betainvestmentreport_jan10

8/6/2019 BetaInvestmentReport_Jan10

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The Index Investing, Asset Allocation & Market Analysis

ETAINVESTMENT REPORT January 2010 BetaInvestment.com V

A Year for the History Books

t was a very good year. Too good, perhaps. Ascalendar years go, 2009 was spectacular. But

markets are cyclical and extremes dont usuallyrepeat, at least not quickly, in the same direction.All the more so given the economic context of late.

Much of what graced asset pricing last year wasa reaction to the year before. Negative return

volatility has a habit of delivering something similardown the roadin reverse. It should surprise noone that one of the worst years in the capital andcommodity markets (2008) was followed by one thebest (2009). That begs the question: Now what?

The answer will depend on the economy, moreso than usual. For the moment, theres reason formild optimism. As we discuss elsewhere in thisissue (see page 24), the general trend is favorable,somewhat more so in fact than it appeared a monthago. But the issue remains one of distinguishing the

post-2008 bounce from 2010s potential for growth.A year previous, the diagnosis du jour was grim.Expected return for risky assets, as a result, wasquite robust. Economic logic demands no less. Themarkets offer a higher risk premium when theeconomic backdrop is dicey. If it were otherwise,thered be no point to buying assets in, say, January2009, when it was easy to think that the global

economy was on its last legs. But someone wasbuying a year ago.

Today, its easier to argue that the future isbright, or at least brighter. Expected risk premiumsare therefore lower. How much lower is the greatunknown. But having witnessed across-the-boardgains in everything, and at historically high levels

as 12-month returns go, were inclined to becautious.The stellar performance in 2009 alone suggests

as much. U.S. stocks (Russell 3000), for examplesoared last year, posting a 28%-plus total returnnearly three times above the long-run historicaaverage. Similarly outsized returns also describelast years run for foreign stocks, REITs andcommodities and our benchmark, the Global MarketIndex, which scored an unusually rich 21.2% rise Not bad for an index that owns everythin

promises to second guess nothing and is forever tiedto owning risky assets in weights determined solelyby market values.

The party rolled on in last years final monthalthough signs of weakness showed up in fixed-income. Bonds were a mixed bag in Decemberi.e., investment grade bonds. Yet the riskier cornersof fixed income kept pace with equities last year,

I


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2 The Beta Investment Report January 2010 BetaInvestment.com

suggesting that risk appetites remain strong. In particular, emerging market bonds and high-yieldbonds earned unusually high returns in 2009. So toodid inflation-indexed securities (here and abroad).

While we anticipate a downshift in returns

overall, thats not necessarily a bearish forecast.Short of a dramatic change for the worse in theeconomy, we expect that the rebound in risky assetsthats been underway since last spring will continuein the months ahead, but at a slower pace. Butwithout the cover of deep discounts in the price ofrisk, markets are more vulnerable to any setbacksthat await on the macroeconomic front.

That includes the possibility of a return ofeconomic contraction. Thats unlikely, in our view, but its too early to rule it out entirely. Still, the

second half of this year may be susceptible to thecyclical pressures that threaten as the natural (andgovernment-engineered) forces of recovery fade a bit, as both tend to do the further we move awayfrom the recessions technical finale. Its been nosecret that monetary stimulus (and to a lesser extentfiscal stimulus) has been extraordinarily potent overthe past 12 months. These liquidity injections,combined with the natural buoyancy that followseconomic contractions, has delivered upwardmomentum in the economy. But the governmentslargess is finite. It wont stop on a dime, but as theyear progresses, economic stimulus in all its variousforms will fade. Slowly, perhaps, but fade it will. Inturn, the economys internal capacity for self-sustained growth will move to the fore.

The business cycle, to put it bluntly, is at risk ofbelow-par results if not stalling. If we were forcedto pick the leading threat to an otherwise typicaleconomic recovery, wed choose debt, whichweighs on both government and householdfinances. Servicing this debt will be burdensome,certainly at the margins. As such, a larger-than-normal share of gains from any economic expansionwill likely be redirected to paying down the red inkthat weighs on government and consumers.

Deciding how much of economic growth is leftto power economic expansion is the great questionfor 2010. Even in the best of times, such forecastsare subject to the usual vicissitudes that hound

guesswork about the future. Considering that thecurrent climate remains something less than the bestof times, our confidence is below normal for theyear ahead. In addition, we no longer have deeplydiscounted assets to smooth over the rough edges

as we did a year ago.Overall, were of a mind that the potential forrisk and reward are balanced. As such, wereinclined to stay broadly diversified while holdingsome cash with an eye on exploiting any surprisesthat bring lower prices.

Yes, 2009 has been a spectacular year, but wedont expect a repeat. Minting risk premiums in2010 much tougher than it was last year, whenvirtually everything paid off in more than modestamounts. We could be wrong, of course. The year

ahead may bring another round of unusually stronggains. But such optimism is necessarily morespeculative sans the deep discounts in asset classes

that prevailed a year ago.

MODEL PORTFOLIOS Anxious optimism continues to dominate ooutlook for asset allocation.

December was a strong month for REITsequities and commodities, but bonds sufferedForeign bonds were especially hard hit, thanks to arebounding dollar last month, a trend that cut deeplyinto prices after translating local currency resultsinto greenback terms.

There were no active asset allocation changes for themodel portfolios in December.

Foreign developed-market bonds represent a bitmore than 18% of our passive benchmark, theGlobal Market Index. As a result, GMI posted asmall retreat last month of 20 basis points. Bycomparison, our model portfolios managed to ekeout small gains in December. Thats largely areflection of the fact that our model portfolios areunderweight foreign developed market bonds(relative to GMI).


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For the year, however, GMI is up more than21%. Thats near the highest 12-month gain for our benchmark since it was launched at the close of1997. Its one more bit of evidence (as if we neededmore) that 2009 was a potent year for the bulls.

The question is whether some of the asset classesare due for something other than robust gains. Thestrongest case for answering yes lies with bonds.As we discussed last month1, the outlook for fixed-income securities is weaker the longer that shortrates hover just above zero. Deciding when theFederal Reserve will begin raising the price ofmoney is speculative, but we know what the nextmove will be even if we dont know when thechange in the monetary winds will arrive.

Table 1

Asset Class(index) 1 month

1/31/09to

12/31/09* YTD 3 yr

REITs (Wilshire REIT) 6.9 57.0 28.6 -13.7Emerging Market Stocks (MSCI EM) 3.9 90.8 78.5 5.1High Yield Bonds (iBoxx High Yield) 3.3 37.2 45.9 4.4U.S. Stocks (Russell 3000) 2.9 40.1 28.3 -5.4Commodities (DJ-UBS Commodity) 2.0 25.7 18.9 -3.8Foreign Developed Mkt Stocks (MSCI EAFE) 1.4 46.1 31.8 -6.0Cash (3-month T-bill) 0.0 0.2 0.2 2.5Emerging Market Bonds (Citigroup ESBI-C) -0.3 28.2 30.5 6.1U.S. Bonds (Barclays US Aggregate Bond) -1.6 6.9 5.9 6.0TIPS (Barclays Treasury TIPS) -2.2 9.6 11.4 6.7Foreign Gov't Inflation-Linked Bonds(DB Global Gov't ex-US Inflation Linked Bond) -3.2 25.3 19.3 Foreign Dev Mkt Bonds (Citigroup WGBI ex-US) -5.8 9.5 4.4 8.6

Aggressive/High Risk Model Portfolio 0.4 30.0 Moderate/Medium Risk Model Portfolio 0.5 24.6 Conservative/Low Risk Model Portfolio 0.4 20.0

BIR Global Market Index -0.2 28.4 21.2 -0.3

* 1/31/09 is the launch date of the model portfolios andfor comparison purposes this start date is offered for allthe asset classes as well.

Model Portfolios launched 1/31/09

GMI is a passive, market-value weighted index ofglobal asset classes (excluding cash), designed andcalculated by The Beta Investment Report

Total Returns through December 31, 2009Ranked by 1 month % total return

annualized

The case for owning bonds in some degreesremains, as always, an issue of diversification.Well always maintain an asset allocation in fixedincome. But given the fact that interest rates canonly rise in the years ahead inspires a cautiousweight at the moment. GMIs overall bondallocation as of last month was 43.9% vs. a 29%-to-34.4% range for our trio of model portfolios.

1 The Trouble With Bonds,BIR, Dec. 2009, p. 6.

Stocks, REITs and commodities pose asomewhat more challenging dilemma for choosing portfolio weights. Having rallied strongly over thepast 12 months, the expected return in the near termfor these assets now appears tightly linked to the

economy to an unusually high degree.The good news is that the positive momentum inthe economy seems likely to persist. Thats themessage in our economic index (see page 24) and inseveral industrial metrics released in early JanuaryThe ISM manufacturing index, for example, rose to55.9 last montha four-year high. A reading over50 suggests an expanding manufacturing sector.

