Investors mull alternatives to cap-weighted index

 Original article published in Arab Times

Index strategies that deliver passive market exposure — or beta — have long attracted investor interest. But the bursting of the tech bubble in 2000 and the more recent global financial crisis have helped galvanise investors into exploring alternatives to the traditional approach of weighting indices by market capitalization. However, the same is yet to catch up in the GCC for two important reasons. Due to market inefficiency, generating alpha is still easy and possible. Empirical research suggests that GCC fund managers are reasonably efficient in generating alpha though not consistently. The second and perhaps the most important reason for the lack of passive investment vehicles is the relative lack of institutional investment. Institutional investors are generally strong users of such products (including hedge funds). Gulf based institutional investors are either mandated not to invest in local markets (like Sovereign wealth funds) or regulatorily prohibited from taking large positions in stock markets (like banks). With gradual easing of these limitations, GCC offers immense potential and therefore scope for index based investment products. Following an earlier article in the Financial Times (FTfm supplement) Raghu Mandagolathur, president of CFA Kuwait and Samuel Lum, Director of Private Wealth and Capital Markets at CFA Institute provide an overview of recent innovations in indexing.

How has beta investing evolved over the years?

Beta investing generally involves passively capturing exposure to the market by replicating an index. This style of investing, first pioneered in the early 1970s following the development of the Capital Asset Pricing Model and the Efficient Market Hypothesis, typically requires minimal application of manager skills and is not capital or labour-intensive. These characteristics result in much lower fees compared to active management. As measuring manager performance against a market benchmark became standard practice, and investors increasingly came to recognize the challenges of picking active managers who are consistently skilful or lucky enough to outperform over the long term, beta investing gradually gained ground, bolstered by lower due diligence costs and lower manager capacity constraints. Today many investors apply a beta investing approach to their core portfolios, which they may complement with smaller allocations to satellite portfolios overseen by active managers. The expanding range of vehicles commonly used to capture beta exposure includes mutual funds, exchange-traded funds, futures, total-return swaps, and separately-managed portfolios.

Why have most beta investing mandates and index funds traditionally been based on capitalization-weighted indices?

A cap-weighted index (or its free-float-adjusted refinement) is generally considered to be the best representation of the “opportunity set” available to investors in an underlying market, and is, in effect, the portfolio which all investors in aggregate can own simultaneously. From a practical perspective, cap-weighted indices such as the FTSE 100, the TOPIX, and the S&P 500 also provide the benefit of substantial investment capacity and are highly tax efficient because little rebalancing is required. For these reasons, many investors are of the view that beta investing should by definition involve indices that are cap-weighted.

What are the problems with cap-weighting?

Beginning in the early 1990s, academic studies have shown that cap-weighted equity indices may be substantially less risk-return efficient. Cap-weighted indices also tend to be concentrated in large-cap stocks. As a highly favoured stock grows in market capitalisation relative to less favoured stocks, it increasingly occupies a disproportionately large share of the index. When stock prices move into bubble territory, therefore, investors in cap-weighted indices will hold proportionally more momentum stocks—that is, stocks that have the highest gains and are likely more overvalued—only to suffer added misery when the crash comes.

Cap-weighted bond indices can also be problematic. A sovereign bond index, for example, may have a disproportionately high weighting in bonds of a heavily indebted (and thus riskier) country simply because that country’s government has issued more debt relative to peers with healthy balance sheets.  To illustrate, prior to the European debt crisis, Greece would have had about three times the weighting of Australia in a global developed markets sovereign bond index because it had three times more debt outstanding; yet its GDP was only a third of Australia’s. Many investors would have been rightly concerned about the relatively high weighting of Greek bonds in the index portfolio, especially given that Greek bond yields had stayed relatively low compared to Australia bond yields for many years prior to the crisis.

What alternatives to cap-weighting have been explored by investors?

Researchers, index providers, and asset managers have proposed or implemented a number of alternative weighting schemes, including equal-weighting, enhanced-cap-weighting, and weighting based on fundamental economic attributes such as GDP or sales. Weighting schemes designed to minimize volatility or to manage risk have also been tested. These approaches are often called ‘enhanced index’ or ‘smart beta’ products. Still, some are of the view that these are best described as active management strategies with typically higher fee structures and lower investment capacity than cap-weighted index strategies.  Some of these alternative approaches require relatively high rebalancing turnover, and any moves by the managers to minimize transaction costs may need to be weighed against the reduced ability to precisely track the index.  

