That’s a broad title that can lead in so many directions.

The world today looks like we’re heading towards another two super-power situation.  Consider economic and political influence, voting on the UN security council, acquisition of oil, the space race, and even the medal count at the coming Olympics … there are a lot of themes that demonstrate the power of China, even relative to the US, and perhaps that’s one of several reasons why China is attracting plenty of foreign investment.

Before I get into a rant that leans in a fairly anti-US bias, I first want to preface this with the fact that I honestly believe that Zakaria’s comments on “the rise of the others” versus the decline of the US seems spot on.  The creativity and innovation of the US, and of course the developed world, will slowly have to compete with those from the emerging world.  But it will be some time coming in my opinion.  Since I focus on China in this post, I’ll give one example care of my cousin Grace who’s doing her grad work in that region.  So on her blog (runs in the family), she has a post showing this visual instruction for spectators to the upcoming Olympic games:

I should be like Jeff Matthews of famed “I Am Not Making This Up”. So Grace gives props to the BBC for sourcing this and here’s the accompanying text for the genius graphic:

Beijing Olympic chiefs are introducing an official cheer for patriotic spectators to spur on Team China at the Games, Chinese media reports.

The authoritative, four-part Olympic cheer, accompanied by detailed instructions, will be promoted on TV, in schools and with a poster campaign.

It involves clapping twice, giving the thumbs-up, clapping twice more and then punching the air with both arms.

The cheer is accompanied by chants of “Olympics”, “Let’s go” and “China”.

The Beijing Olympic Organising Committee has hired 30 cheering squads who will show spectators how it is done at Games stadia, reports Xinhua state media.

Say wha?  First, China is so NOT totalitarian since they won’t even have the masses practice before hand with drills.  Why not go full North Korean and have 25,000 people do that fully orchestrated “all in unison” song and dance that’s likely choreographed by the same person who gets 25,000 soldiers to march in unison each lifting their foot to the exact same height.  Scary in that “Brave New World” kind of way and all joking aside we can only hope some type of reform similar to what we’ve seen in China happens one day for North Korea.  Sadly there’s little to no chance they’ll do it on their own and given what’s happened to them over time (even before the Korean War) it will be a real challenge for them to move towards a world of partnership as opposed to isolated self-reliance.

But clearly, going back to the China graphic above, China still has a bit of North Korea old school in it and is still about hardcore conformity … it’s only a relative few who are taking hold of the new world and taking advantage of opportunities that result in tangible benefits for themselves.  It’s the creative/innovative class of the younger generation in the emerging world that will be the ones to watch.  Take a look at elite grad schools and note the demographics compared to ten and twenty years ago and you’ll get an idea of the growth of this new group.  Books are written about the billions in China and India and the demographic weight they impose is undeniable.  But it’s the future Gates, Jobs, Page/Brin to watch out for.

If the US is to really lose its place as the economic power, the rest of the world will have to compete in a manner where people try to copy their software, gadgets, and certain lifestyle attributes.  We’re nowhere close to a world where automakers try to copy the latest vehicles out of India.  They’re probably copying German not US auto designs but it’s still about the domination of the West.  How long will it be until China is designing the latest “iPhone of 2007″ Jesus Phone with the US leeching on with a fake?  I’m thinking not in my lifetime.  Maybe not.  Perhaps the blockbuster will be some YouTube, FaceBook, high intensity website that catches on fire like no other before it.

Well, long journeys begin with one step and clearly China is on an ambitious to its road to dominance.  They may not be the significant innovators until much later but in so many ways, they will be influential.  Of course, the trick for investors will be dealing with the bumps along the way and in today’s world the reality is that it’s all about a rather indirect manner to gain exposure into China.  For now, the easiest path is indirect investment via a closed end fund, mutual fund, ETF or hedge fund.