Table 2

Aggressive/High Risk Allocation % Change*U.S. Equities 18.3 0.4

Foreign Developed Market Equities 22.3 0.2

Emerging Market Equities 5.0 0.2

U.S. Bonds 12.3 -0.2

Inflation-Indexed Treasuries 2.6 -0.1

High Yield Bonds 3.2 0.1

Commodities 6.1 0.1

Real Estate Investment Trusts 4.2 0.3

Foreign Devlp'd Market Gov't Bonds 12.4 -0.8

Emerging Market Bonds 1.9 0.0

Foreign Gov't Inflation-linked Bonds 1.9 -0.1Cash 9.7 0.0

Moderate/Medium Risk Allocation % Change*

U.S. Equities 15.7 0.4



U.S. Bonds 12.9 -0.3

Inflation-Indexed Treasuries 4.4 -0.1

High Yield Bonds 3.3 0.1

Commodities 4.0 0.1




Foreign Gov't Inflation-linked Bonds 2.0 -0.1Cash 21.5 -0.1

Conservative/Low Risk Allocation % Change*

U.S. Equities 14.0 0.3



U.S. Bonds 13.4 -0.3

Inflation-Indexed Treasuries 4.6 -0.1High Yield Bonds 2.3 0.1

Commodities 3.1 0.0




Foreign Gov't Inflation-linked Bonds 2.1 -0.1Cash 30.6 -0.1

MODEL PORTFOLIOSAsset Allocation as of December 31, 2009

Total allocations may not equal 100% due to rounding* Change from previous month, measured in percentage points. For example, anallocation change from 10% to 11% would be a change of 1.0


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But its too soon to declare that the macrodanger has passed. Indeed, the consumer remainsstressed, and the fallout is still evident in variouscorners of the economy, starting with residentialreal estate. The housing market was among the

hardest hit in the Great Recession and its not yetobvious that a robust recovery has taken root in thissector. Consider that so-called pending home salesdropped a hefty 16% in November, the NationalAssociation of Realtors reported early this month.Thats the first decline in nine months and the lossraises fresh concerns about the strength of theeconomic rebound.

A bigger challenge on the economic front seemslikely to arrive in this years second half, when themonetary and fiscal stimulus of late begins to fade

and the economic momentum is forced to rely moreon the natural dynamics of the business cycle.Attempting to time this transition exceeds ourmedium-to-long-term mandate. Instead, our nod tothe shaky economic rebound we expect is one ofowning some cash and staying broadly diversifiedamong all the major asset classes.

Lets be clear: the months and quarters ahead arelikely to be stressful at times as the economy andthe markets grope about in search of the newnormal. Its unclear what economic and financiallife will look like in the post-crisis world order. Forwhat its worth, we foresee generally modesteconomic growth, punctuated by bouts of anxiety asthe price tag for all the monetary and fiscal stimuluscomes due.

The outlook is brighter in foreign markets in thedeveloping world. But as the equities and bonds inthese countries still constitute a tiny slice of globalmarket capitalization were reluctant to venturemuch deeper into these waters beyond our currentallocations, which are already above-weight in allour model portfolios.

Overall, were content to drift with the markettide. We made no active changes to the assetallocations of our model portfolios last month. Weexpect more of the same in the months ahead.

Barring a dramatic move in one or more of theasset classes, theres no compelling reason toembrace big bets one way or the other. Valuations

arent particularly lofty, but neither are theyunusually low either. In fact, the various riskmeasures we routinely monitor are mostly balancedin terms of risk and reward. Yield spreads, forinstance, are now distinctly mediocre relative to

year-ago levels (see page 30). Combined with theeconomic questions for the year ahead, weredistinctly uninspired when it comes to holding riskbeyond what the market portfolio suggests.

Table 3

Allocation % Change*

U.S. Equities 25.4 0.7Foreign Developed Market Equities 25.7 0.5Emerging Market Equities 4.1 0.2U.S. Bonds 20.4 -0.3Inflation-Indexed Treasuries 1.2 0.0

High Yield Bonds 0.8 0.0Commodities 0.2 0.0Real Estate Investment Trusts 0.6 0.0Foreign Devlp'd Market Gov't Bonds 18.1 -1.1Emerging Market Bonds 0.8 0.0Foreign Gov't Inflation-linked Bonds 2.7 -0.1Cash 0.0 0.0

GLOBAL MARKET INDEXAsset Allocation as of December 31, 2009

Total allocations may not equal 100% due to rounding* Change from previous month, measured in percentage points: an allocationchange from 10% to 11% would be a change of 1.0

For good or ill, we continue to favor a wait-and-see attitude with a modest bias toward risk

exposure. In effect, were hedging our betsUnwilling to hold more cash beyond already robustlevels, neither are we eager to expose our modeportfolios to more risk. We are, it seems, drifting ina realm of middling risk and return expectationsEventually the markets will encourage somethingmore (or less). But until we have a firmer grasp ofthe macroeconomic trends, were disposed to keepour risk allocations modest.

Having earned a tidy return over the past yearwere in no rush to lose it. The price of that securityis giving up a chunk of the potential upside, alongwith the flip side of sidestepping the potentialdownside risk. As we see it, theres a touch more ofthe latter and so our asset allocation is structuredaccordingly. For the time being, well leave thedrama to the thespians and the political debates in

Washington.


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SUMMING UP A DECADEShould we be surprised to learn that U.S. stocks lostground in the decade just passed?

The first decade of the 21st century is history.

What have we learned?One lesson is that stocksU.S. stocks, to be precisecan lose money over a 10-year run.Indeed, the Russell 3000 is light by a negative 0.2%annualized change on the decade. This is unusual but not unprecedented, at least if we considerrolling 10-year periods through history.

Chart A

A CENTURY OF DECADES

Rolling 10-yr annualized return:

S&P 500 (monthly price index)

-10

-5

0

5

10

15

20

Dec

1909

Dec

1929

Dec

1949

Dec

1969

Dec

1989

Dec

2009

Source: Robert Shiller (www.econ.yale.edu/~shiller) In fact, as Chart A above suggests, we should

expect that equities will occasionally lose moneyover a 10-year stretch. Fortunately, it doesn'thappen often, but it does happen. The good news isthat 10-year losses, when they do arrive, tend to precede a period of positive returns. The return tonormalcy, if we can call it that, doesnt always

come quickly, or at least it hasnt in the past. But itdoes come. It requires a extraordinarily dark strainof pessimism to think otherwise.

The bigger message is that cycles endure.Expecting equities to deliver consistently positivereturns is, by now, akin to believing in the toothfairy. The expected return on stocks, and everyother asset class, very much depends on when you

run the analysis. One of the more compelling chartssupporting this point comes by way of comparingcurrent dividend yield on stocks with thesubsequent 10-year return, as shown in Chart B.

Chart B

S&P COMPOSITE U.S. STOCK INDEX

(monthly price return data)

0

1

2

3

4

5

6

7

8

Sep-49 Sep-64 Sep-79 Sep-94 Sep-09

Source: Prof. Robert Shiller (www.econ.yale.edu/~shiller)

Dividend yield % (trailing 12 months)

Subsequent 10-year price return on $1

The black line tracks the current dividend yieldon U.S. stocks through time. The red line is thesubsequent 10-year value of $1 invested in a given

month. For example, the last entry for the red lineshows that $1 invested on September 1999 (whenthe current yield was 1.25%) had dropped to 79cents a decade hence. Meanwhile, the general riseof dividend yields over the past 10 years suggeststhat prospective equity returns will again be in theblack for future 10-year periods.

In sum, expected return fluctuatesfor all assetclasses. Although financial economics has taught usa thing or two over the years for predicting returnwe should remain humble in thinking that our

capacity for divining the future is anything morethan marginal. That inspires holding some variationof the market portfolio a la our proprietary GlobalMarket Index (GMI).

Just as we should be reluctant to own a handfulof stocks as a proxy for an equity allocation, wemust be cautious in cherry picking asset classeswithout recognizing the associated risk.


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Theres no law that says any one asset class cantlose money over a 10-year stretch. But itsextremely unlikely, if not impossible, thateverything will retreat over lengthy periods. In fact,thats one prediction were supremely comfortable

dispensing: Therell always be one, and probablyseveral asset classes in the black over each andevery subsequent 10-year period. Why? The shortanswer is that different asset classes respond toeconomic cycles in different ways.

Table 4

Asset Class

10 yr %

totalreturn*

Emerging Market Bonds (Citigroup ESBI-C) 11.1REITs (Wilshire REIT) 10.7Emerging Market Stocks (MSCI EM) 9.6

TIPS (Barclays Treasury TIPS) 7.7Commodities (DJ-UBS Commodity) 7.1Foreign Dev Mkt Bonds (Citigroup WGBI ex-US) 6.6U.S. Bonds (Barclays US Aggregate Bond) 6.3High Yield Bonds (iBoxx High Yield) 4.9Cash (3-month T-bill) 3.0Foreign Developed Mkt Stocks (MSCI EAFE) 1.2U.S. Stocks (Russell 3000) -0.2

BIR Global Market Index 3.7

* through 12/31/09

Accordingly, a 10-year review shows a range ofresults for the major asset classes, including a loss(see Table 4 above). Some are using this last bit ofhistory to proclaim equities as worthless from hereon out. Thats shortsighted, even if such headline

grabbing predictions help sell newspapers.

TheETAINVESTMENT REPORTJames Picerno, editor

Elizabeth Bennett, managing editor

732.710.4750 [email protected]

www.BetaInvestment.com

BIR is published monthly, 12 times a year, by Beta Publishing,L.L.C. Annual subscriptions are $235 each. Single issues, current and

previous, can be purchased for $25 each. Back issues are free forannual subscribers. Discounted group-rates (3 or more subscriptions)are $185 per subscription.

BIR and all its contents are copyright 2010 by Beta Publishing,L.L.C. U.S. copyright law prohibits reproduction or redistribution ofthis newsletter, in part or whole, in any form, electronic or otherwise,without the express consent, in writing, of the editor.