What other approaches to beta investing are attracting attention?

‘Exotic beta’ strategies seek passive exposure to commodities, collectibles, default risk, catastrophic insurance or other non-traditional asset classes.   Investors need to evaluate whether they are being adequately rewarded with a risk premium for the volatility, downside ‘fat tail’ exposure, or the liquidity they are providing to hedgers. Another approach, ‘active beta’ investing, is based on research showing that stocks with ‘value’ and ‘momentum’ attributes outperform over long periods. While these anomalies can be exploited in a systematic and transparent manner, and with relatively low fees compared to active management, it is not clear that they will persist across significantly different market environments in the future.

How safe are we in the UAE from another global recession?-MR comments

Gulf may witness collateral damage in terms of lower oil prices, say experts

By

• Shuchita Kapur

Published Wednesday, October 05, 2011

Global recession is more likely today than an extended period of sluggish growth and high unemployment rates, Bill Gross, founder of Pimco, the world’s largest bond fund, wrote yesterday in his comments sent to 'Emirates24|7'.
Since 2009, Gross has said the US and other developed economies were entering a period of what he terms “new normal,” a period marked by lackluster economic performance but still one of growth. Now, he says things might have taken a turn for the worse but assures that we’re still not past the point of no-return. “…[S]overeign balance sheets resemble an overweight diabetic on the verge of a heart attack. Still, if global policymakers could focus on structural as opposed to cyclical financial solutions, New Normal growth as opposed to recession might be possible,” Gross wrote in his monthly investment outlook.
The UAE may not (yet) be faced with the prospects of a second recession, but most residents in the country seem unsure about their future prospects given the turmoil in the Eurozone and the crises that a Greek default can trigger. Many believe that property demand may dampen further and their jobs may not be safe again. Two in five (44 per cent) employees working in the UAE fear losing their job with increased stress levels as a result of the economic downturn, according to a poll run by this website, indicating that consumer confidence may be dwindling.
However, economists and experts believe that the situation in the region may not be a repeat of what we’ve seen in 2008.
Recently, Sheikh Ahmed bin Saeed Al Maktoum, Chairman of Dubai’s Supreme Fiscal Committee, said local banks have sufficient liquidity to weather a global downturn. “[Local banks] have lots of cash and lots of liquidity as well,” Sheikh Ahmed told reporters on Monday. “We’re not directly affected [by Europe] but I'm sure some [foreign] banks which are here could have certain issues. But the world will never be with no crisis,” he was quoted as saying.
“Another recession has not begun yet. But there is a fear that there is one round the corner,” MR Raghu, Senior Vice-President-Research at Kuwait Financial Centre (Markaz) told this website. “There is no doubt that the global economy is already slowing down, but the degree of the slowdown will depend on how events come to unfold in the Eurozone,” said Giyas Gokkent, Group Chief Economist at National Bank of Abu Dhabi (NBAD).
“The Gulf is well positioned to meet challenges in the sense that bank capital buffers are very high and fundamentals of the sovereigns are quite strong. There has already been significant price adjustment in the real estate sector. Citing the reasons behind his outlook, he added: “We do not currently have contraction in regional economic activity in our basecase forecasts, but this is reviewed monthly depending on the oil price outlook in particular. The long term outlook for commodities is positive. The pattern for slowdowns tends to be a dip and subsequent bounce as a result of a number of factors such as built-in automatic stabilizers in the global economy such as a reduced burden of taxation and energy price movements.
“I do not see a 1930s style depression at this time because widespread bank failures, closures, and money/deposit destruction would have to occur for that type of scenario. Central Banks and governments will do everything in their power to avert a systemic banking sector failure.”
But there are many ways in which the troubles in the West can affect us. According to Gokkent, “there are multiple channels through which GCC economies could be affected.”
“One direct linkage is through the price of oil. Dubai spot is now at $97.9 per barrel, significantly off from its highs earlier in the year. Lower oil prices impact trade and fiscal balances adversely in the region. While the current level for the price of oil is still fine for regional economies, the fiscal breakeven oil price is higher across the region. For example, IMF estimate for fiscal breakeven in Saudi Arabia in 2011 is $80 per barrel. In the event that oil prices soften sharply, then OPEC would presumably cut production to support prices; i.e; a double impact with lower oil price and lower output.
“The financial sector is another channel through which there would be an impact. Banking sector liquidity would tighten with repercussions on economic activity; cost and availability of credit would be affected.
“Declines in asset prices would create a negative wealth effect discouraging expenditures by households. Uncertainty about the job market would further weigh on household expenditure. Firms would rein in expansion plans given uncertain demand growth. Overall economic activity would therefore suffer,” he explained.
Last is the exchange rate which could impact the economy in the region. “Exchange rate is another channel through which there would be an impact. Dollar strength appears to go hand in hand with rising global risk aversion. A stronger dollar is negative for commodity prices and this is one element explaining a lower oil price. A stronger dollar, and therefore local currencies, is generally negative for non-oil economic activity,” added the NBAD economist.
Raghu believes that even though we may not be in a recession but globally the revision of growth numbers is a worrying factor. “The recent World Economic Outlook report by IMF expects global growth to moderate to about 4 per cent through 2012, from over 5 per cent in 2010. Real GDP in the advanced economies is projected to expand by about 1.9 per cent in 2012 and emerging markets to grow by 6 per cent in 2012. Hence, technically we are not seeing another recession yet,” he stressed.
“However, what should be noted here is the sharp revisions to the growth numbers by IMF in a space of three months. Within three months, the growth outlook for US has come down by 1 per cent. The main problem is the lack of private demand due to tight bank lending, a phenomenon that we can easily notice even in GCC,” he added.
According to him the problem lies in the two biggest economies of the world. “Recovery will not happen unless two important things happen. The locomotive of world economy, i.e., US should learn to depend less on domestic consumption as a single most important factor for growth and depend more on exports backed by increasing productivity. On the other hand the lion of all emerging markets, i.e., China should learn to depend less on exports and take measures to grow by stimulating domestic demand. And both are very much possible. If the US and China adopts this course, they can easily remove the imbalance that is log jamming the growth today.
“Recessions are part of business cycles and hence they need not be feared. But the governments should anticipate them wisely and provide policy measures that can reduce the pain. The collateral damage to the Gulf will be via lower oil prices. Job losses may not be a big issue here,” he added.
In the run-up, though, we have seen gold prices plummet 15 per cent last month as confused investors look for safe havens to preserve their wealth in these troubled times. “The trouble is that, as investors search for safe havens, no one is immune,” said Gerard Lyons, Chief Economist and Group Head of Global Research at Standard Chartered Bank.
“In an era of globalisation, problems in one part of the world soon spread elsewhere. Before the crisis in 2007, Asia and other regions such as Latin America and the Middle East were not decoupled from events in the West, but they were better insulated. This allowed them to rebound strongly, helped by high reserves and sound fiscal positions. Now, they are still not decoupled from the crisis hitting the West, but they are more diversified and better able to cope,” he said.http://www.emirates247.com/news/emirates/how-safe-are-we-in-the-uae-from-another-global-recession-2011-10-05-1.421975