But I can’t help recalling one of many (MANY!) presentations on China I’ve attended in the past year where this gentleman (honestly, I can’t remember his name) was concerned about investing in the iShares FTSE/Xinhua China 25 Index ETF (FXI) since the underlying firms were controlled by a few people.  I’m paraphrasing but his point was clear and simple:  the Politburo controls virtually all the companies in this ETF.
Before the commentary, here’s a 1-year chart:

That’s about an 85% climb to nirvana over a two and a half month period last autumn.  Unfortunately, that’s about a 40% ulcer for the period thereafter that has dragged on for what must feel like years for anyone long FXI.  No wonder ProShares is having the time of their life with FXP and many of their other inverse ETFs.

So back to the Politburo which I still recall was the term used in the speech.  I’m no political scientist so I have no idea if the term applies for China as it did with the old USSR.  For now, I’ll assume that the situation described may still be true but given the latest helping hand from the Fed/Treasury Department/White House, you have to wonder.  The writers at Barron’s definitely have in this article with the sub-title “Socialism takes hold in US finance.  Get over it.”

We all know what’s happening and after Bear Stearns, this looks like chapter 2 of what could be a long story revolving around US policymakers adding band aid after band aid on a body that needs to bleed and perhaps follow up with a transfusion.  I thought I was decent in the art of metaphor but Randall Forsyth sets thing out clearly:

Even so, the descent down the slippery slope of socialization of the financial system is gathering speed.

“Capitalism without failure is like religion without sin,” Allan Meltzer, the distinguished economic theorist and historian once wrote.

Yet, like it or not, we don’t want to deal with such harsh verities, either in religion or the marketplace. Traditional churches are losing out to TV evangelists who promise material rewards now rather than later.

Forsyth concludes that we’ll see the pendulum swing back to increased regulation which shouldn’t be a surprise especially if the Democrats take over.

But the irony will be the trends taking place in both China and the US.   I seem to observe that they’re moving in opposite directions.  China is wanting to move into a dominant two-power global paradigm with the US as a capitalist powerhouse.  The US is on the defensive trying not to lose ground (influence).

It’s always funny when the US government comment on how bad the Chinese do things.  In the past, comments on the manner in which certain areas are treated or marginalized are retorted with Chinese counterarguments as to the manner native Americans or various other visible minorities are discriminated against.  It’s the same as the nitpicking both sides have with the other related to votes on the UN security council.

But today’s scenario is a juicy one for China.  The US government has often criticized the Chinese over various economic policies (currency, trade, commodity deals with foreign despots) and keeping a too-firm-hand on the wheel.  It’s almost too easy to respond with Bear Stearns, Fannie and Freddie.  It’s down right silly when Wall Street takes their show on the road to ask SWFs “Can you spare a billion?” and I wonder if they’ve come knocking on China Investment Corp?  Oh, wait a second … Morgan Stanley.  It’s so hard to keep track these days of all the SWFs and commentary regarding their dealings with Wall Street I-banks and the sense now is that the second wave of deals should be starting soon.

I leave you with this final chart showing the two most popular ETFs for the US and China since October 5, 2004 (inception date of FXI):

Quick note on FXI:  Don’t be fooled.  Of any asset category, it’s the China ETFs that differ from each other the most so selection criteria is critical in this niche area.

I state earlier that these two nations seem to be moving in opposite directions.  One is on the offensive while the other is on the defensive.  It’s a tough call to simplify things to the point of “buy FXI and short SPY” but in the longer term, how many investors are thinking about this?  From the SWFs point of view, it looks like it’s buy their buddies in the emerging markets but also buy the US … or at least financials at fire sale prices and with preferrential treatment in terms of yields.  The diversification story may be boring but owning some of both countries would make a ton of sense … the only difference among investors based on volatility and personal beliefs is what proportions.

A few quick points here:

1.  I’m not as excited as I once was to post something about me on TV or video.

2.  I could say it’s simply lost its appeal but frankly I feel like whatever I say is surely going to be irrelevant by the next day.

3.  If you’re reading this post and today’s date is past July 16th, 2008, the video I refer to below is no longer available for viewing.  Sucks to be you cause you would have made a mint no matter what I said in point 2 above.  I know you trade on what you just heard from the Boo-Yaa guy on CNBC.  You think I don’t know?  Joke stops here but when you consider the amount of trading software commercials on that channel, you have to stop and wonder.