MEASURING THE MARKET PORTFOLIOCalculating a passive asset allocation for the majorasset classes is quite valuable, but its not

completely free of subjectivity.

The notion of computing a passive benchmarkfor the market portfolio, comprised of all the majorasset classes, is grounded in decades of financialeconomic research and a fair bit of common senseBut the details can get messy.

That doesnt stop us from estimating a passivemix of everything, which boils down to a globalindex of stocks, bonds, REITs and commoditieseach weighted by their respective market valuesThe rationale behind monitoring such an index isthat it represents the optimal portfolio for the

average investor with an infinite time horizonAccordingly, this is the benchmark for everyoneeven if were inclined to second guess the assetallocation.

Although a passive benchmark of everything hasimmense value, theres no one definitivemethodology for calculating such an index. For ourGlobal Market Index (GMI), the focus is acombination of simplicity and the ability toreplicate the benchmark results in the real world.

GMIs allocation was initially set to marketvalues at the close of 1997. The subsequent ebb andflow in GMIs asset allocation is based solely on price changes through time in the 11 componenasset classes. Investors can easily replicate GMIs performance by purchasing and holding ETFand/or index mutual funds in the appropriate proportions as currently measured. No subsequenadjustment required.

Allowing GMIs asset allocation to fluctuate based solely on price changes in the capital ancommodity markets has great appeal. But theres aglitcha small one, but a glitch nonetheless. Theasset allocation implied by market prices wileventually differ from the asset allocation based onmarket capitalization. In other words, the assetallocation for a given asset class based on marketcap over, say, 10 years is likely to shift at a differentrate relative to fluctuations suggested by pricechanges alone.


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For instance, lets say that the U.S. stock market posted a 10% annualized total return over a five-year period. In a perfect world, the stock marketscapitalization would also rise by an annualized 10% pace. Rarely, however, are the two measures

changing at an identical pace. But as our analysisbelow shows, neither are the two measures of assetallocation radically different. In turn, that suggeststhat letting market prices drive GMIs passive assetallocation is a reasonable approximation of portfoliostructure based on allowing market cap to dictateasset allocation shifts.

Consider Table 5, which compares GMIs assetinitial allocation (gray column) as of December 31,1997, using market values at the time. In the middlecolumn (blue) is the asset allocation based on

2009s year-end market-cap values. The thirdcolumn on the left (tan) shows GMIs assetallocation as of December 31, 2009, as defined andapplied on these pages, i.e., using market capweights initially and letting price changes in themarkets shift asset allocation subsequently.2

Table 5

Asset Class

GMI

2009Asset

Allocation%

2009Market

CapAsset

Allocation%

GMI

1997Asset

Allocation%

U.S. Equities 25.4 21.1 32.9Foreign Devlp'd Mkt Equities 25.7 24.4 25.2

Emerging Market Equities 4.1 6.1 2.4U.S. Bonds 20.4 21.9 20.3

Inflation-Indexed Treasuries 1.2 1.0 0.1High Yield Bonds 0.8 1.0 0.9Commodities 0.2 0.9 0.3

Global REITs 0.6 0.8 0.5Foreign Devlp'd Mkt Gov't Bonds 18.1 20.7 17.0

Emerging Market Bonds 0.8 0.5 0.5Foreign Gov't Inflation-linked Bonds 2.7 1.6 --

TRACKING THE MARKET PORTFOLIOPassive asset allocations (year-end data)

Sources: S&P BMI Indices, Citigroup, BIR

2 Market-cap data for equities and REITs is based on S&PBMI Global Indices. Bond market values are compiled fromdata published by Citigroup. The market value forcommodities is based on the open interest of the major futurescontracts (as reported by Barchart.com) multiplied by theyear-end price.

Note that while GMIs latest allocation (tacolumn) doesnt exactly match the market-valuemix (blue), its reasonably close. Nonethelessmanaging a portfolio based on current marketvalues isnt practical if were trying to create a

passive index thats also investable. ETFs and indexfunds track changes in markets, which are primarilydriven by price changes rather than market capchanges.

In the end, estimating the true market portfolio isa guess. The true market portfolio, in fact, isunobservable, as Roll (1977) advises.3 Accordinglyevery real-world approximation of the market portfolio is a compromise of one sort or anotherThat said, the goal isnt identifying the exact valueof the market value at any given point in time

Rather, our mandate with GMI is calculating thereturn and risk profile for a reasonably definedinvestable index of all the major asset classes. As itturns out, GMIs asset allocation tracks a marketcap-inspired definition of the market portfolio. Allof which suggests that GMI captures the lionsshare of the planets market portfolio comprised ofthe leading capital and commodity marketspassively weighted.

GMI, in sum, is a robust investment benchmarkfor most investors. That alone doesnt impart thesecrets to investment success. But theres strategicvalue in knowing the risk and reward profile of a passive measure of all the worlds major asseclasses. If we decide to pursue market-beatingperformance, the first step is studying the mix thatMr. Market defines as the default portfolio. Forinvestors with a global mandate in a multi-asset

class framework, GMI fits the bill.

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3 A critique of the asset pricing theorys tests, by R. Roll,Journal of Financial Economics, March 1977.


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THE BIG RETREATThe U.S. asset allocation footprint has receded inrecent years.

Theres nothing magical in the passive asset

allocation of our Global Market Index (GMI), but asinvestment strategies go this benchmark provides afair degree of stability. Most of the time. But whileowning everything, initially weighted by marketvalue and subsequently left unmanaged, offers somedurability, the internal composition of the marketportfolio is forever churning.

Most of the changes come from the ebb and flowin the big-four components: U.S. stocks, U.S.bonds, foreign developed-market stocks and foreigndeveloped-market government bonds. This quartet

dominates the asset allocation in our benchmarkGMI. No wonder, then, that the big four alsorepresent the front line in terms of where activeasset allocation decisions are likely to have theirbiggest impact, for good or ill.

Suffice to say, everyone should keep an eye onthe how these elephants meander. Speaking ofwhich, the most-obvious change in recent years isthe diminishing presence of U.S. stocks in the assetallocation. Its a gradual trend, subject to reversal inthe short term. But since the end of 1997, the launchdate for GMI, foreign stock markets have come todominate our indexs equity allocation, reversingthe former U.S. dominance.

At 1997s close, U.S. stocks comprised 32.9% ofGMI. As of this past November, the domestic equityshare of GMI had dropped to 25.4%, as Chart Cshows. Over the same period, foreign stocks indeveloped markets rose from 25.2% to 25.9%,inching ahead of U.S. equities. If we add inemerging market stocks, the domination of foreignshares is even higher. (Equity allocations are basedon data using S&P BMI Global Equity Indices.)

The change in bond allocations has been moresubtle. The value of U.S. investment grade fixed-income in GMI still exceeds foreign bonds, but thegap is closing, as Chart D illustrates.

Chart C

BIR Global Market Index Equity % Allocations

Dec. 31, 1997 v. Nov. 30, 2009

0

5

10

15

20

25

30

35

1997 2009

U.S. StocksForeign Devlp'd Mkt StocksEmg Mkt Stocks

How do these relative shifts compare withreturns? As it turns out, U.S. equities have trailedthe aggregate for foreign developed stock marketssince the end of 1997 through this past NovemberThe Russell 3000s 1.9% annualized total returnover that stretch falls well behind MSCI EAFEs3.5%, according to Morningstar Principia software.

Chart D

BIR Global Market Index Bond % Allocations

Dec. 31, 1997 v. Nov. 30, 2009

0

5

10

15

20

25

1997 2009

U.S. Bonds

Foreign Devlp'd Mkt Gov't Bonds

Emg Mkt Gov't Bonds


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The foreign performance edge remains intactwith bonds, but by a lesser degreeless than a full percentage point. The Barclays Aggregate U.S.Bond Indexs 5.8% annualized total return fromDecember 1997 through November 2009 trails the

6.3% for Citigroups World Government BondIndex ex-U.S. over that period.Keep in mind too that U.S. investors generally

favor a home bias when it comes to investing. Halfif not more of global stocks and bonds resideoutside America, but studies show that U.S.investors prefer asset allocations that are dominated by domestic securities. If so, there are manyinvestors in these United States with stock/bondportfolios that have trailed a passive allocation thatdistributed assets by way of market cap in recent

years.The bias for overweighting local markets is particularly strong among individuals, althoughinstitutional investors and money managers arentimmune. A recent survey by MSCI Barra, forinstance, reports that 60% to 70% of assetallocations among plan sponsors are in domesticsecurities.4

That doesnt mean that foreign markets willcontinue to beat the U.S. or that everyone shouldoverweight foreign assets by a dramatic degree. Infact, theres enough risk lurking both here andabroad to keep a lively debate going for some timeas to whether the U.S. will, or wont, outperform itsforeign counterparts in the months and years ahead.

But even if youre neutral on the outlook fordomestic vs. foreign stocks and bonds, the case forholding a substantial slice of offshore assets iscompelling for several reasons.

First, roughly 59% of global equity capitalizationinhabits markets other than the U.S. Meanwhile, aconservative estimate of global bond markets showsthat the value of offshore debt at least matches thesize of domestic fixed-income capitalization. Unlessyou have an unusually compelling analysis thatsupports radical surgery on the passive assetallocation, a strategic-minded portfolio should holdmore than a token amount of non-U.S. assets.