Weighty Matters

Self- flagellation is something I indulge heavily in and though I have a great many grouses, one that unfailingly perseveres to break my heart and shatter it into a million pieces, is my weight.

Yeah suuure, I’ve heard all the lines –”it’s the inner beauty that counts” and “you are beautiful as long as you feel beautiful” and all that crap.  Whoever said that, I’d like to see.

But really, it should be the other way round. You feel beautiful when you look beautiful!

I think my weight is the bane of my existence. I am a first born and my mother’s relatives all told her to eat as much as she could so that the baby would be “healthy”. Oh, how I hate that word with a vehemence that even baffles me sometimes! Anyway, the doctor proclaimed the baby to be “very” healthy and such was she to remain always K My mother probably learnt her lesson the first time because a year and a half later, my brother was born and weighed less than a turkey towel, is what they all said.

Getting back to why my weight bothers me so much, I have a whole list that could and probably will fill a book.

 Well,I hate having to go to a shop and look for  the larger size. I hate not able to buy clothes because they don’t fit me well. I hate having to put down a gorgeous dress because it makes me look huge in all the wrong places. I hate….well, I hate a lot of things about being fat but let’s devote an entire entry to that later,shall we?

I mean, I bet if I became heavily pregnant now, nobody would even be able to tell the difference K

On an extremely dysfunctional level,I tend to associate weight with self-confidence. People who are thin and have spidery long legs, can saunter into a room and own it. They don’t need to worry about tucking away any excessive flab while walking around and even if they threw their weight around, nobody would notice( obviously because they’re so thin.Still.).

