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While there is no historical proof of the origin of that curse, there is ample current proof in the securities markets that  we are living in interesting times. It’s simply nasty out there — or at least it feels that way.

The image shows the year-to-date performance of six key asset classes:

• US Total Stk Mkt (VTI)
• Non-US Developed Stk Mkts (EFA) - excludes Canada
• Emerging Markets (EEM)
• US Equity REITs (VNQ)
• Commodity Basket (DJP)
• US Aggregate Bonds (AGG)

Commodities are up, REITs are up but rolling over, and everything else (stocks and bonds) is down.

Click image to enlarge

That made us think about advice from Warren Buffet for difficult times.  Here are some of his comments that may be relevant as investors watch wilting portfolios:

Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics is equally unpredictable, both as to duration and degree. Therefore we never try to anticipate the arrival or departure of either. We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.

Our favorite holding period is forever.

If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. … buy a cheap index fund and slowly dollar cost average into it.

We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.

The stock market is a no-called-strike game. You don’t have to swing at everything  –  you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!’

Clearly, Warren Buffet did not mean that if you hold a poorly designed portfolio you should hold forever.  He means that if you used good judgement and had conviction when you invested, you should not be troubled by storms, which are always followed by sunshine.

Richard Shaw
QVM Group LLC

The FTSE All World Index covers 47 countries and 2,908 companies, including both developed and emerging markets.  FTSE says the index covers 98% of the investable world universe.

The ETF from Vanguard charges a 25 basis point fee.  The sister mutual fund (VTWSX) has a higher expense ratio and charges a 2% fee for redemptions in the first two months (not a factor for the ETF).

In the short term, the mutual fund would be a better choice if you have a time horizon over 2 months, because of the liquidity factor.

The mutual fund will definitely execute at NAV on the day you place your buy order and will definitely execute at NAV on the day you place your sell order.

However, the ETF may not execute at all on the day of an order given the negligible initial volume.  Here is a place where Vanguard has a strength that most other ETF sponsors don’t have — the ability to offer a mutual fund or an ETF for the same objective (actually the same investment pool).

Here is a listing of the top ten country holdings and the sector weightings as provided today in a FTSE email to investment advisors:

This fund will likely be useful to some investors as a core equity holding, to which they would add other country and sector funds to “tilt” their equity exposure this way or that, based on their situation and market views.

Note: FTSE is a joint venture of the Financial Times of London and the London Stock Exchange.

Richard Shaw
QVM Group LLC

For those clients who wish to allocate primarily on a country basis (as opposed to a sector basis, for example), our general philosophy is to begin the design process from the starting point of world market capitalization, then deviate from there as appropriate per client.

More specifically, we recommend placing at least 50% of equity assets in broad index funds in proportion to world market capitalization.  Then, depending on your degree of aggressiveness and your confidence in your assessment of markets, placing up to 50% of equity assets in regional or country funds with anywhere from minor to massive overweights or underweights.

In order to make a conscious overweight or underweight decision, you need to know the neutral weights.

The major weight categories, US (proxy VTI), non-US developed (proxies EFA + EWC) [see prior article], and emerging (proxy VWO) are: 41.08%, 48.35% and 10.57% respectively, according to S&P/Citgroup Global Broad Market Indices, as of June 24, 2008.

The individual country weights (and proxy investment funds) for the developed markets and the emerging markets are provided in the following two graphic tables:

World funds would tend to contain stocks from all the listed countries, but you don’t lose much by constructing your own “world fund” with the available investment proxies, since they cover about 97% of the developed world market-cap.

Note: The major indexers tend to use the term “world” to refer to the developed world only, and the term “global” or “world all countries” to refer to the combined developed and emerging countries.

A smaller portion of the emerging market countries have their own proxy investment funds, but they comprise about 90% of the emerging markets capitalization in total.

There is much more to consider than simply market weights, however knowledge of market weights in your allocation program is important to understanding how your risks and opportunities differ from a world neutral allocation.

Finally, you need a benchmark.  You might consider using the world index performance as the benchmark against which you measure whether or not your “tilted” investments are adding value.