4 The Future of Market Risk Management: A Global Surveyof Institutional Investors, Dec. 2009 (MSCIBarra.com).

Holding non-U.S. assets also spreads risk byowning securities denominated in currencies otherthan the greenback. The dollar may or may not farewell in the years ahead, depending on yourperspective and your preference in matters of global

economic analysis. In fact, no one really knowswhats coming. The currency markets arenotoriously difficult to forecast, particularly in theshort term. One reason is that many of the key players in forex (i.e., central banks) donnecessarily buy and sell for purely economicreasons. In sum, diversifying by currencies as wellas asset classes has merit.

How much is too much, or too little? Looking atthe passive allocation of GMI gives us a neutralstarting point for considering an optimal mix. By

that standard, a bit more than half of our benchmarkis denominated in currencies beyond U.S. dollars.Of course, the standard for a neutral weighting is

also the basis for making tactical and strategic betsIf youre intent on beating the market in the yearsahead, you should plan on holding an assetallocation that sufficiently deviates from MrMarkets portfolio structure. Theres more than oneway to skin this cat, but the elephant in the room is

the domestic/foreign blend.

EMERGING MARKET STOCK FUNDSLots of choicestoo many, in fact.

Emerging markets represent a small share ofglobal equity capitalization, but there's nothingdiminutive about the menu of product offerings inthis space.

There were 149 ETFs and mutual funds inMorningstar's diversified emerging marketscategory as of November 2009, collectively holdingnearly $50 billion of assets. There are many morefunds if you include single-country, regional andindustry portfolios focused on the developingworld. Theres also a relatively new subset: so-called frontier markets, which are the smaller, less-


10/31


developed and higher-risk members of the category.And, of course, theres never a shortage of newactively managed funds plying the emerging marketwaters.

It all makes for a dazzling array of product

launches, breathless copy in press releases andsoaring expectations. As usual, were unimpressedwith all the light and heat. Our short list ofemerging market equity funds is a spare five, aslisted in Table 6. By your editors accounting, theseare the lowest-cost index funds available that focuson a diversified mix of emerging markets in arelatively clean and uncomplicated manner that usesmarket capitalization as a weighting scheme.

Why so few choices? The answer comes down to price and strategic focus. Most products targeting

emerging market stocks are too expensive for ourmiserly preferences. At the extreme, a few activelymanaged portfolios gouge investors for nearly 400basis points, based on net expense ratio as reportedby Morningstar Principia. Unsurprisingly, the highfees don't automatically bring above-averageresults.

As an antidote to the usual mischief, we favor products that are inexpensive and broadminded interms of covering the emerging market equityrealm. As part of a multi-asset class portfolio,theres little reason to search for moreor less.

The standard emerging markets beta inunmanaged form is already a potent beast. Thats nosurprise for an asset class whose returns are roughly50% more volatile than stock markets in the U.S. orforeign developed world. Of course, the extremeworks two ways: as a return enhancer and as a lossmaximizer, depending on the time period. But as ageneral proposition, no one will confuse thestandard emerging market benchmarks as tame.

For the 12 months through last November, forinstance, the MSCI Emerging Markets Index rushedskyward with an 85% return, or more than twice thegain for developed markets (MSCI EAFE) andnearly three times higher than the rally in U.S.stocks (Russell 3000) over those months.

The dark side of volatility is that emergingmarket indices suffered deeper shades of redcompared with developed countries when stocks

tumble. Last year, the MSCI Emerging MarketsIndex shed more than 50%, a good deal more thanthe 37% dive for U.S. Stocks, based on the Russell3000.

Table 6

Fund (Ticker)Target Index

1 yrTotal

Return%

3 yrAnnlz'dTotal

Return%

NetAssets($ mm)

NetExp.Ratio

%

12-moyld%

Vanguard Emg Mkts Stock (VWO)MSCI Emerging Markets 83.7 5.0 17,787.0 0.27 2.94

SPDR S&P Emerging Markets (GMM)

S&P BMI Emerging Markets 80.7 -- 106.1 0.59 2.30

iShares MSCI Emg Mkts (EEM)

MSCI Emerging Markets 80.4 5.5 37,346.3 0.72 1.45

Invesco PowerShares BLDRS

Emerging Markets 50 ADR (ADRE)

BNY Mellon Emerging Markets50 ADR Index 74.5 8.3 686.1 0.16 1.93

GlobalShares FTSE Emerging Markets

(GSR)

FTSE Emerging Markets Index -- -- -- 0.39 --

Vanguard Emg Mkts Stock (VEIEX)

MSCI Emerging Markets 84.0 5.1 7,446.2 0.39 2.77

Morningstar Diversified Emerging

Markets Equity Fund Category 80.3 2.5 406.7 1.8 0.9

MSCI Emerging Markets Index 85.1 5.3 -- -- --

Emerging Market Equity Index Funds

ranked by trailing 1-year total return*

0.0% until 1/31/10* as of 11/30/09

Source: Morningstar Principia, BIR

Mutual Funds

ETFs

Indices

Call us crazy, but the emerging market equity beta is already sufficiently risky. Attempts to jazzup this beta are misguided. There are more productive things to do in matters of portfolistrategy than look for opportunities to throwgasoline on a fire thats already blazing. Oneexample is spending more time analyzing emergingmarket trends in search of timing signals formanaging the asset allocation in these stocks. But beware: the outsized opportunity is matched withunusually steep hazards if your analysis and/ortiming are off, as recent history reminds.

Even by its own volatile standard, no one shouldmistake the 80%-plus surge for the year through November 2009 in the MSCI Emerging MarketIndex as middling. As Chart E on the next page


11/31


shows, the past 12 month-run is one of the indexsbest annual calendar-year runs. Whats possible onthe upside, however, suggests the potential in timesof stress.

On a fundamental basis, the arguments in favor

of emerging markets are well known and we won'trepeat them in great detail here except to say thatwe generally agree with the bullish aura. The long-term growth projections for China, India and otherdeveloping markets around the world remain bright,arguably much brighter compared with Europe andthe U.S.

Chart E

REACHING FOR THE STARS

Rolling 12-month % change for

MSCI Emering Markets Index

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

No

v-89

No

v-91

No

v-93

No

v-95

No

v-97

No

v-99

No

v-01

No

v-03

No

v-05

No

v-07

No

v-09

Sources: Mornings tar Principia and BIR

The emerging market edge is also conspicuous inthe here and now. Although much of the world isnow reporting economic growth as of 2009s thirdquarter, the revival is much stronger in theemerging markets. Thats especially clear if weconsider how GDP has changed on an annual basisthrough last years Q3. China and India, to take the

obvious examples, have reported annual GDPgrowth rates of 8.9% and 7.9%, respectively. Bycomparison, the economies of the U.S., the Euroregion and Japan have contracted on a year-over-year basis through Q3 2009.

Looking at more recent comparisons on amonthly basis, the latest numbers on industrial production show China and India enjoy growth of

10% to 20% vs. declines in the developed world ona month-over-month basis. The gap will close as theexpansion takes root in 2010, but emerging marketshave another advantage thats likely to enduresuperior fiscal finances.

A number of countries in the developing worldare in fiscally better shape compared with theirdeveloped-market counterparts. The extreme book-end example: Chinas current account surplus ismeasured in the hundreds of billions of dollars; asimilar total applies to the U.S., albeit in thenegative.

Low levels of debt, if not outright surplus, may be a distinguishing feature in the years ahead in aworld where red ink is the new norm. A new studynotes that when government debt-to-GDP rises, the

burden weighs on economic growth. Above 9 percent, median growth rates fall by one percentand average growth falls considerably more,according to Growth in a Time of Debt.5 Foremerging markets, the threshold is lower at around60% of GDP. (For perspective, the recent U.S. debt-to-GDP level is 84% vs. 9% for China, the studyreports.)

The relatively favorable outlook for emergingmarkets vs. developed nations cant be acceptedmindlessly, of course. Higher expected returns stillcome at a price of higher risk. If fiscal risk isgenerally lower in emerging markets, whats thesource of the higher expected return? The possibility if not the likelihood of higher stocmarket and GDP volatility is one answer.

Recent research suggests a linkage betweenvolatility and returns. First, consider that developingnations, by definition, report lower per-capitameasures of income compared with developedcountries. The expected growth of low-incomecountries may be higher, but thats associated with ahigher level of GDP volatility relative to developednations. In turn, higher GDP volatility appearsconnected with higher stock market volatility. Infact, to the extent that GDP bounces around more

5 Working paper by C. Reinhart and K. Rogoff, forthcoming inAmerican Economic Review.


12/31


the heightened volatility tends to elevate stockmarket volatility.6

The higher risk tends to pay off with higherreturns, or at least it has in the past over time. Butthere are other risks to consider as well. For all the

economic progress in the developing world, some ofthese countries are also known for a higher degreeof political instability, for instance.

Meanwhile, even if we accept the rosy scenariothat many strategists see for developing markets,that doesn't annul shorter-term issues of volatilityand the implications for rebalancing.

The fact that emerging markets have recentlyscored their strongest 12-month gain since thesector became a formal investment destination inthe 1980s implies that its time to do a little

trimming. We did exactly that in our modelportfolios at the end of October, when we modestlycut back on foreign equity allocations.7 If theunusually strong rally rolls on, we may do so again.

If so, unusually heady gains will only be part ofthe reasoning for paring the allocation. Anothercatalyst is the size of emerging marketcapitalization relative to the rest of the portfolio. Atthe close of October 2009, stocks in the developingworld represented between 4.4% to 6.9% in ourmodel portfolioswell above the 3.9% neutralweight at the time, as per our passive GlobalMarkets Index. We were inclined to hold an above-market weight of emerging market stocks at that point, and we remain overweighted as of 2009sclose. But letting a freight train run free on theassumption that itll continue running is assumingtoo much. Although we dont underestimate thepower of price momentum to keep a party going (orsustain the pain when prices are falling), theres alimit to how far well let any one component driftabove its market-value-implied share of theportfolio.