But I’m not that far gone that I’d actually get a doctor cut some of my “flabby fat” away( what, do I look like pork to you-cut and chopped into perfect pieces?)

But the silver lining, if any, to being fat is the insane number of “ Yo Mamma” fat jokes you can crack without looking like a skinny weirdo that’s had too much to drink!

My favourite ones are- “ Yo Mamma so fat she jumped in the air and got stuck”’

                                     “Yo Mamma so fat she’s on BOTH sides of the family”

                                     “Yo Mamma so fat she fell in love and broke it”..etc

Point is, they are hilarious and actually help you laugh at yourself.

I have these bouts of introspection and on one such day, I realized how shallow my perspective was and how being “chubby” didn’t have to mean being ‘ugly’ and you didn’t have to be self-conscious and constantly keep wondering what people are saying about your weight.

Just being comfortable in your own skin will automatically translate into an increase in your self –confidence and it’s only when you love yourself that others will love you.

Because, “it’s the inner beauty that counts and you are beautiful as long as you feel beautiful and all that crap”.

Oh, who am I kidding?!

Shruthi Lr

The Value of Human Capital

Raghu Mandagolathur, President of CFA Kuwait together with Robert R. Johnson, senior managing director, and Stephen M. Horan, head of professional education content, at CFA Institute review the value of Human capital in the Middle East market.
Diversification is one of the most basic principles of investing. Our common understanding of it, however, typically overlooks an investors' largest asset – the value derived from one's profession, commonly known as "human capital".
Economists define human capital as the actuarial present value of our earnings or wages over a lifetime. For most individual investors, human capital dwarfs financial capital. In the United States, for example, it represents 90% of total assets (including home equity and private businesses) for investors under 30 years of age (see Figure 1). As an investor’s career progresses, human capital transforms into financial capital through savings. Even for investors in their 50s, human capital still oftentimes represents at least half of total wealth.

Figure 1: Magnitude of Human Capital

Source: Kyrychenko, Vladyslav, 2008, “Optimal Asset Allocation in the Presence of Nonfinancial Assets”. Financial Services Review, vol. 17, no.1 (Spring): 69-86.

Because the importance of human capital increases with schooling, per capita GDP, and life spans, countries with high human development in these areas have relatively large reserves of human capital. In the Middle East, for example, countries like the United Arab Emirates, Qatar, Bahrain, and Kuwait have a higher population-weighted average human development index than Europe, according to the United Nation’s 2010 Human Development Report. They rank particularly high in educational development (e.g., adult literacy, years of schooling), which has expanded more quickly in the Middle East than in Europe.
Human capital is fundamentally different from financial capital. For one thing, it is not easily converted to cash. One cannot immediately sell these cash flows in the marketplace. They must be realized over time. Second, earnings derived from one’s employment prospects or entrepreneurial endeavors are often tied to the fortunes of a particular sector or industry, which creates a concentrated comprehensive portfolio that is not always easily diversified.
The Nature of Human Capital
Estimating the magnitude of an individual’s human capital requires identifying the cash flows derived from one’s profession and estimating a growth rate. It also requires one to determine whether the volatility of those cash flows is more bond-like or more stock-like. For a tenured university professor, human capital is more bond-like. For an investment banker, it is more like a volatile stock.
To understand its influence on portfolio management, we also need to understand how our human capital is correlated with the overall market. The investment banker’s human capital, for example, is likely to be impaired at exactly the same time that market values of other assets decline. A high correlation with the overall market provides little diversification risk-reducing benefit for the larger comprehensive portfolio.
An industry-specific or firm-specific skills set is also riskier than a transferrable one. An investment banker, for example, may have more difficulty replacing his income stream in an industry downturn than a human-resources professional who can transcend industry or sector boundaries.
Finally, the ease or flexibility with which one can leave and re-enter the work force is important. Human capital is relatively less valuable if external factors, such as political instability, health concerns, market performance, or employer whims determine retirement timing.

Implications for Portfolio Management
Perhaps the most obvious and profound portfolio management insight is that a portfolio that appears diversified in relation to one’s financial assets may be highly concentrated in the context of one’s life balance sheet, which incorporates human capital. Suppose, for example, the income and employment prospects of the young executive are derived from petrochemical manufacturing in Saudi Arabia. The value of that net employment capital depends heavily on the state of the price of petroleum products. A traditionally diversified or indexed “market” portfolio that includes additional exposure to oil-sensitive stocks exacerbates this already-concentrated position.