So anyway I was invited to speak on BNN on Wednesday.  BNN’s our version of CNBC in the great white north and BNN stands for “Business News Network” … yeah … I know … “Business News Network” … classic.  Don’t know why but for some reason I didn’t think about posting it until now.  Well, to be perfectly honest, for anyone with even the most basic self-education on VIX, there will be little new in this clip (after the short ad, scroll forward to just past the 29 minute mark and I’m on for about 7 minutes).  So again, if you’re reading this post a few days after I’ve posted it, you’re really not missing much from the video.

Funny that BNN called me on Tuesday to talk about VIX but due to a busy schedule I couldn’t make it that day … luckily we were both good for the next day. Tuesday’s close for VIX was somewhere around 23, a low for the past few weeks.  And they wanted to know why it wasn’t up over 30 given the market declines in those same past few weeks.

Bottom line: Should VIX be somewhere closer to 30?  Probably.  But being down where it was on Tuesday/Wednesday and given how volatile VIX is (volatility of volatility?!), well geez Louise, where are we now?  Here’s the one week chart:

So VIX came pretty darn close to 30 and if it does in the next day or two, does that mean all’s well with the planet again?  Come on … rules of thumb rarely apply and if there’s one place they basically never apply, it’s in VIX land.  Positive or negative correlations (like the kind I mention in the clip) exist for many relationships but can’t be construed as solid rules of thumb that necessarily can be relied on with a great level of confidence.  If you want to trade on generalizations, that’s fine but when things don’t go as expected (i.e. when you switch from paper trading to real trading), investors shouldn’t be surprised when things go astray.  That’s the beauty of life and the real art and science of trial and error.

Makes me think about middle school algebra when we first were introduced to variables.  Like “VIP”, VIX should mean “Very Important X” or variable.  It’s important, VIX is, because it can give clues to other important things just like the unknown variable in high school math.  But it’s not much later in our young academic careers when we realize that sometimes we can’t solve for X.  I don’t know about you, but a lot of the math courses I took didn’t end with X=3.  It was more like an equation where X equals some formula.  And that was even before calculus and statistics.

Thus, you have to wonder if VIX as a trading instrument is something for the masses.  Perhaps it’s best to be used as a signal for trading SPY or its inverse ETFs (or S&P futures or some other derivation of this strategy).  Trading VIX, whether via existing options or futures, or perhaps one day by way of an ETF, could be an area of exploration for hedge funds, day traders and various short-term active managers.  But with all the rules of thumb I hear and [false] expectations that “VIX should be at whatever”, if it were really that easy, why don’t we have an actively managed fund (mutual fund or hedge fund) that focuses entirely on trading the VIX?  Maybe there is one and if so please let me know.  I’d be interested in seeing its performance record.

In May 2007 I put up two posts on this blog related to uranium.  The first was “Uranium Mania” which discussed the astronomical price chart for uranium prices.  One of the easiest ways to gain exposure to the commodity price, as opposed to the producers, is via Uranium Participation Corp (U).  Interesting how that post was written very close to the peak of uranium prices.

At that time, my thinking was that any exposure to uranium would best be accomplished with a combination of U plus Cameco.  Here’s the chart for Cameco over the past three years:

Very different performance patterns between the commodity and one of its major producers.  But it wasn’t until mid-August of last year that Van Eck came out with the first nuclear energy related ETF, the Market Vectors Nuclear Energy ETF (NLR).