In the end, we cut back emerging markets atOctobers close while keeping it above market

6 See Macroeconomic Volatility and Stock Market Volatility,Worldwide, by F. Diebold and K. Yilmaz, Volatility andTime Series Econometrics (Oxford), forthcoming. Also, seeThe Volatility Connection,BIR, Feb. 2009, p. 20.7 See Model Portfolios, Part ITrimming exposure toforeign equities, November 2009,BIR, p. 2.

weight. Thats a reasonable compromise for a smallcorner of the equity market with huge long-termpotential thats in the midst of what appears to be anoverextended rally. A correction isnt necessarilyimminent or even inevitable, but the pace of returns

since last spring is almost surely due for aslowdown of some magnitude. Given the improving but still-precarious state of the global economy, slowdown in market rallies continue to harbor ahigher-than-usual risk of turning into somethingworse. If emerging markets continue to hand usoutsized gains, we reserve the right to take profitsand redeploy a portion of emerging market equitycapital elsewhere.

Another risk management technique is favoringan index fund that goes easy on the expenses while

embracing an expansive definition of the asset classIts tough enough deciding on the appropriateweight for emerging markets on any given day; thechallenge is far more daunting if we break up thisrelatively thin slice of equity markets into even finerdesignations. Thats a chore for a specialist assetmanager, and one were happy to sidestep.

For example, some are tempted to divideemerging market exposure into its four primaryregional pieces: Emerging Asia, Eastern EuropeLatin America and the Middle East/Africa. Unlessyoure deeply analyzing these regions on a routine basis, we recommend sticking with one or tw broad-minded products. All the more so if yourecommitted to a multi-asset class portfolio on theorder of GMI, which breaks the major asset classesinto 11 parts12 if you include cash. For mostinvestors and institutions, dividing the world up intothese 11 chunks will suffice for maximizingrebalancing opportunities while minimizing thepotential for portfolio complexity.

Our first choice for a core fund in this neck ofthe woods is the Vanguard Emerging Market ETF(VWO). With a net expense ratio of just 27 basispoints, the fund is virtually the lowest-cost gatewayto emerging markets short of institutional products.

We say virtually because the lowest for retailproducts is the BLDRS Emerging Markets 50 ADRIndex Fund (ADRE), which charges a mere 16 basis points. As much as were moved by inexpensiv


13/31


access to betas, were reluctant to choose thisInvesco PowerShares product over its Vanguardrival. The sticking point is the benchmark. TheBNY Mellon Emerging Markets 50 ADR Index, asit name suggests, is comprised of American

Depository Receipts, which are U.S. listed sharecounterparts to the local equities trading in thehome countries. That provides a less-expensivemeans of accessing foreign companies, thus thelower expense ratio. Indeed, most if not all of theemerging market funds on our list hold some ADRs.But doing so exclusively, and limiting the portfolioto 50 names, strikes us as needlessly arbitrary andoverly concentrated.

VWO, by comparison, recently held more than780 securities, according to Morningstar. We might

be persuaded to consider a more concentrated portfolio if there was a convincing research studybehind the BNY index. But such academic supportis lacking.

Yes, concentration can juice return, in the handsof a talented stock picker. But it comes with higherrisk too. In the end, concentration risk is not thetype of risk were focused on. Ours is a strategy ofharnessing (or attempting to harness) the volatilityand opportunity that arises from an intelligentblending of asset classes.

It doesnt help that ADREs year-to-date returnthrough November trailed the competing emergingmarket fund choices in Table 6. In short, an obscure benchmark with an uncertain indexing foundationtrumps a relatively low expense ratio.

What about a zero expense ratio? Is that worthventuring into new product waters? Were speakingof the new GlobalShares FTSE Emerging MarketsETF (GSR), which was launched on December 8.Its 39-basis-point expense ratio has been slashed tozero, albeit temporarilythrough the end of thismonth. Even so, 39 basis points is low enough totake a second look, but were in no rush. As with allnew ETFs and mutual funds, we recommend a wait-and-see period to judge the markets reaction. The primary question for GSR: Will trading volumegrow sufficiently? Stay tuned. (For more detail onthis new ETF, see page 26.)

As for the other two ETF offerings on our shortlist of emerging market equity funds, the sharplyhigher expense ratios arent encouraging. As wediscussed above, were not averse to paying more(if its not too much more) for something of value

But its not obvious why we would pay two to threetimes more (measured by net expense ratio) forexposure to a given beta.

One can argue that the greater liquidity iniShares MSCI Emerging Markets (EEM) is worthyof a 72-basis-point expense ratio vs. 27 for theVanguard offering. Considering that both track thesame index (MSCI Emerging Markets), volume isthe only conspicuous difference. But this isunpersuasive for our purposes, which can besummarizes as long-term holding periods with

modest trading tied to periodic rebalancing. IndeedVWOs 9-million-plus average daily tradingvolume is more than sufficient to insure a lowtracking error. Yes, EEM boasts a higher 30-million-share-a-day average, according to YahooFinance. But the marginal advantage of 30 millionvs. 9 million is slight in terms of expected savingsand is unlikely to offset EEMs expense ratio thats167% higher than VWOs.

The 59-basis-point expense ratio for SPDR S&PEmerging Markets (GMM) is better, but still toohigh. Another obstacle: GMMs average dailyvolume is roughly 30,000a tiny fraction ofVWOs trading liquidity. Meanwhile, GMM tracksa different benchmark: S&P BMI EmergingMarkets, which is a worthy alternative to MSCIEmerging Markets, but not at twice the price.

Finally, if youre looking for a mutual fundVWOs open-end equivalentVanguard EmergingMarket Stock (VEIEX)is the only product thatmakes the grade for BIR, assuming that theminimum investment is no higher than $10,000 andthe shares are available to the general public. Thatsaid, youll pay an extra 12 basis points forinvesting via the open-end structure. To which we

respond: Is a mutual fund really necessary?

In sum, our preference for emerging marketsremains the Vanguard ETF. The productscombination of low expenses, high liquidity and


14/31


broad focus elevate it to our top pick for tapping

equities in the developing world.

WHERE RETURN MEETS THE ROADComparing 2009 returns for ETFs, ETNs and indexmutual funds that target the major asset classes.

We spend a lot of time dissecting markets onthese pages, and rightly so. Betas broadly definedcast a long shadow on investment results foreveryone. But for all the value in analyzing markets,real-world results are defined by proxies, includingETFs, ETNs and index mutual funds.Unsurprisingly, theres a difference between market

returns and fund returns, which suffer all the usualfrictions that come with investing actual dollars.How big a difference depends on the fund

company running the portfolio, the cost of runningthe fund, the asset class, the index design and thetime period under scrutiny. Accordingly, returns netof expenses and other complications can and dovary.

For some perspective, we offer a review of 2009total returns via our short list of ETFs, ETNs andindex mutual funds that target the major asset

classes. The following is our usual inventory foundnear the back of each issue of BIR. The onlydifference is that we also include 2009 total returnsfor each product, as reported by Morningstar.com.

The following presents 2009 total returns byfund category for the major asset classes, ranked by performance within each category. Please note toothat newly minted funds without full-year 2009

results are also listed.

Global Equities (broad including U.S.) 1 yr % total ret

Vanguard Total World Stock (VTWSX) 33.3Vanguard Total World Stock (VT) 32.7iShares MSCI ACWI (ACWI) 32.3

Foreign Equities (broad, ex-U.S.) 1 yr % total ret

Vanguard FTSE All-World ex-US (VFWIX) 38.7Vanguard All World ex-US (VEU) 37.6SPDR MSCI ACWI ex-US (CWI) 37.1Vanguard Total Int'l Stock (VGTSX) 36.7

iShares MSCI ACWI ex-US (ACWX) 36.3

Foreign Equities (developed mkts ex-U.S.) 1 yr % total ret

SPDR S&P World ex-US (GWL) 28.6

Fidelity Spartan International (FSIIX) 28.5Vanguard Tax-Managed Int'l (VTMGX) 28.3

Vanguard Developed Markets (VDMIX) 28.2Vanguard Europe Pacific (VEA) 27.5iShares MSCI EAFE (EFA) 26.9Schwab International Equity (SCHF) --

U.S. Equities (broad) 1 yr % total ret

Vanguard Total Stock Market (VTI) 28.9Vanguard Total Stock Market (VTSMX) 28.7iShares Russell 3000 Index (IWV) 28.3

SPDR DJ Wilshire Total Market (TMW) 27.9iShares S&P 1500 (ISI) 26.6Schwab U.S. Broad Market (SCHB) --

Emerging Market Equities (broad) 1 yr % total ret

Vanguard Emerging Markets (VWO) 76.3

Vanguard Emerging Markets (VEIEX) 76.0SPDR S&P Emerging Markets (GMM) 72.3iShares MSCI Emerging Markets (EEM) 68.8BLDRS Emerging Market 50 ADR (ADRE) 65.5GlobalShares FTSE Emerging Markets (GSR) --

