI9CfI1SwZrbpT-GfGxtMoejc61aEo7liwZoaa_2l1LBqdMaSblqndKQ3OTo5xeN0hiF5OQQfloUkkSYuT5zEVCSmmHPBM=&c=ooeVFTt6H4jTqP8vHNnbm9N5XOnH_Wp9nb8Ji-Ac_hStC0jpojnMfw==&ch=CHElpzQIrizr5D1ADF6Sfng46C2oqWF2d5XgG81auUnH9GaWQUozog==http://r20.rs6.net/tn.jsp?f=001xIjx96CUPcGA-y_kb4p1SyumUsB7ffIFfAqBZmpto4VhUK_UgqJ_odzSioJXnDjpl0Y-JhBamfn3P7wMYD_AldIfcZBLpkN-3QtLWLhb-z9OowI9CfI1SwZrbpT-GfGxtMoejc61aEo7liwZoaa_2l1LBqdMaSblqndKQ3OTo5xeN0hiF5OQQfloUkkSYuT5zEVCSmmHPBM=&c=ooeVFTt6H4jTqP8vHNnbm9N5XOnH_Wp9nb8Ji-Ac_hStC0jpojnMfw==&ch=CHElpzQIrizr5D1ADF6Sfng46C2oqWF2d5XgG81auUnH9GaWQUozog==http://r20.rs6.net/tn.jsp?f=001xIjx96CUPcGA-y_kb4p1SyumUsB7ffIFfAqBZmpto4VhUK_UgqJ_odzSioJXnDjpl0Y-JhBamfn3P7wMYD_AldIfcZBLpkN-3QtLWLhb-z9OowI9CfI1SwZrbpT-GfGxtMoejc61aEo7liwZoaa_2l1LBqdMaSblqndKQ3OTo5xeN0hiF5OQQfloUkkSYuT5zEVCSmmHPBM=&c=ooeVFTt6H4jTqP8vHNnbm9N5XOnH_Wp9nb8Ji-Ac_hStC0jpojnMfw==&ch=CHElpzQIrizr5D1ADF6Sfng46C2oqWF2d5XgG81auUnH9GaWQUozog==

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the CPI index ratchets higher or goes negative. That's when we will see the comeback of the bigGMO (GET ME OUT!) trade.

Remember Oscar begged to Felix to "take the money" when Monty Hall offered an exchange of theircash winnings of $800.00 (quite a lot for the early 1970s) for whatever was behind Door Number

Two. Of course, Felix went for the switch and The Odd Couple was left with a few cases of cannedsquid. Oscar was right, always take the cash...an investor you should never be surprised by what isbehind the curtain.

Edward Talisse is the founding partner and Managing Director of Chelsea Global Advisors, a consulting and

advisory firm providing specialist advice in the area of global capital markets.

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