Hands off My Cash, Monty

Edward Talisse
July 21, 2014

Always Read the Label
Index investing is all about capturing the market's beta (systematic risk) premium in a particular asset
class. Pioneered by legendary investor John C. Bogle, founder of the Vanguard Group, index
investing is a low cost replication strategy for those, like me, who generally believe that security
selection is a mug's game. Today there is no shortage of low fee Index ETFs and ETNs that match
the overall performance of an asset class, with little or no tracking error. That's the good news. The
bad news is that many of the most popular index products, such as the Barclays Aggregate Bond
Index, which is designed to track the performance of the US Investment Grade bond universe, involve
some fairly complicated index construction nuances. For example, as of QI 2014, Mortgage Backed
Securities (MBS) and other Asset Backed Securities (ABS) constituted close to 20% of the
outstanding U.S.Bond Market Debt (Source: SIFMA Research Statistics). So the Barclays Index will of
course mirror the composition of the overall debt markets and have an MBS/ABS weight of around
20% too. For sure, most investment professionals know all about negativity convexity associated with
MBS and other path dependent securities. If and when interest rates rise, MBS duration will actually
extend - meaning their prices become more sensitive to rate changes. If you want exposure to a
product that is negatively convex like MBS, then the Barclays Aggregate Bond Index is perfect. If you
don't, then you should look at a more targeted index product.
Here is another example. Many investors want exposure to commodity indices due to their perceived
correlation and inflation hedge benefits. According to etfdb.com, an online database of ETF factoids,
the ETF DBC is the largest (as measured by asset size) Commodity Index Trading Fund. This ETF is
very liquid, and according to NASDAQ, it trades on average more than 2 million shares per day.
However, on closer inspection, this particular ETF, which is advertised as representative of a broad
basket of commodities, is currently running more than 50% its exposure to one commodity - OIL and
a full 20% of the fund is invested in US Treasury Bills. Now, there is absolutely nothing wrong with
that allocation - it may in fact turn out to be very fortuitous and is certainly within the manager's
mandate. However, I bet that very few individual investors that hold DBC are aware that they are
basically long a combination of Oil futures and T-bills.
What about equities? The S&P 500 index is weighted by market capitalization. If you own the index,
SPX via the popular ETF SPY, then you are by definition a momentum trader - your allocation to the
winners automatically goes up and your share of the losers goes down. Market capitalization indices,
like SPY, are great when the market is trending strongly in one direction - you are always with the
move so to speak. However, when the trend changes, you will be left holding an outsized portion of
the biggest winners and you will be underweight the laggards.
Final example: Let's say you are like me and you own U.S. Treasury Inflation Protected Securities.
What do you really own? Well you own a nominal claim on the U.S. Treasury for the initial principal
plus you own a strip of cap and floor options on the Consumer Price Index (CPI). If the CPI sets
higher, your cash flow improves and if it sets lower, well then you lose out. The point is that it is
extremely difficult to price the strip of options, although there is certainly a surplus of sophisticated
models than can help. I find it surprising that U.S. and international accounting standards set by the
FASB and IFRS, respectively, permit holders of these securities to value the notes using traditional
methods such as mark to market or amortized cost. The embedded derivatives (options) should be
extracted from the nominal claim and valued separately. As of June 2014, there is about one trillion
dollars of US TIPS outstanding (source: Treasury Direct), which also means that there are a lot of 3
embedded derivatives attached to these securities as well. Who knows what those derivatives are
really worth, say in a hyperinflationary or deflationary environment? CPI has been well behaved, at
least statistically for the past 15 years, so valuation has not been a problem. That may all change if


the CPI index ratchets higher or goes negative. That's when we will see the comeback of the big
GMO (GET ME OUT!) trade.
Remember Oscar begged to Felix to "take the money" when Monty Hall offered an exchange of their
cash winnings of $800.00 (quite a lot for the early 1970s) for whatever was behind Door Number
Two. Of course, Felix went for the switch and The Odd Couple was left with a few cases of canned
squid. Oscar was right, always take the cash...an investor you should never be surprised by what is
behind the curtain.

Edward Talisse is the founding partner and Managing Director of Chelsea Global Advisors, a consulting and
advisory firm providing specialist advice in the area of global capital markets.

















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