For some reason, BGI with its newly listed iShares Global Nuclear Energy ETF (NUCL), must feel like being “second to market” ain’t half bad if the longer term outlook is strong.  I’m posting this blog after having seen this article in Canada’s Financial Post which gives some bullish views given the recently depressed price and a demand situation here in Ontario.  My interest is more related to significant energy policy shifts in the US (regardless of who wins the White House) and even more importantly, the choices made in the emerging world.  The developed world (well, mainly the US) complains about the relative lack of participation of the developing world in environmental policies such as Kyoto.  However, evidence from the annual reports of major uranium producers suggest that the market for them is the emerging world and that’s where they see the future growth.  Who would call that surprising?  Aside from foreign policy roadblocks for concerns that perceived unfriendly regimes would produce weapons grade materials, the necessity for the developing world to access nuclear energy is clear.  How can they compete with the US, China and larger (& more powerful) nations for oil?  I think they need alternative energy sources even more than the big guys.  I’m still a longer term bull for uranium.  The question is whether the exposure should be to uranium prices, the producers or a combination.

Well, aside from Uranium Participation Corp traded in Toronto, there are also uranium futures traded on the NYMEX.  The futures contracted started trading about the same time as my blog from May 2007 … as usual product development seems to be a decent market top provider.  And yes, it’s cash settled … no jokes about delivering 250 pounds of uranium.  That’s about it.  I’m kind of surprised that firms like ETF Securities in London or PowerShares (with their association to Deutsche Bank) haven’t created a uranium price tracker given their expertise in ETFs with futures based underlyings.  It’s just a matter of time.  I’m thinking that it would be nice to have this now and NOT near the next intermediate term top.

To go after the producers, like I said before, we now have two ETFs.  From a year ago, my simplified approach was to put it all in Cameco but for the passive fan, the ETFs would be the way to go.  Since NUCL only came out only about two weeks ago, we can’t do much comparison shopping.

Both have global exposures.  The newer NUCL is about 20bps cheaper in fees but with less holdings at 25 versus 38 for NLR.  The list of holdings for NUCL and NLR show some clear differences in the top 10’s in each as well as proportional weightings.  But what seals the deal for NLR over NUCL is the sector allocations.  Take note that for NLR, the breakdown of the top three sectors is 31% nuclear generation, 29.5% plant infrastructure, 28.8% uranium mining, with the remainder in uranium storage, nuclear conglomerates, uranium enrichment and nuclear fuel transport.  NUCL’s top exposure is in utilities (54.2%).  Their remaining catergory names are relatively generic like “energy”, “industrials” and “financials” (in that order, actually) and so part of their flaw is not doing a better job educating investors on the real uranium sub-sector breakdowns.  Hey, isn’t BGI the experts in ETF education?  You know I just like pickin’ on the big guy.

So, bottom line, this might be a decent time to get in to nuclear/uranium as an alternative energy and emerging market play.  The holdings list does not give enough information on its own so a bit of homework is required to see how much of each name is actually going out to places where energy infrastructure for the longer term is a concern.  Because the uranium producer space is limited to a few big names and many microcaps, it’s a tough call.  Pick a few of the big producers and you’ll do fine but if you’re from the industry or are a commodity freak, hopefully you’ve got some talent in picking the future successful producer (who will likely get acquired by one of the big guys).  Since that’s a tough sport, I think the focus should be on the uranium price for the longer term.  With limited instruments available, the challenge now is to decide between Uranium Participation Corp and uranium futures.  Until, that is, an ETF or ETN for this commodity gets launched.

The EDHEC Business School in Nice, France and its EDHEC Risk and Asset Management Research Centre produce a lot of great material on their site with free access to all.  The research centre’s focus on asset management hits me the right way with writing grouped into areas such as “Indexes”, “Alternative Investments” and “Asset Allocation” to name a few.

Via an EDHEC-Risk email, I received a complimentary copy of Investment Management Review and found an interesting article on beta.  After receiving permission I now provide the text in its entirety.  No comments from me … just the content as it is.

Ok, just one comment.  Note Anson’s introduction of a continuum from classic beta to pure alpha.  Very similar to my alpha/beta spectrum but with well defined zones along the line.  I can spend a lot of time thinking about this and how it will apply to future product/service offerings in the changing investment industry.