Richard Shaw
QVM Group LLC

[Securities mentioned in this article: VTI, EFA, EWC, VWO, EWZ,FXI,EWT, RSX, INP, EZA,EWW, EIS, EWM, ECH, IF, TUR, THD, VTI, EWJ, EWU, EWC, EWQ, EWG, EWA, EWL, EWP, EWI, EWY, EWN, EWD, EWH, EWS, EWK, EWO, IRL ]

The table, based on the S&P/Citigroup Global Broad Market Indices, shows the ratio of free-float market-cap of the GICS (Global Industrial Classification System) sectors in the emerging markets versus those of the developed markets, excluding the US market.

In total, the emerging markets provide a lot more Telecom and Energy, and a lot less Health Care and Consumer Discretionary, for example.

The broad emerging markets are represented by exchange traded funds such as EEM from Barclay’s and VWO from Vanguard.

The non-US developed markets are represented by exchange traded funds such as EFA from Barclay’s and VEA from Vanguard, in combination with EWC from Barclay’s, which tracks Canada.

Note the the EFA and VEA products track the MSCI/Barra Europe Australasia and Far East Index, which does not include Canada.  EFA + EWC or VEA + EWC will cover the developed world excluding the US (see prior article for relative Candada and EAFE weights).

Richard Shaw
QVM Group LLC

Solar is currently 1% of 7% of US energy sources.  Wind is currently 5% of 7% of energy sources.

While those sources may grow tremendously, and while some of the companies in the space may do very well, the nation will have to invest heavily in more traditional energy sources in the short-term to make a significant difference in supply and prices.

Alternative energy may be our future, but our immediate solutions must come from traditional energy sources and/or conservation.

There may well be more profit potential in clean coal investments or coal liquefaction or coal gasification, for example, that in wind or solar over the short-term.

This situation may be useful in making choices between ETFs such as:

• TAN (solar)
• FAN (wind)
• NLR (nuclear)
• KOL (coal)
• USO (oil)
• UNG (gas)

The chart above is what the US Dept of Energy, Energy Information Agency says about current energy sources.

Richard Shaw
QVM Group LLC

That would minimize the risk of buying into a bubble and the “greater fool” approach to investing, which assumes that someone will pay you more for something you paid too much for in the first place.

Of course, conservative investing based on takeover value also greatly reduces the universe of eligible stocks, because by far most stocks are priced beyond private takeover value.

While one overvalued, high multiple public company can use its inflated stock as currency to buy another overvalued company sporting a lower multiple, a cash buyer or a leverage buyer must look at affordability and cash-on-cash return, or debt service capacity of the target.

One of the measures that private acquirers look at is Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV / EBITDA).

Private buyers (those playing with their own money) prefer to buy at an EV / EBITDA of 4 or less, and may go to 6 (maybe 7). Those multiples are based substantially on the ability of the acquired company to generate cash to pay purchase debt or to provide an attractive cash return on debt-free cash used to make the purchase.

There are other issues to consider beyond EV / EBITDA, but it is a good starting place to begin to identify companies valued such that they could make sense if purchased for money instead of stock.

Definition:

EV is the market capitalization of the company plus its long-term debt. EBITDA is similar to “cash flow”. It is operating earnings before interest on and amortization of long-term debt, and before depreciation and taxes.

What We Did:

We did a screen of approximately 9,000 stocks (including ADRs) available in the US markets, to see what kind of EV / EBITDA opportunities are out there today. We used continuing earnings in our calculation of EBITDA.

We also excluded those companies priced below $5 and excluded those that did not have a positive EBITDA in the preceding 12 months. Those two criteria reduced the universe to 4,243 stocks (more than 1/2 of stocks were eliminated.

We did not require a minimum market-cap.  If we had put a $100 million market-cap minimum into the screen, we would have excluded another 636 stocks.

The table above shows the percentage of stocks in each EV / EBITDA range along with the cumulative percentage of stocks included as the EV / EBITDA increases.

The Screen Results:

The table shows that the great middle (aproximately the 80% middle) of stocks with positive EBITDA are currently priced at an EV / EBITDA between 8 and 21.  About 16% are priced at 7 or below and less than 3% are priced at 4 or less.

Looking at quartiles, the break point multiple between the 1st and 2nd quartile was 8.2.  The median multiple was 11.8.  The break point betwen the 3rd and 4th quartile was 18.3.

