New Gold ETF

The long anticipated launch of a U.S. gold-based Exchange Traded Fund finally happened in November, and quickly attracted over $1 billion in assets. Trading under the ticker GLD, and with an expense ratio of just 0.48%, the new ETF resembles similar offerings already available in the U.K. Australia and South Africa. The ETFs are designed to trade at a price equal to ten percent of the prevailing price for an ounce of gold. In addition, they are backed by an amount of physical gold equal to ten percent of the notional physical volume represented by the ETF. For example, if the total value of the ETFs outstanding represent 1,000 ounces of gold, the shares would be backed by 100 ounces of physical gold. Supporters of this new product claim that it is much cheaper to own gold this way, because you avoid many costs associated with storing and safeguarding the physical product (e.g. gold coins you directly purchase and hold in a bank safety deposit box). Detractors claim that because the ETFs are only fractionally backed by gold there is still a large difference between this new financial product and, for example, having a pile of gold coins in your safety deposit box.

We also have concerns about this new product, but they are of a different nature. First, as described in this month’s letter to the editor, there is a significant difference between the source of returns from owning a physical commodity versus owning a futures contract on that commodity. In our opinion, direct ownership of a physical commodity is a more speculative investment than a continuously rolled over futures position. In other words, as a financial investment, we’d be more comfortable with an ETF tied to the gold futures contract that trades on the New York Mercantile Exchange.

Our second concern is with the treatment of gold as a separate asset class. We have included it as part of the broader commodities asset class. Our reasoning is as follows. Between 1976 and 2000, the total return on gold, in U.S. dollars, had a very low correlation to the total return on other asset classes, including (as measured by the Goldman Sachs Commodities Index, in which gold has a very low weighting). The specific correlations were as follows: U.S. Investment Grade Bonds (-.01); U.S. High Yield Bonds (.03); U.S. Commercial Real Estate Investment Trusts (.05); Goldman Sachs Commodities Index (.25); U.S. Equities (.04); Foreign Equities (EAFE) (.22). These low correlations suggest that a strong argument can be made for gold as a separate asset class.

On the other hand, over the same period, the average annual return on gold was much lower, and the standard deviation of returns was much higher, than it was for these other asset classes. On balance, this more than offset the advantages of gold’s low correlations, and caused most asset allocation software programs (including ours) to reject an allocation to gold. However, this still leaves unanswered the question of whether there exists a set of circumstances under which an allocation to gold would make sense.

As we have written, we like to think of the economy as being in one of three states: normal (cyclically varying real growth with low to moderate inflation), high inflation, and deflation. Traditionally, people looked at gold as a hedge against inflation. However, in recent years the total returns on gold have not been closely correlated with inflation. Broadly speaking, this has weakened the argument for investing in gold, and led people to look to commodities (more broadly defined) and real return bonds as hedges against inflation risk. The remaining question is therefore how gold would perform under a period of extended deflation. The traditional asset of choice for hedging against this risk is investment grade bonds. Moreover, as a commodity, one would generally expect to see the price of gold (and the returns on holding it) decline during a period of deflation.

However, this argument neglects gold’s other historical role as a store of value and unit of exchange (note that this only applies to physical, monetary gold — i.e. coins). One could therefore envision a scenario in which prolonged deflation (and expectations of an eventual sharp reflation) led people to lose faith in the long-term value of a currency (and/or a domestic debt market). Under these circumstances, in its role as a monetary unit, gold’s attractiveness (and the returns earned by holding it) might sharply increase. Unfortunately, the world’s recent experience with deflation has, thankfully, been so limited that very little data is available to support or contradict this scenario. Given this, we will continue to view gold as a potential tilt within the larger commodities asset class, rather than a separate asset class in itself. Moreover, if one intends to take such a tilt, the most logical implementation strategies seem to be gold futures contracts or gold coins, rather than the current gold ETF.