BETA CONFUSION

 

Editor’s introduction

 

What does ‘beta’ stand for? The terms ‘alpha’ and ‘beta’, once the province of academics, quants and risk managers, are now familiar to every professional in fund management. Unfortunately, they do not mean the same thing to everybody and there is considerable looseness in the current jargon. ‘Beta’ as it was in the old-fashioned sense represented the bet one took against a market, a beta of more than and less than 1 meaning riskier or safer than the market respectively (see ‘What is beta?’ box).

 

 

A current widespread interpretation of beta is different. In the simplest sense, it is used as the proxy for matching the market risk and, in a wider sense, it is used to represent all sorts of risks which can be easily replicated, perhaps with a computer.

 

The two papers below highlight the different ways, the old and the new, in which the word ‘beta’ is interpreted. Markowitz’s conclusion in the first paper rests on the old idea of beta (see above box)

 

Anson’s paper for the most part implicitly refers to the newer idea.

 

As widely referred to now, beta is no longer a number as it used to be, defining leveraging or de-leveraging relative to the index. It is now a concept reflecting the matching of the market performance, as opposed to alpha, representing the excess return. Undoubtedly, many still adhere to the previously prevalent rigour, including academics and quants, but the newer use of beta conflicting with the old is now widespread throughout the industry and among commentators.

 

 

 

 

Markowitz back on the warpath

 

‘CAPM investors do not get paid for bearing risk: a linear relation does not imply payment for risk’, Harry M. Markowitz, The Journal of Portfolio Management, Winter 2008, p91

‘Markowitz attacks beta’, Investment Management Review, Winter 2005/06, p46

 

Prof. Harry Markowitz, the founder of modern portfolio theory, has returned to attacking the use of the capital asset pricing model (CAPM).

 

In the above paper, Markowitz focuses on the outperformance by a security over its benchmark going up and down proportionately with its beta. He attacks the fact that the proportionality between the excess return and beta is wrongly interpreted as investors being paid for bearing systematic risk.

 

He uses high-level mathematics in showing that this is not so, because two securities with two identical risk structures in terms of the way they are correlated with other securities in the market place can have different excess returns.

 

Different types of beta

 

‘The beta continuum: from classic beta to bulk beta’, Mark Anson, The Journal of Portfolio Management, Winter 2008, p53

 

Mark Anson provides some insights into the different ways the term ‘beta’ is referred to by investment practitioners, which as mentioned above is different from the sense in which it was formulated in the capital asset pricing model.

 

He starts by defining beta as the efficient capture of risk exposures tied to broad asset classes such as equity markets, bonds and commodities. Beta should be acquired cheaply, because active asset management is not necessary for exposure to an entire asset class. For instance, equity market exposure can be achieved by investing passively in an index. Beta represents passive management and alpha refers to active portfolio management. Along with many others, Anson refers to the excess return as alpha, though, as the box above shows, beta also can be a source of excess return in the old-fashioned meaning of the word.

 

Anson argues otherwise. But he does not revert to the old meaning of beta. He disputes the notion of a sharp demarcation between alpha and beta, and argues that in fact that there is a continuum from classic beta at one end to pure alpha at the other, with various types of beta in between.

 

In elaborating, he outlines the following different types of beta.

 

1. Classic beta – This is related to the ‘beta’ as referred to in past decades, though now corrupted to mean precisely matching the market. In the new parlance the word beta is equivalent to a beta of 1 under the older definition. It effectively means just matching the market, whether the market is the US stock market, the UK FTSE 100 or the global MSCI-EAFA. Standard index funds come under this category.    

 

2. Bespoke beta – This refers to the same as 1 above except that the index no longer represents the broad market but particular sectors or other asset classes. For instance, the banking sector or a basket of commodities.

 

3. Alternative beta – Anson describes this by example. The rationale is that there are systematic risk exposures which were previously not available to investors but which can be now accessed through ETFs. As an example, he cites a currency ETF linked to the price of the euro in terms of the dollar.

 

4. Fundamental beta – There is now a raging debate as to whether indices constructed by weighting the constituent stocks by market capitalisation are the best proxies for the market. A strongly supported school has sprung up which claims that fundamental indices, in which the constituents are weighted by fundamental factors such as revenue or dividends, are much better. Anson refers to matching these fundamental indices as fundamental beta.