Example Stocks:

Not as recommendation, but simply as markers, two stocks at each of the quartile break points were:

• EV / EBITDA 8.2  — CNOOC (CEO) and Oppenheimer Holdings (OPY)
• EV / EBITDA 11.8 — Mattel (MAT) and Diamond Offshore Drilling (DO)
• EV / EBITDA 18.3 — Smith & Nephew (SNN) and Yingli Green Energy (YGE)

Other Factors:

Of course, you will want to examine why a company carries a low multiple.  Surely, it will tend to be that way due to low expectations or some perceived flaw.

Low expectations can be a good thing, because the probability of positive surprises may be greater than for companies priced to perfection.

Perceived flaws are OK, if you know what they are and believe they are curable.  Incurable flaws are potentially fatal, but curable flaws can lead to good long term value.

Remember that great companies are not always great investments (because they may be overpriced), and mediocre companies are not always bad investments (because they may be substantially underpriced).

Moral — do your homework.

Richard Shaw
QVM Group LLC

This table shows the Kg of oil equivalent consumed per unit of GDP on a purchasing power parity basis for 32 countries, as reported by the United Nations.

This data is not a measure of energy use efficiency, because it does not distinguish between countries with high energy intensity industries (such as steel making) versus those with low energy intensity industries (such as software).

The data also does not indicate how much margin exists to be more efficient if necessary.

Interesting observations, include that the United States and China have similar energy consumption per unit of GDP, although the US figures probably include a much higher personal energy use component as part of the overall energy use.

Also, India uses only about 82% as much energy per unit of GDP PPP as China.

Russia uses the most energy to produce its GDP.

Brazil consumes less energy for its GDP PPP than Japan.  Given that Brazil is essentially energy independent of the rest of the world and is an energy exporter, and given that Japan is an energy importer, Brazil might be expected to fare better than Japan when dealing with rising energy costs.

Richard Shaw
QVM Group LLC

[securities mentions in this article: EWH, IRL, EWL, EWI, EWU, EWO, EIS, EWP, EWZ, EWJ, EWG, TUR, EWQ, ECH, EWW, EWN, INP, EWK, THD, EWA, EWD, VTI, FXI, EWY, EWS, EWM, IF, EWC, EZA, RSX]

They are the recipient of the bulk of 401-k assets and a large portion of IRA and other individually controlled investments.

While they also include nearly 14% institutional assets, mutual funds hold $12 trillion in assets of which 86% are from individual accounts.  That makes them probably the best overall gauge available of retail investor decisions.

The chart shows the money flows into and out of mutual funds investing primarily in US stock funds versus those investing primarily in international or global stock funds for the years 2002 - 2007, plus an annualization of the first 4 months of 2008.

The chart shows that since 2003, US investors have been reducing their relative net new money commitment to domestic stocks while increasing their commitment to international stocks.

For the first four months of 2008, net money flows to stock funds have been negative, but all of that came from reducing domestic commitments while only slightly increasing international commitments.

Reductions in US stock fund money flows were not counterbalanced by increases in international/global stock fund money flows.  Two major possibilities could explain that.

Retail investors could be changing the risk composition of their portfolios by reallocation from US stocks (proxies VTI and SPY) and non-US stocks (proxy VEU) to other classes such as bonds (proxies AGG and IEF) or money markets, or something else.

Alternatively, they may be redeeming investments to maintain lifestyle now that home equity loans are hard to find, and the cost of everything is rising, but their real wages are not.

Richard Shaw
QVM Group LLC

Within the equity category, US retail investors were 74.1% allocated to US stocks and 25.9% allocated to international stocks. Based on world market-cap allocations, that represents an approximate 80% overweight for US stocks and an approximate 56% underweight for non-US stocks.

Although some US institutions do invest in mutual funds, they accounted for only 13.9% of US mutual fund assets in 2007. That was sufficiently low, that we believe mutual fund allocations are reasonably representative of US retail investor behavior.

US mutual fund assets at the end of 2007 represented 46% of worldwide mutual fund assets. That tracks fairly closely with the 44.15% US market-cap among the world’s stock markets — the US stock market was 44+% of world stock market assets, and US mutual funds were 46% of world mutual fund assets.

Richard Shaw
QVM Group LLC

Consider a real world situation that most of us have seen — a stream emptying in to a pond and another stream at the the other end of the pond draining the overflow.