ETF Tracking Error Problem Continues

One of the hazards of running an index fund is what is known as tracking error. This is the amount by which the performance of your fund deviates from the performance of the index it is supposed to track. In an ideal world, the only tracking error that exists would be caused by the fund’s expenses. We have noted in the past that other writers (e.g. Bill Bernstein from www.efficientfrontier.com) have criticized a number of Exchange Traded Funds for the size of their tracking errors, especially in comparison to index mutual funds based on the same index. We expressed our belief that the workings of the market (also known as the incentives to avoid mistakes and thereby keep your job) would shrink the size of these ETF tracking errors. Recently, an alert reader wrote to remind us that the market is apparently not functioning as efficiently as we had expected.

Specifically, the size of the tracking errors at the ETFs that track inflation protected U.S. Treasury Securities (ticker TIP) and the Lehman Brothers Aggregate U.S. Bond Market Index (AGG) have substantially underperformed similar index mutual funds offered by Vanguard. Specifically, for the period between 31Dec03 and 29Oct04, the total return (price change plus dividends) on TIP was (in USD) 4.0%, versus 6.6% on VIPSX. Similarly, the total return on AGG was 3.9%, compared to 4.4% on VBMFX. We admit that this surprised us. We will monitory this issue more closely in the future.

Retail Funds that Offer Hedge Fund-Like Strategies

A reader recently asked us to take a look at Hussman Funds. He wondered about the similarities of the Hussman Strategic Growth Fund (HSGFX) to the hedge fund strategies we had written about in the past. Was it similar, he asked, to an equity market neutral strategy? We promised to take a look and write about it when we did.

HSGFX is run by John Hussman, who received an economics PhD. From Standford, and who subsequently taught finance at the University of Michigan Business School. Moreover, Hussman’s disclosures of his fund’s fees and trading costs have been commendable, and haven’t exactly earned him the admiration of his peers in the fund management community. Hussman’s investment approach stresses the use of trailing peak earnings as his metric for judging current prices, rather than a traditional P/E approach. This is consistent with some interesting recent findings from cognitive psychology. There are two aspects of any piece of data you receive: the strength of the signal itself, and what it tells you about the state of the underlying system that generated it. Many investors tend to overweight the former, and underweight the latter. Apparently, Hussman’s active management strategy tries to systematically exploit this failing by shorting the market when it appears undervalued, while holding long positions in the stocks he likes. This is a classic market neutral, pure alpha hedge fund strategy. On the other hand, Hussman’s published materials also indicate that he seems willing to drop the market hedge when valuations appear favorable, in order to further boost his returns through a little market timing. The good news is that at an expense ratio of 1.25% and no sales load, he is charging a lot less than hedge funds do to implement this strategy. In short, it isn’t surprising that HSGFX has attracted over $1 billion of assets.

However, John Hussman still faces the fundamental active management challenge: how to maintain his forecasting success over time. As have repeatedly emphasized, this requires some combination of superior information and/or a superior model for deriving insights from it. Unfortunately, regulatory and technological changes have made information advantages much harder to sustain, while superior models all suffer from the same two failings: the tendency of changes in the real economy (a complex adaptive system) over time to invalidate the model’s assumptions, and the equally powerful tendency of competitors to discover (and act on) similar approaches (and compete away their potential benefits). In light of this, from our reading Hussman’s edge really comes down to a combination of the traditional (stock picking) and the non-traditional (market timing based on behavioral insights grounded — implicitly perhaps — in a clear understanding of cognitive psychology). The unanswerable question is how far into the future these will continue — and, unfortunately, research has shown that past performance is not a reliable guide to the answer to this question.

So, the bottom line is this: HSGFX does appear to employ investment strategies similar to those used by equity market neutral hedge funds, at a much more attractive price that is accessible to individual investors. In this respect it is similar to the PIMCO All Asset Fund (PASDX), which offers individual investors a strategy similar to that used by global macro style hedge funds. We have written in the past about how the equity market neutral and global macro hedge fund styles are the ones that best blend with the broad asset class allocations used in our portfolios. So, if an investor were seeking to mimic, at a reasonable cost, the institutional strategy of mixing index funds with hedge funds, one could do worse than to consider HSGFX and PASDX.

Economic Indicators Update

A reader recently wrote to ask us to update the indicators we presented in our September economic update. Here is our assessment of recent events: