The Curmudgeon - Marrying Vice And Virtue

November 01, 2007

Brad Zigler

The Preacher was in rare form last Sunday. "The wages of sin," he gasped, punctuated by an organ tremolo, "are COR-re-lations! Say ‘Amen.'"

From my perch in the balcony, I wasn't half convinced. For months—nay, YEARS—The Preacher warned that active management strategies would lose ground as market correlations increased. And he had a point, too. For a time.

Correlations did rise. Notably, hedge fund performance did fall off. But lately, correlations have turned tail, reversing to new lows, while fund performance remains lousy.

The correlation trend may not be readily visible if you're only looking at the "gross" numbers, though. Take the venerable S&P 500 Index (SPX), for example. SPX's five-year correlation to its small-cap cousin, the S&P Small Cap 600 (SML), is 80 percent; for the past three years, the correlation is 82 percent. It appears, at first blush, that the two market sectors have tightened their relationship in recent years.

Drill down to recent monthly figures, however, and you see quite a different picture. Five years ago, SPX and SML shared an 80 percent correlation. From there, the coefficient rose, rather unsteadily, to ultimately peak at 89 percent in June 2006. By May 2007, though, correlation fell to a five-year low of 76 percent.

That pattern is replicated in the relationship between SPX and the S&P MidCap 400 and, more or less, the MSCI EAFE indexes.

Come to think of it, investing in sin may offer just the diversification needed. Still, little diversification effect should be expected from benchmarks with correlation coefficients measured in the 70s or 80s. It's enough to drive a portfolio runner to drink. Or to other sins.

Index investing, as this publication is wont to extol, is something practiced by our better angels. For years, there was no benchmark for blackguards, no sin index. There were, however, managers who took an, um, active approach to peccadillo-picking, such as the Vice Fund (VICEX). VICEX, in case you don't know, puts its assets only into gaming, booze, tobacco and defense stocks.

"Investing should be about making money long term, not about making social statements," says one-time VICEX manager Dan Ahrens.

Ahrens and VICEX's current manager, Charles Norton, are on to something too. VICEX gained 24 percent in 2006, compared with SPX's 14 percent return. Its market-beating return in the first eight months of 2007 put it among the top 4 percent of comparable portfolios according to Lipper Inc. One of the reasons for VICEX's success could be its low correlation to SPX: only 66 percent over the past five years.

Recently, the virtues of indexing were wed with veniality when the International Securities Exchange launched SINdex, an equal-weighted matrix of gaming, booze and tobacco stocks. SINdex will undoubtedly be a boon to black sheep when it soon becomes the basis for a futures contract and an exchange-traded fund.

Still, the pantheon of peccancy represented by VICEX and SINdex lacks something. Porn.

Not to worry. We're here to help. Say hello to IndeXXX, the porn benchmark. Just a half-dozen stocks wide, IndeXXX is dominated by pioneering Playboy Enterprises (PLA), adult nightclub operator Rick's Caberet International (RICK) and skin-video dynamo New Frontier Media (NOOF). Rounding out the roster are Private Media Group (PRVT), NuWebSolutions (NWEB) and Metro Global Media (MGMA).

That IndeXXX has cranked out an average annual return of 29 percent over the past five years—nearly two and a half times the gain realized by SPX—should surprise no one. Craig Israelsen, in a 2006 study undertaken for Financial Planning magazine, found that the chaste are chumps. "People who follow a moral mandate in their investing behavior for go impressive returns," he says.

Porn, whatever it's worth, is also a great portfolio diversifier. IndeXXX has exhibited a low 27 percent correlation to SPX over the past five years. Best of all, the SPX-IndeXXX homology has actually decreased of late: IndeXXX's three-year correlation to SPX is only 12 percent.

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