Think of the streams as the emerging markets and the pond as the developed markets. Think of the water as money.

The water in the stream feeding the pond moves quickly.  When the water enters the pond, it slows as it spreads out in the breadth and depth of the pond.  When the water enters the stream draining the pond overflow, it moves quickly again.

The streams are narrow and shallow by comparison to the pond, which is broad and deep.  Any fixed amount of water moving through the streams must move more quickly than the same amount of water moving through the pond between the two streams.

Today, the developed markets free-float (represented collectively by VTI, EWC and EFA) is about nine times the size of the emerging markets free-float (represented by VWO). Within the total equity allocation of all investors, an increase or decrease in the developed markets allocation will show up as a magnified opposite change in the emerging markets allocation.

If investors decreased their current 89% developed markets allocation to an 88% allocation (a minimal change), the emerging markets would change from 11% to 12% (a substantial change).  The inverse changes are similarly minimal for developed markets and substantial for emerging markets.

The comparatively minimal nature of the developed markets changes create only minimal supply-demand pressure between money and shares, whereas the comparatively substantial nature of the corresponding emerging market changes create substantial supply-demand pressure between money and shares.

The greater the supply-demand pressure, the greater the degree of price change.

Considering the current 9:1 developed-to-emerging markets ratio, if the current bear market causes collective investors to become more risk averse and to significantly reduce their emerging markets exposure in favor of developed markets, the emerging markets would be crushed.

Richard Shaw
QVM Group LLC

Canada:

Unless you invest in a global fund, you are likely to lack Canadian stocks in your allocation if you use broad index funds.  That is because Canada is not part of the popular MSCI EAFE (Europe, Australasia and Far East) index that is tracked by ETFs from Barclays (EFA) and Vanguard (VEA). If you use those funds, you would need to add a separate Canadian fund, such as EWC, to round out the developed markets category.

As a practical matter, it may be useful to divide your equity planning around four categories:  US stocks, Canadian stocks, stocks of other developed markets and emerging market stocks (and possibly frontier market stocks).

Frontier Markets:

Frontier markets are so small that they barely register on the market-cap scale, and would have only a nominal representation in a world free-float weighted equities portfolio.

How Much Weight for Each Category?

The final weight for each category is, of course, an entirely individual matter based on your facts and circumstances, as well as your market interpretation and expectations.  Notwithstanding that general admonition, we believe you should start your planning process with a world free-float market-cap allocation, and then deviate from that based on a reasoned evaluation of your situation and market views.

Put another way, a world market-cap allocated equities portfolio is one without any particular convictions about the market.  Any deviation from a world market-cap allocation within the equity portion of your portfolio is either an intended or unintended overweight or underweight of regions or countries.

Regardless of your country of domicile or your currency base, beginning with a world allocation is world neutral. Based on your situation and how you expect markets to perform, you can then make reasoned deviations.  That we feel is a logical approach.

The Alternative:

The alternative approach is to begin with a 100% allocation to your home country equities, then deviate from that toward some level of non-domestic equities.

Most retail-level literature in the US for US investors comes from that perspective.  We feel that is a less effective approach.  It sets up psychological barriers to a fully open consideration of the possibilities for diversification, and to the risks and consequences of potentially too much domestic exposure.

Ever Changing World Allocations:

World market-cap allocations are not static. They change constantly.  You should make an effort periodically to find out what the latest world allocation is.  Our recent article about shrinking US work market-cap illustrates the changing nature of world allocations.

Current Allocation Ratios:

This table shows what portion of your overall portfolio would be allocated to each of US stocks (proxy VTI), Canadian stocks (proxy EWC), other developed market stocks (proxy EFA) and emerging market stocks (proxy VWO), at various levels of overall equity allocation within your portfolio in 10% increments from 50% to 100%.

click image to enlarge

These allocations would apply whether you invest in mutual funds, ETFs or individual stocks.

Japan:

For those of you who wish to deal with Japan (proxy EWJ) as a separate category, it represents 9% of world free-float market-cap.  The remainder of non-Canadian, non-Japanese developed markets is therefore about 35.6% of world free-float market-cap.

Note:

The chart shows you the appropriate allocations BEFORE you make specific reasoned deviations based on your situation and your market views.