 

5. Cheap beta – This refers to a situation where beta cannot be produced by investing in an index or ETF, but where beta is embedded in a complex basket of risks within one security. An example is a convertible bond. This has the following elements of risk embedded in it: interest rate risk, stock market risk, credit risk, and volatility risk. Players in convertible bonds are effectively getting indirect exposure to all these different betas. Interestingly, here Anson thinks of beta as numbers rather than as the concept of matching the market.

 

6. Active beta – Here Anson refers to long-short funds such as 130/30, where the overall exposure of the portfolio matches the market but additionally there is 30% additional long exposure in favour of stocks, counterbalanced by short exposures in unattractive stocks.

 

7. Bulk beta – This refers to traditional equity portfolio management of the standard type, where portfolios consist of a large element of beta, i.e. market exposure, as well as the ability to generate alpha through stock selection.  

 

Editor’s comments

 

This is not the first time that Markowitz has gone for the CAPM and the use of beta. In late 2005, he attacked the concept of beta and the CAPM as not relevant to the real world, though he did describe the CAPM as a thing of beauty. In particular, he criticised beta being used for risk-adjusted performance (see Investment Management Review, vol.1, issue 4, p46).

 

What is particularly fascinating is that, when Sharpe was awarded the Nobel Prize for Economics for his CAPM, in 1990, Markowitz received the same accolade alongside him for his seminal work in the early 1950s. Markowitz’s seminal research was not regarded as very practical at that time, given the lack of computer power. It was the simplification introduced through Sharpe’s model that allowed modern portfolio theory to take off. It is ironic that it is now Sharpe’s model that is more suspect, whereas Markowitz’s techniques of correlation have more widespread uses across other asset classes, because of advances in computing.

 

On a different note, having done his path-breaking work in the early 1950s, Harry Markowitz cannot exactly be described as young today. What this paper perhaps demonstrates is that his intellectual vigour remains intact, which must be encouraging to baby boomers who want to carry on being productive.

 

Anson has embarked on an unenviable task of trying to introduce order and clarity into the use of the word ‘beta’, which has been highly corrupted since its inception during the 1960s.

 

There are some logical deficiencies in Anson’s classification. His classic beta (1), bespoke beta (2) and fundamental beta (4) are all essentially the same type of beta, but with the market defined differently. There is no conceptual difference, whether one talks about the global Morgan Stanley index, the national S&P, the sector-based banking index, or the fundamental index. It is the same type of beta, with just the index being defined differently.

 

With his ‘alternative beta’ (3), calling a euro-versus-dollar currency bet a beta is stretching the applicability of the concept too far. It is open to even the poorest individual to go into a bank and buy a fistful of foreign currencies. Of course the spreads he has to pay might be different, but it is difficult to justify the use of the word ‘beta’ merely because there is an ETF alternative.

 

Overall, Anson plays a useful role in highlighting the looseness of the term. Previously, beta has been also defined as any process or investment that can be easily replicated.

 

There is possible reason why this looseness in the use of the word beta might have arisen. A beta of 1 is easy to understand and accept as matching the market index, whatever that is.

 

When, however, beta values significantly differ from 1, their validity and reliability have always been regarded with considerable scepticism by many investment practitioners, even those well versed in the theory. Equally it is difficult to explain the concept to many non-technically minded players. Many academics, including even Markowitz, as referred to above, have joined the band of disbelievers in beta in the CAPM sense.

 

Against this background, perhaps it is understandable why so much looseness surrounds the idea, and why many people when referring to beta merely think of beta having the value of 1 in terms of the theory.

 

This is not just an academic debate. It is now common for asset allocators to talk about splitting their fund into two separate portfolios of alphas and betas. Industry-wide uniformity in the use of the word ‘beta’ would be welcome, though perhaps not achievable. Anson has contributed strongly to this topic, the deficiencies of his classification notwithstanding.