The Active Index Strategist

February 11, 2004

This column aims to provide a big picture view of the major investable asset classes, with a focus on investment strategies that are implementable with index products.
January/February 2004


To many investors, the words 'active' and 'index' are opposites, and to use them together is simply an oxymoron.

However, as I will describe in detail in the forthcoming book Active Index Investing, one can be "as active as you want to be" using index products (index funds, ETFs, and index futures/options). Whether you are a long-term investor who chooses to make annual asset allocation rebalances or a hyperactive market timer, index-based vehicles are usually the most efficient way to get precisely targeted exposure to sectors, style categories, market-cap ranges or entire markets-domestic or international. And increasingly, as readers of this publication know, index products are becoming available for virtually every asset class, including fixed income, precious metals, currencies and even hedge funds.

This column aims to provide a big picture view of the major investable asset classes, with a focus on investment strategies that are implementable with index products. Unlike investment outlooks that I wrote when working at a major institutional asset manager, I will be unconstrained about making specific macro - and sometimes micro - recommendations, and whenever possible I will indicate some of the specific positions and index products one could utilize to capture the trends. I will also derive my opinions from a blend of fundamental views based on global economics and politics, as well as n what some consider the "Ouija Board School of investment Strategy"-technical analysis. (1)

The column will not, however, be a newsletter or tip sheet, but instead aims to provide a framework for investors to develop their own investment strategies. One more caveat - this essay was originally written in early/mid-January, for the publication deadline for The Journal of Indexes. Therefore, some of it's investment conclusions are a bit dated (although I'm happy to say that more of my views were correct than wrong - and where appropriate, I've updated some of my thoughts [ in brackets] ). Anyhow, the primary goal of the column is to demonstrate how one can actively use index products for both short-term and long-term investment strategies - and hopefully you'll find those examples 'timeless.'

* * *

So, after 2003's spectacular performance in most global equity markets, and clear, tradable trends in fixed income, commodity and currency markets, what can we can expect in 2004? We know that politics will be a big feature of this year-not just the U.S. primary and general elections, but also national elections in major economies such as Russia, India, South Africa, Taiwan and Indonesia. The U.S. election will be tight, with major implications for tax/fiscal policy and global trade relationships.

Regardless of one's political views, many of us are trying to determine which current or soon-to-be-launched index products are the appropriate vehicles with which to implement our market views. For this initial column, I will refer to some of the key performance figures for major markets and asset classes, but I will not try to be comprehensive (one can consult the Index Research section for complete and up-to-date statistics on a variety of index returns).

My perspective will be of medium-long term (my definition of this being a six-month to 12-month view), with the goal being to highlight implementable positions to capture these trends. Although I consider my globalist credentials quite up-to-date, and I take a global macro view of markets and opportunities, in this column I am writing with the U.S. as the 'home' market and thus when I refer to international it means outside the United States.

* * *

By the time this column is published, investors will have fully absorbed the extent of 2003's recovery in equity markets and the signs of economic resurgence that were increasingly evident by the end of the year. In essence, during 2003 the world moved out of deflation and recession and into reflation and recovery, led by surging growth in Asia ex-Japan. In 2004, I expect the world economy to move solidly forward, with the U.S. and Japan joining the party, and combined with China's accelerating growth, the world will move toward an inflationary environment. Economic signals-such as the re c o rd Institute for Supply Management (ISM) figures announced in early January and steadily rising commodity prices-all point to economic growth and signs of nascent inflation.

All is not rosy in the macro picture-there are significant imbalances and distortions in the world economy. Interest rates in the U.S. are too low for the current stage of the cycle, but the Fed is holding steady-for now. Furthermore, as noted by the International Monetary Fund (IMF) in January, the U.S. is running dangerously high fiscal deficits, as well as massive trade and current account deficits.

American net financial obligations to the rest of the world could reach 40% of GDP within a few years, a level of external debt more familiar for emerging markets, and we've already seen some of the impact in erosion of the dollar's foreign exchange value. In the IMF's own words, "an abrupt weakening of investor sentiment vis-à-vis the dollar could possibly lead to adverse consequences both domestically and abroad." In other words, there is nothing to be sanguine regarding the U.S. bond market or the stability of the dollar.

China's steadily accelerating economic growth is a well-known story, as is its increasing impact on commodity prices-copper, zinc, oil and coal and the precious metals. But other Asian economies, ranging from Japan to Australia to India, are also showing strong growth, much of if domestic-demand led, and I believe we'll see Asia's secular growth becoming more recognized in 2004.

With this backdrop, 2004 will be a challenging year for investors, but also one ripe with opportunity. It will be a good year for the world economy, but we'll see more evidence of inflation. And index-based products are efficient ways to gain and adjust exposure in this dynamic market environment. The mutual fund scandals of 2003 will also have a big impact on indexing. I expect even greater interest in ETFs and index-based strategies among financial advisors and individual investors, with the growth trends for these products already outpacing the active strategies. I'll now provide some highly opinionated views on the major asset classes, and some ideas and index products that may yield profitable investments.

U.S. Equity Market

After a spectacular 2003, with the DJIA up 28%, the S&P 500 up 29%, the Nasdaq Composite up 50% and the Russell 2000 up 49%, will investors be able to simply ride the trend?

It certainly seems so at the start of the 2004, with these benchmarks hitting new highs. But I don't think it will last. While the resurgence could continue through the winter, with new highs likely in the major indexes, it will be ephemeral and could fade as early as the spring. The best case scenario I envisage by autumn will be for a relatively flat market with a dramatic shift in sector leadership; the worst case will be the resumption of the 2000-2002 bear market, with a drop toward the October 2002-March 2003 lows on many key indexes. The high-beta small-caps, especially technology and financial stocks, are unlikely to remain leaders and may become laggards.

Defensive sectors, especially energy and insurance, are likely to outperform. Why won't the market benefit further from economic recovery in the U.S.? First, the U.S. is borrowing its growth-consumers from their home equity and other debt, and the government from foreign investors, mostly Asian central banks-and it's not sustainable. Second, even as corporate profits increase (consensus 2004 earnings estimates for the S&P 500 are above 2000's peak of $55), the market could be flat as the PE ratio contracts due to higher interest rates. It is important for investors to remember that the long-term average PE ratio (since 1960) is 15.6, and yet the U.S. market is still "priced for perfection", with the S&P 500 and Russell 3000 both having PE ratios over 20. This is down from 1999 highs of 35, but is still a historically high valuation for the market.

While long-term investors might want to maintain broad market exposure through super efficient index funds such as the Vanguard Total Stock Market Fund tracking the Wilshire 5000 (or its Vipers ETF share class, VTI), or iShares tracking the Russell 3000 (IWV) - see the figure below - or the Dow Jones US Total Market Index (IYY), they should certainly not be overweight in the small-cap or high-beta sectors that outperformed so dramatically in 2003.

Source: CBS Marketwatch and BigCharts, 2-year daily price movement of iShares Rusell 3000 (IWV) - data as of February 9, 2004.

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