Foreign Gov't Bonds (developed markets) 1 yr % total ret

SPDR Barclays Int'l Treasury Bond (BWX) 5.0SPDR Barclays Short Term Int'l Treas (BWZ) --iShares S&P/Citigroup Int'l Treas Bond (IGOV) --

iShares S&P/Citigroup 1-3 yr Int'l Treas (ISHG) --

U.S. Bonds (broad investment grade) 1 yr % total ret

Vanguard Total Bond Market (VBMFX) 5.9Vanguard Total Bond Market (BND) 3.3iShares Barclays Aggregate Bond (AGG) 3.0SPDR Lehman Aggregate Bond (LAG) 1.6

Emerging Market Bonds 1 yr % total ret

Fidelity New Markets Income* (FNMIX) 44.6PowerShares Emg Mkt Sovereign Debt (PCY) 35.7T. Rowe Price Emg Mkt Bond* (PREMX) 35.0Payden Emerging Market Bond* (PYEMX) 28.9iShares JPMorgan $ Emg Mkt Bond (EMB) 15.5

Foreign Inflation Indexed Gov't Bonds 1 yr % total ret

DB Int'l Gov't Inflation-Protected Bond (WIP) 16.3


15/31


U.S. Inflation Indexed Gov't Bonds 1 yr % total ret

Vanguard Inflation-Protected Secs* (VIPSX) 10.8SPDR Barclays TIPS (IPE) 10.0iShares Barclarys TIPS (TIP) 9.0PIMCO 1-5 Year TIPS (STPZ) --

PIMCO 15+ Year U.S. TIPS (LTPZ) --

PIMCO Broad U.S. TIPS (TIPZ) --

High Yield Bonds 1 yr % total ret

Vanguard High Yield Corporate* (VWEHX) 39.1SPDR Lehman High Yield Bond (JNK) 36.4iShares iBoxx $ High Yield Corp Bond (HYG) 28.9PowerShares High Yield Corp Bond (PHB) 23.7

Global Real Estate/REITs 1 yr % total ret

Northern Trust Global Real Estate (NGREX) 37.0First Trust FTSE EPRA/NAREITGlobal Real Estate (FFR) 32.8SPDR DJ Global Real Estate (RWO) 32.0

Foreign Real Estate/REITs (ex-US) 1 yr % total retiShares FTSE EPRA/NAREIT

Global RE ex-US (IFGL) 43.1SPDR Dow Jones Int'l Real Estate (RWX) 36.3

U.S. REITs 1 yr % total ret

Vanguard REIT (VNQ) 30.1Vanguard REIT (VGSIX) 29.6First Trust S&P REIT (FRI) 28.4SPDR DJ Wilshire REIT (RWR) 28.2

Commodities (Broad) 1 yr % total ret

AB Svensk Elements

Rogers Int'l Comm (RJI) 26.5iPath Dow Jones-AIG Commodity (DJP) 20.1GreenHaven Continuous Commodity (GCC) 20.1

PoweShares DB Commodity (DBC) 16.2iPath GSCI (GSP) 15.3Credit SuisseCommodity Return A (CRSOX) 13.1

iShares S&P GSCI Commodity (GSG) 11.2UBS E-Tracs DJ-UBS (DJCI) --

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BetaInvestment.com

A BRIEF REVIEW OF BETA(s)What is the workhorse of risk metrics telling usthese days?

Its been declared irrelevant if not dead, but once

you look beyond the hyperbole its clear that betaremains a productive measure of risk. Yes, itsflawed, but so is everything else. Should we acceptbeta at face value for estimating risk premiums? Ofcourse not, but no one measure of risk is divinelyinspired. Investors intent on developing robustforecasts of risk premiums for asset classes shouldadopt a buffet-style approach to estimating thefuture by sampling an array of risk tools.

Beta, meanwhile, is held to a higher standardthan other metrics. Some dismiss it because it

doesnt offer an incessant stream of accuratepredictions at all times for all investment horizonsNothing else does either, of course, but that doesnstop the attacks.

In fact, beta remains one of finances mostremarkable innovations. In essence, beta tells uswhat to expect for the return of assets in aportfolioany portfolio, regardless of compositionSystematic risk, as influenced by the portfolio, isthe dominant driver of return, or loss. Accordingly,systematic risk should be priced and monitoredclosely.

The great question that animates the investmentdebate is centered on what exactly is the source, orsources, of systematic risk? For our purposes here,well stick with the traditional answer: the marketportfolio.

In fact, there are multiple sources of priced risk, but arguably the portfolios systematic risk is thmost important. It follows, then, that much of whatwe think of as investment risk is linked, for good orill, to what we can think of as conventional portfolio beta. The supporting evidence is available in rigorous mathematical proof as well as from theempirical record. True for stocks, true for hedgefunds, true for any asset pool. If youre searchingfor a general description of why prices rise or fall,you can start by looking at a broadly definedportfolio of similar assets.


16/31


On these pages, we see the market portfolio betavia a multi-asset class portfolio that holds all themajor asset classes in a passive mixas defined byour Global Market Index. In turn, the individualasset classes (U.S. stocks, commodities, foreign

bonds, etc.) are priced in some degree relative toGMIs beta.Ideally, beta should be evaluated in context with

multiple risk metrics, which is our habit forpredicting risk premiums in the cause of managingour model portfolios. Beta cant tell us everything,and depending on the portfolio and/or the time period it may tell us less than wed prefer. Butgenerally it imparts valuable information formanaging asset allocation using broadly definedasset classes for the medium and long run. If beta

was no better than astrology as a risk measure, cap-weighted index funds wouldnt report a long historyof living up to their theoretical expectations:minting middling returns and risk.

At its core, beta tells us how much influence themarket portfolio casts over each asset class.Although the specific degree of influence is alwaysdebatable as well as variable, investors ignore thisfundamental linkage at some peril. In 2008, forinstance, the market portfolio (GMI) suffered anunusually sharp decline. Without knowing anythingelse, that small piece of information tells ussomething. Indeed, the fate of the 11 major assetclasses was inextricably tied up with the marketportfolio, albeit in varying degrees.

Evaluating the betas for each of the major assetclasses is no crystal ball, but its one piece of thepuzzle (and an important piece) in an ongoing effortto peer into the future. The process of running thenumbers helps us develop context for thinkingabout risk premiums and the implications for assetallocation.

If we had absolute clarity on future betas, wecould reverse engineer expected risk premiums foreach asset class with high precision. Alas, our viewof the future is clouded (as always) and so ourprojections for betas, and therefore risk premiums,

are only a guess. The goal is making intelligentguesses, and looking at assets through beta-coloredglasses can help.

Lets start with a review of the basics. Thestandard equation for calculating asset is beta(i) is

i = im m

i

(1)

so that im is the correlation of return between asset

and market portfoliom, which is multiplied by i/mor the ratio of volatility (standard deviation) forasseti and market portfoliom.

Beta, in sum, is the product of an assetscorrelation with the portfolio multiplied by the ratioof the assets volatility to the portfolios volatility.

Lets also recognize that equation 1 can berewritten so that

im

i

= (2)

This means that an assets beta (i) inequilibrium is equal to the ratio of the assets

expected risk premium (i) to the market portfolios

expected risk premium (m). This relationship is

especially useful as a framework for considering thefuture, and so well return to it later.

Meantime, lets face facts: the market isntalways in equilibrium, which is to say that supplyand demand arent continually matched. We mighteven conclude that equilibrium is rare. If so, theratio in Equation 2 doesnt always hold. Perhapsthen, its more accurate to say that prices fluctuatearound the values implied by Equation 2. In thatcase, Equation 2 is still quite valuable. In effect beta can be thought of as a source of gravity tha

keeps individual assets, asset classes and portfoliosin an economically logical orbit around the marketportfolio. As it turns out, history suggests that assetclass returns do in fact fluctuate around GMIsperformance through time.


17/31


For some real-world perspective, lets startcrunching the numbers. Lets begin with historical betas, based on our Global Market Index and itsasset class components. The resulting betas fromrecent history are ranked in Chart F.8

As per the customary interpretation, betas abovethe market portfolios ranking (which always equals1.0) carry more risk and potentially higher return; below-market betas harbor relatively low risk andtherefore potentially lower return. With that inmind, the results in Chart F arent terriblysurprising. REITs and equities post historical betasabove the markets; bonds score below-marketbetas.

Chart F

A BEVY OF BETASHistorical asset class betas: 1997-2009,

relative to GMI (the "market portfolio")

0.0

0.5

1.0

1.5

2.0

2.5

USBonds

TIPS

ForeignDevlp'dMktGov'tBonds

EmergingMarketBonds

Commodities

JunkBonds

BIR

GlobalMarketIndex

REITs

USStocks

ForeignDevlp'dMktStocks

EmergingMarketStocks

The challenge is deciding if historical betas can

help us estimate future betas. As with all efforts inparsing the past for clues about the future, history isonly a guidean imperfect guide, to be precise.There are several issues to consider, includingidentifying the ideal historical period and decidingwhat forward investment horizon is the correct

8 Based on monthly total returns for the major asset classes(January 1998 through November 2009).

match for projecting risk and return. Inevitablysuch decisions are subject to a degree of error andso any projections are, at best, a rough estimate.

For example, emerging market equitieshistorical beta of around 2.0 in Chart F advises that

the asset classs return (or loss) is expected to betwice as large as the market portfolios gain (loss)over the long haul. At the opposite extreme, theU.S. bond beta of 0.1 suggests that domestic fixed-incomes gain (loss) will be a small fraction of themarket portfolios rise (fall) through time.