Richard Shaw
QVM Group LLC

The US market share has been declining steadily in recent years, while other markets have been increasing. Today, the US market (proxy SPY) has declined to less than 41% from nearly 53% as recently as of 2004, according to the S&P “World by the Numbers” report.  In earlier times, the US share was much higher than 53%.

Emerging markets (proxies VWO and EEM) have been gaining market share notably through the BRIC countries of Brazil (proxy EWZ), Russia (proxy RSX), India (proxy INP), and China (proxy FXI).

Germany (proxy EWG) and Japan (proxy EWJ) have held their own and actually increased their market share since 2004.

This table presents the annual market shares for the US, Japan, Germany, China, India, Brazil and Russia as of January of 2004, 2005, 2006, 2007, 2008 and May 2008.

Note that market share in this case is “free-float” market share, meaning freely investable shares. Free-float excludes shares not available for trading, such as government owned shares.

As of May 2008, world free-float market-cap was about $30.7 trillion versus a total market-cap of about $50.7 trillion. In other words, only about 61% of world total market-cap is considered free-float.

The US share has declined in part because the US market has not appreciated as fast as many other markets, but also because emerging markets have been releasing more shares into the free-float category.

The US share will likely continue to decline as more non-US markets open up their free-float, and perhaps as other markets gain in value at a faster pace.

Consider that 90% of US total market-cap is free-float, whereas only 19% of China’s total market-cap is free-float. China’s free-float market share would quadruple if 90% of its total market-cap were free to float.

Similar but less extreme circumstances exist between other developed market countries and other emerging market countries. For example, Japan and Germany have 75% and 76% of their total market-cap as free-float respectively, while Brazil, Russia and India have 51%, 39% and 31% of their total market-cap in free-float.

The approximate 41% US world market-cap share is in stark contrast to the typical 75% to 85% or higher US weight within the stock allocation of most US investor portfolios.

Those allocations may be suitable and appropriate, but here are some interesting questions to consider:

• Are most US investors aware that they have massively overweighted US stocks versus the US world weight?
• Do most US investors actively feel that US stocks are a better investment return opportunity which they have intentionally overweighted?
• Are most US investors underweight non-US stocks because they are concerned about foreign currency risk exposure of investing in non-US stocks?
• Do most investment advisors inform their clients of world market shares as it may relate to allocation choices, and then make an active and reasoned choice to overweight their US positions?
• Will most US investors continue to hold 75% to 85% or more in US stocks when/if the US world market-cap share falls to 30%?
• As a global citizen in a global investment world, what is the rational country allocation for you?

Richard Shaw
QVM Group LLC

We found the same tendency to be true in a study we performed for Business Islamica Magazine of Dubai, U.A.E in 2007. (download PDF version of article here).

Interest, whether paying or earning it, is to be avoided in Shariah compliant investing.  The result is that banks and insurance companies, for example (fund proxies: KBE, KIE, and XLF) are not found in Islamic funds.

There are other prohibited investments, but the overwhelming economic impact of Shariah investing is the avoidance of financial companies and leveraged companies.

The story is not all positive however. As logic would suggest, and as our study demonstrated, Shariah compliant funds outperform the general market (whether US, Europe, or Japan) in times when financials do badly, and underperform the general market when financials do well.

In any event, Shariah compliant funds are proliferating globally and their assets under management are growing very rapidly, due in part to the increased petro-dollar flows to regions where Shariah compliant investing is attractive.

Richard Shaw
QVM Group LLC

He did not specifically address China in that article.  Did he mean that India would fare worse than China or worse than most Asian countries?  We don’t know.  We hope to hear more from him on that question.

We would have thought that India would be somewhat less sensitive to spiralling energy costs than China, because India is less manufacturing intensive in its export business than China.

Here is a table of total energy consumption for oil, natural gas, coal and electricity in India and China. [note that electricity consumption is duplicative of oil, gas and coal consumption, except for nuclear, hydro and other sources]

If, in fact, either China (proxy FXI) or India (Proxy INP) will suffer significantly more than the other due to energy costs, there may be an opportunity to short the most energy cost sensitive one against the least energy cost sensitive one. That question may possibly deserve further evaluation.

Of course, if you do such a trade effectively and oil backs down, the trade would then go against you.  Given oil price volatility, you would need wide tolerances for profit swings in the position.