Figure 2: Hypothetical Example of a Young Executive’s Life Balance Sheet

Executives of Saudi Arabian petrochemical manufacturers might ameliorate this situation by excluding petroleum–sensitive assets from their portfolios or over-weight assets that are uncorrelated or negatively correlated with petroleum prices. Investors who are particularly concerned about their human capital risks might even use sector or industry ETFs to hedge their human capital. By shorting an ETF that tracks returns to companies in the industry in which they work or investing in an inverse ETF that tracks the same industry, investors can hedge some or all of their human capital exposure.

Conclusion
By their very nature, Middle Eastern corporate executives have concentrated positions in the companies they manage. By recognizing that a large part of their “portfolio” is human capital, they can identify, diversify, and even hedge some of these risks. Analyzing this broader portfolio is likely to suggest that a domestically or even an internationally indexed portfolio will not provide maximum diversification benefits. Rather, a diversified portfolio is unique to each individual.

Click here to read the article as published in Arab Times

Gold prices set to hit $2,500/oz as buying season kicks in

Beginning with Eid, gold buying to heat up with Indian wedding season, Diwali, Christmas and Chinese New Year

The price of gold, the ‘safe haven’ commodity, is expected to continue its new rally in the forthcoming months as the gold buying season kicked in on Tuesday with the first day of Eid – a traditionally strong period of gold sale in the Middle East.
Closing at $1,791 per ounce on Monday, the first day of Eid saw gold price jumping more than 2 per cent, or $38, to $1,827on Tuesday, followed by another rise on Wdnesday, and was trading at $1,837/oz at 12 noon UAE time. Spot gold held steady on Thursday with little change at $1,824.39 an ounce.

This rise is despite a massive increase in margin requirements to trade gold announced last week by the CME Group Inc., the parent company of the main metals and energy exchanges in the US. It raised the amount of money needed to trade gold contracts by 27 per cent to $9,450 per100-ounce contract.

Experts believe that this latest rally will defy the hike in margin requirements and propel gold prices beyond the$2,000-mark in the coming months. In fact, some experts are calling for double of that level.

According to Steen Jakobsen, Chief Economist from Saxo Bank, gold still has a long run ahead. “Looking at how precious metals will react to a new QE (quantitative easing), the answer is simple. I think we will see $3,000 if not $4,000 for gold, and other metals should follow suit.”

Gold’s latest upward journey has already begun with Eid, and gold buffs maintain that it will continue until the Chinese New Year with significant gold buying happening during Diwali, Christmas, and the Indian wedding season.

However, downward risks remain, say experts. “As with the dollar, if this is the ‘end game’ then the spike will be followed by risk-aversion which could overall curtail the highs. At all times, one has to realise this is close to the end of the trend, and for every $100gold rises, the risk increases disproportionately as there is more and more speculative hangover involved,” added Jakobsen.

M.R. Raghu, Senior Vice-President-Research at Kuwait Financial Centre (Markaz), believes that some moderation is likely. “Gold has performed 33 per cent for the year out of which 13 per cent was post the US downgrade (August 5). Obviously, the run up is too fast and hence some moderation is bound to happen at this level,” he told Emirates 24/7.

“For investors that entered the party early on, it may be a good idea to cash out partly at these levels. From here, the price may correct, say 5 to 10 per cent, before resuming another go. Hence, I would not advise investors a total exit from gold since the macro picture is negative, which is kind of positive for gold at least for some time to come. It may find it difficult to hit $2,000 [per ounce], but once it does, you can see more buying coming in,” he said.

Advocates of gold affirm that gold remains the world’s go-to currency. Commodities analysts at Standard Bank said recently that after touching record levels, gold came off its highs a few days back, as risk aversion subsided. “Equities across the globe rebounded as investors shrugged off the pessimism of the past few days and moved into riskier assets, amid growing concern that the bullion rally was overdone and hopes of further Fed monetary stimulus. However, this was short-lived, as risk aversion was soon apparent, as Asian markets opened. Moody’s downgrade of Japan’s sovereign credit rating reignited concerns over the developed world’s fiscal problems, sending Asian equities into the red, to the benefit of safe-haven precious metals,” said a recent report released by the bank.

“[A] drop in prices has attracted an element of bargain hunting, which should provide support across the precious metals complex in today’s trade. However, with European stocks currently trading up it appears as if risk appetite is not completely absent, which could limit the upside for precious metals,” it added.
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