Its debatable how accurate these historical betasare relative to the true expected betas, which areunobservable. Even if we were sure of what theexpected beta is at this moment, it almost certainlywill change in the future. Indeed, expected risk

premia fluctuate, which means that betas wander aswell.Thats certainly clear when looking backward

Consider, for instance, the ebb and flow in historicathree-year rolling betas for U.S. stocks in recentyears, as shown in Chart G. Using longer rolling periods smoothes the change, although the overaltrend is the same. The main lesson: extrapolatinghistorical betas at any point in time is hazardousifif we expect it to hold as a long-terproposition.

Chart G

ANYTHING BUT STABLE

Rolling 3-year historical beta

for U.S. stocks (Russell 3000) relative to GMI

1.00

1.10

1.20

1.30

1.40

1.50

1.60

1.70

1.80

Nov-

02

Nov-

03

Nov-

04

Nov-

05

Nov-

06

Nov-

07

Nov-

08

No

09


18/31


Does this mean that historical beta is worthless? No. Its a slippery devil, to be sure, but a carefulstudy of historical beta drops a few clues forinterpreting this meandering measure of risk. Oneimplication of shifting betas is that we should

project risk premiums for the near term as well asthe long run. To the extent theres a divergence, thegap offers useful information for adjusting the assetallocation.

In fact, relatively extreme betas tend to movetoward 1.0. The pull of equilibrium isnt absolute but we shouldnt ignore this financial gravity. Aline of research that dates to the 1970s shows thatestimated betas below 1.0 have a tendency to rise inthe future and those above 1.0 have a habit ofdrifting lower.9 The original research was focused

on individual securities, although the intuition canbe transferred to asset classes and their fluctuationsaround the market portfolio.

Chart H

Historical Beta (based on GMI) vs. Risk Premium

1997-2009

US Bonds

TIPS

Comm.

REITs

Emg Mkt

Bonds

Emg Mkt

Stocks

Junk Bonds

GMI

Foreign

Devlp'd Mkt

Gov't Bonds

Foreign

Devlp'd Mkt

StocksUS Stocks

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0.0 0.5 1.0 1.5 2.0 2.5

Beta

AnnualizedRiskPremium%

9 On the Assessment of Risk, by M. Blume, Journal ofFinance, March 1971; and Betas and Their RegressionTendencies, by M. Blume,Journal of Finance, June 1975.

Holding that thought, take a look at Chart Hwhich graphs historical asset class betas (based on1997-2009 data) relative to the market portfolio(GMI). Before we consider the results, letsacknowledge that if every asset class was

continually priced exactly as beta predicted, returnwould remain forever proportional to for all assetclasses at all times over every investment horizonDifferent betas for different asset classes would still prevail, as would different risk premiums in thiidealized world, albeit in a symmetrically neatfashion. That is, if an asset class returned twice asmuch as GMI, the asset classs beta would alwaysbe 2.0. If it returned only half as much as GMI, itsbeta would be 0.5, now and forever.

But markets do not operate so cleanly, at least

not in the short term. One reason is due to thetautological explanation that if higher betas alwaysdispensed higher returns, those assets would nolonger deserve a higher beta since theyd be lessrisky after all.

Another reason why a perfect beta world doesntexist is that market beta isnt the only priced riskfactor. Its arguably the leading one, or perhaps weshould label it the primary risk factor that enduresin the long run. But over shorter periods there areother betas to consider, such as the small-cap valuefactor for equities and the default-risk premium forbonds, to cite two of the more popular examples obetas beyond the market portfolio.

Lets recognize that asset classes wont alwayslive up to expectations based on historical market portfolio beta, or any other single beta for thamatter. In general we recognize that higher risk brings higher return, but thats not always true awe break the market portfolio into smaller piecesthus the term expected risk premium. The broaderthe portfolio and the longer the time horizon, themore confidence we have that a risk premium wilbe realized. Of course, broader portfolios and longertime horizons also equate with lower risk premiumsgenerally. Forecasting betas for stocks over the nextfive to 10 years is one thing; making similarprojections for equities in the financial industry, orone stock in particular, is something else.


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In other words, whatever you gain in confidencein projecting betas by focusing on broader portfolios, you must give up in realized return. Somuch for free lunches.

We can debate if all this is evidence against beta

and market efficiency vs. a case thats in favor oftime-varying expected returns in a generallyefficient market. But thats an academic question.On a more practical level, all strategic-mindedinvestors should take advantage of deviations from beta-implied returns, or at least consider theimplications.

For example, U.S. stocks in Chart H are inmodestly negative return territory in recent historydespite a beta reading of 1.4. Meantime, the market portfolios risk premium, as per GMI, was an

annualized 0.4%, which implies a U.S. equity risk premium of nearly 0.6%. The mismatch suggeststhat the U.S. equity beta was too high, returns toolow, or some combination thereof.

In fact, we expect U.S. stocks, along with GMI,to deliver superior results in the years ahead relativeto the history in Chart H. We know that betas arentconstant in the short term. But we also know thatequities generally are more volatile than the market portfolio, which suggests that equities shouldgenerate a premium over the market portfolio in thelong run. The fact that recent history for U.S. stocksis well below the beta-implied return is one reasonfor anticipating that domestic equities will generatea risk premium above the market portfolios in thefuture.

Beta, in other words, offers a clue about an assetclasss outlook. To be precise, if we have a robustforecast of the market portfolios risk premium, thathelps us forecast risk premiums for the componentasset classes.

Consider that in equilibrium, the expected risk

premium for a given asset classiis determined

by its beta (i) times the market portfolios expected

risk premium (m). Equation 2 tells us that

i = im (3)

Equation 3 is a critical reason for studying themarket portfolio. If we can develop some

confidence about the market portfolios expectedreturn and risk, the insight sheds light on theoutlook for each of the portfolios components. Thedeeper our understanding of the market portfoliothe more intuition we have about how its likely to

fare in the years ahead. In turn, the insight gives ususeful clues about individual asset classes, perhapsto the degree that were inspired to overweight orunderweight one or more relative to the passivemarket weight.

Why not analyze the individual asset classesdirectly? In fact, we do. But its easier to buildconfidence in the long-term prospects of the market portfolio compared with analyzing one asset clasalone. For the same reason that forecasting thefuture of a lone company is more precarious than it

is for a diversified portfolio of stocks, so too is theuncertainty a bit less intimidating for a multi-assetclass portfolio vs. any one of its components. Assuch, developing expectations for individual assetsindirectly via the market portfolio is productive.

Broader is better for gazing into the morrowTheory and market history tell us to define themarket portfolio as broadly as possible in order tominimize forecasting error. The futures still indoubt, of course, but an expansive measure of themarket portfolio a la GMI aids our mission ofgenerating reasonably robust projections of risk andreturn as a benchmark prediction.

The logic boils down to the recognition that a broader definition of the market portfolio relatively stable. Our benchmark for these pagesGMIlives up to that profile compared with theunderlying pieces. GMI exhibits middling levels ofreturn and risk compared with its 11 major assetclass components. The relative stability of GMIthrough time promotes confidence in projecting arisk premium for the benchmark over the medium tolong term. And as equations 2 and 3 suggest, ahigher degree of faith in projecting GMIs risk premium supports the cause of forecasting ris premiums for the underlying asset classes. Thiintelligence helps us make decisions about how toadjust asset allocation, if at all.

As an example, our current long-run risk premium forecast for GMI is 2.5%. (This is


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forecast of excess returns above the risk-free rate,which we define as the 3-month T-bill return.10)Using this projection, along with the historical betasfor the asset classes reported in Chart H, gives usthe following expectations for risk premiums via

Equation 3:

Table 7

Emerging Market Stocks 5.1%Foreign Devlp'dMkt Stocks 4.0%US Stocks 3.6%

REITs 3.4%BIRGlobal Market Index 2.5%Junk Bonds 1.8%Commodities 1.7%Emerging Market Bonds 1.6%Foreign Devlp'dMkt Gov't Bonds 0.7%TIPS 0.4%US Bonds 0.2%

Risk Premia Forecasts

based on historical betas(1997-2009)

and a GMI risk premiumprediction of 2.5%

The forecasts in Table 7 are interesting buttheyre based on historical betas for 1997-2009. We

shouldnt blindly assume that risk premium projections drawn from recent history are the lastword on the future. Nonetheless, these estimatesoffer an opening bid on anticipating the long-termoutlook. We can think of these as first-runestimates. But we must do more, such as decidinghow future betas may change.

For example, lets consider U.S. stocks. Table7s risk premium forecast for domestic equities is3.6%. Thats based on a beta of 1.43 for 1997-2009and our 2.5% risk premium outlook for GMI

10 Our calculation for expected equilibrium risk premia is

derived from the formula: Sharpe ratio i im, defined as1) the market portfolios Sharpe ratio (the market portfolios

excess return over its volatility); 2) i as the volatility of asset

i; and 3) im as the correlation between asset i and marketportfolio m. In fact, this equation is a corollary to projectingrisk premiums via beta. For some background, see In Searchof Equilibrium-Based Forecasts, Part I & II,BIR, June 2009,p. 12.

(calculated as 1.43 2.5%). But as Graph Greminds, betas arent static, particularly in the shortrun. The 3-year trailing beta for U.S. stocks hasbeen rising steadily over the past four years. If weanticipate that U.S. equity beta will rise over the

next several years, that implies a risk premiumabove 3.6%. On the other hand, if U.S. equity betafalls, the risk premium forecast for domestic stocksmay be 3.0% or even lower. Perhaps, then, we cansay that a naive risk premium forecast for U.Sequities falls in the 3.0% to 4.0% range.

Is that prediction robust? To test it, we shouldconsider other variables. Continuing with U.Sstocks as an example, the expected return suggested by the Gordon Growth Model11 suggests that thelong run stock market total return will be roughly

7.3% (based on a 5.5% long-run growth individends over the past 60 years plus 1.8% dividendyield on U.S. stocks as of November 2009). If wesubtract a T-bill return outlook of 3.0%,12 the equityrisk premium via the Gordon Growth Model becomes 4.7%, or higher than our adjusted betainspired forecast of 3%-4%.

We can look to other metrics for assessingexpected return for U.S. stocks as well, which mayor may not influence our expectations. Among thevariables worthy of consideration: volatility trends

yield curve analysis, and yield and return spreadsbetween asset classes, for instance.Beta, in sum, is one of many tools for assessing

prospective risk premia. It cant pull back thcurtain of uncertainty any more than other financialevaluations can. Yet beta does offer a usefulfoundation for additional analysis in the necessarybut hazardous job of estimating risk and return.

Truth and wisdom come slowly in finance,usually with lots of hard work. But they do arrivealbeit in small doses, one risk judgment at a time

Beta is but one step on a thousand-mile journey.

11 Prospective total return for equities via the Gordon model is based on current dividend yield plus the long term rate odividend growth.12 A 3.0% Treasury bill return is based on a 3% inflation ratein the U.S. since 1926. We can debate if thats a practicaoutlook for T-bills, but for illustrative purposes we quote ihere.


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RESEARCH REVIEW

What Ties Return Volatilities to Price Valuations and

Fundamentals?by Alexander David (University of Calgary) and PietroVeronesi (University of Chicago, NBER and CEPR).

Working paper (via Veronesis home page atwww.chicagobooth.edu), November, 2009 draft.

Value and Momentum Everywhere

by Clifford Asness (AQR Capital Management), TobiasMoskowitz (University of Chicago), and Lasse Pedersen (NewYork University).Working paper (via www.aqr.com), July 2008 draft.

The maddening reality of investing is thatnothing works all of the time. Every strategy isambushed at some point, usually when an investorcan least afford a failure in what was formerly a

successful system.The fact that everything stumbles from time to

time is called risk. If youre expecting your finelytuned money management plan to triumph most ofthe time, much less all of the time, youre expectingtoo much. Recognizing limitations doesnt mean weshould abandon efforts to enhance portfolio resultsby intelligently analyzing markets in search of asset pricing laws. It does mean that we should berealistic and distinguish between whats possibleand whats not and seek the pragmatic terrain of the

middle ground.All investors must prepare for the inevitability of

model failure, temporary though the stumble may be. Recognizing this fate keeps us humble, which promotes overlaying multiple risk managementtechniques.

For example, were reluctant to stray too farfrom Mr. Markets asset allocation, as proxied inour Global Market Index. Were also cautious aboutrebalancing, preferring gradual changes to dramaticadjustments on any given day. We also routinely

monitor a range of market metrics and economicsignals so as to minimize dependence on any onetechnique that may unexpectedly break down as atimely and accurate indicator of near-termprospective risk and return.

Financial economists are only just beginning tochronicle and quantify the dynamic nature ofmarket metrics and how they can be used

collectively to reduce the hazards tied to any singlemeasure or model for projecting risk premia. In theMay 2009 issue ofBIR, we looked at one of themore intriguing papers that promotes the idea that acombination approach is productive (A Wider

ViewA new study reveals the power of studyingmultiple, p. 10.). What follows are two moreresearch monographs that are worthy of closerinspection on this front.

The first paper reviews the relationship between price volatility and fundamental valuation in thequity and bond markets. The second documents acomplementary link between price momentum andvalue investing strategies for equities.

Lets start with David and Veronesis analysis ofvolatility and price valuation. Its been known for

some time that periods of high trailing marketvolatility tend to precede high risk premiums. Highdividend yields and low price-earnings ratios alsohave a history of forecasting robust risk premiumsThe opposite tends to be true as well: low dividendyields, low volatility and lofty p/e ratios imply lowexpected returns.

In fact, this relationship seems to have held uprather well in recent times. The dramatic fall in thestock market in late-2008 into early 2009 wasaccompanied by an equally sharp rise in thedividend yield and trailing measures of pricevolatility. Those changes in valuation predicted alarge rise in expected return for equities, as weobserved at the time in the February and March2009 issues ofBIR. For the moment, at least, the projection has been accurate, as suggested by thesubsequent rally in 2009, which dispensed one ofthe biggest calendar-year gains for stocks on record.

The connection between volatility and marketfundamentals, it would seem, is strong. But asDavid and Veronesis research observes, thecorrelation between volatility and p/e ratio hasfluctuated widely since the 1960s. A similarvariation describes the correlation between the yieldon a 5-year Treasury and its return volatility.

The correlation for vol and p/e tends to benegative over the long term, as you would expectDuring recessions, stock market volatility has ahabit of increasing sharply as the markets p/e ratio


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drops. But this negative correlation isnt constant.You shouldnt blindly assume that a rise involatility will be accompanied by a fall in p/e ratioand that expected return will always increase.Although the relationship tends to endure over

decades, its subject to change at any givenmoment, depending on current conditions andinvestor expectations.

As one example, the long-run tendency toward anegative correlation between p/e and volatility mayturn positive for a time if the market expects thatearnings will increase at an unusually high rate foran extended period. In that case, relatively highequity volatility may temporarily be associated withstrong economic growth and high p/e ratios. Thatdescribes the market climate during the late-1990s.

The bond market is subject to a similaradjustment based on new expectations that deviatefrom the historical norm. Over the long haul, a positive correlation tends to prevail between the bond market yield and fixed-income returnvolatility. Thats unsurprising, since times ofturmoil in the bond market (i.e., selling andtherefore higher price volatility) translates intohigher bond yields. But the correlation could benegative at times, as it was in the late-1970s. Thecatalyst for the negative correlation during thoseyears: the expectation that high inflation wouldpersist.

Whats the lesson? Dont automatically assumethat the relationship between market fundamentalsand volatility is constant. Investors must evaluatecurrent conditions, including the outlook for theeconomy, how it differs from history (if at all) andwhat it implies for asset classes for the periodahead.

As David and Veronesi explain, there aremiddle economic states that are much morecommon than others. For example, moderatelyhigh earnings growth is more common than verylow growth or very high growth. Another example:low/medium inflation is more typical than highinflation. During the more common states,uncertainty falls somewhat, which is associatedwith lower volatility. When the economy departs

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Dynamic Asset Allocation Modern Portfolio Theory Updated For The Smart Investor

By James Picerno

Published by Bloomberg Press (February 2010)

from this middle ground, the relationship betweenvolatility and market fundamentals can also deviatefrom the historical norm.

In the late-1990s, the negative correlation between p/e ratios and return volatility gave wayThe arrival of a rare bout of positive correlationbetween market valuation and volatility was driven by the markets growing expectation that the U.Swas moving into an era of sustained high cash flowsfrom equities. The expectation turned out to bemisguided, of course, but thats another story.

* * *A dynamic relationship also describes the ebb

and flow in the risk premiums associated with thevalue and momentum factors. In fact, the two arecomplimentary: one tends to dominate at theexpense of the other in a given period. In turncombining the two factors in an investment strategycan generate higher risk-adjusted returns comparedto using either strategy in isolation, according toValue and Momentum Everywhere by Asness, etal.


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Financial research and real-world track recordsdemonstrate the long-run persistence of excessreturn in the value effect in the equity market.Generally, this is defined as equity prices belowsome fundamental measure of value, such as book

value or cash flow.Yet price momentum is a powerful source ofexcess returns in the short term. That is, equity prices that have been rising (falling) in recenthistory tend to continue rising (falling) in the nearterm.

Over time, value and momentum strategiesexhibit negative correlation. When one is generatingexcess returns, the other is usually unprofitable.Value and Momentum Everywhere shows that anave, equally weighted mix of the two factors

delivers a substantially higher Sharpe ratio (risk-adjusted return) than either does on its own. Theauthors also report that the value and momentumfactors are present in foreign markets and acrossasset classes.

The message, once again, is that investors shouldembrace (or at least monitor) a range of factors formanaging asset allocation. The idea that theres asilver-bullet methodology that will routinely carrythe portfolio through thick and thin is misleadingand dangerous. Eventually, every model hitsturbulence. That doesnt mean the underlyingtheory is flawed. But different risk factors pay off atdifferent times, in different degrees. The reasoningthat leads us to diversify across asset classes is noless persuasive when it comes to recognizing that avariety of factors help us manage the assetallocation.

The markets are continually dropping cluesabout prospective risk and return. But the strengthof the clues emanating from any one factor isconstantly fluctuating. Sometimes the message maybe downright misleading. The real challenge, then,is a) choosing which factors to consider formanaging asset allocation and b) interpreting thesignals in real time.

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The stakes are high. If we limit ourselves to toofew factors, we may have a distorted view of thefuture and our models capacity for projecting riskpremia. At the other extreme, processing too manyfactors threatens to dispense middling advice thatwill simply replicate the market portfolio, in whichcase weve wasted time and effort on results thatcould be generated with a passive allocation a la ourGlobal Market Index.

The search for the optimal mix of factorsandthe right factorsis at the heart of strategicportfolio management. There are no easy solutionor guaranteed results, but at least we have a productive framework for thinking about thchallenge. That starts by recognizing that using arange of factors is essential, if only to minimize thefallout when one or more metrics suffer a fall fromgrace, as they all eventually

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