Richard Shaw
QVM Group LLC

The energy commodity funds are leading the pack. The broad based commodity funds GSG, DJP and DBC, which we reviewed in some detail in a prior article, show middling performance.  The other narrow scope commodity funds are generally doing less well than the broad based funds.

On a three-month basis, the narrow scope funds are generally in negative territory.

Many of the funds currently have too few assets under management and too little trading volume to warrant investment.

click image to enlarge

Richard Shaw
QVM Group LLC

Arithmetic charts space each Dollar move equally on the vertical Y-axis. Semi-log charts space each percentage move equally on the vertical Y-axis. Either method creates only minor differences for short-term charts, but dramatic differences over the long-term, particularly if the security is strongly trending.

The following charts of MSCI emerging market indices illustrate the point. They show 15+ years of gross performance (price plus all dividends) for the emerging market index (proxies: EEM, VWO), India (proxy: INP), China (proxy: FXI), Brazil (proxy: EWZ), Russia (proxy: RSX) and Mexico (proxy EWW).

The semi-log format (called “semi” because the X-axis remains arithmetic with equal spaces between dates) gives a truer picture of trend.  A constant rate of change on an arithmetic chart creates a sharply curved line.  A constant rate of change on a semi-log chart creates a sloped straight line.

Consider the Dow Jones Industrial Average (proxy: DIA):

For the week ended 09/12/1986 the DJIA fell 141.03 points (-7.4%), and for the week ended on 07/12/2002 it fell 694.97 points (-7.4%).  On a semi-log chart both price changes would show as lines with the same slope, but on an arithmetic chart the 2002 decline would have shown as a much steeper decline.  In fact, both declines were 7.4% and had equal impact on investors at the time.

Similarly, for the week ended 11/14/1980 the DJIA rose 53.93 points (+5.8%), and for the week ended 01/18/1991 it rose 145.29 points (+5.8%).  The 1991 change was about three times the 1980 change.  An arithmetic chart would have shown a steeper rise in 1991 than in 1980, but the percentage change was the same at 5.8% for each.

Back to Emerging Markets Charts:

The arithmetic chart would suggest that Brazil is in an extreme bubble state and that China is flat.  The semi-log chart suggests that Brazil has been in a strong and steady uptrend since about 2002, as was China.

China has not made much net Dollar progress in 15 years due to a major decline in the first approximate 10 years of the 15 year period.  However, since about 2002, China has been trending upward strongly too.

We think the semi-log chart format tells the story in a clearer way.

The rate of change for the various emerging markets in the charts is much closer than is apparent from the arithmetic charts.

The Takeaway Thought:

The moral of the story is to be aware of the differences between the two types of charts and to be aware of which you are looking at when you make investment judgments.

Richard Shaw
QVM Group LLC

The following charts use these ETFs as proxies for key asset classes:

• VTI - US stock market
• EFA - non-US developed stock markets
• EEM - non-US emerging stock markets
• VNQ - US equity REITs
• DJP - global commodities*
• USO - oil alone
• AGG - US aggregate bond market

* DJP represents the DJ-AIG Commodity Index which is a “balanced” index. It limits any one of the 19 commodities it follows to a 15% weight, and any of the 5 commodity groups to a 33% weight. Since oil has been the overwhelming performer lately, DJP underweights oil in comparison to its world significance. The S&P GSCI Commodity index represents its commodities on a world production basis. For a more detailed discussion of commodity index composition and performance differences, see our article on that topic.

YTD chart:

REITs were slightly positive for the YTD period after an encouraging period in March and April, but they have since faded.

4-week (20-day) chart:

2 week (10-day) Chart:

Richard Shaw
QVM Group LLC

We find that to be an attractive yield for a long term holding, which may yet have further to decline, but that will eventually recover and continue to pay an attractive and growing dividend income stream.

We like equity income. We like the tangible confirmation of strength by dividends versus reports from management that all is well, but more importantly — we like getting paid cash from the businesses we own.

click image to enlarge.

There are some stinkers in the index, but on a portfolio weight blended basis, key attributes are not so bad.

There are some outrageous executive compensation packages, but that’s life these days. We’ll let CALPERS and the like tackle that problem.

The 93 basis point earnings spread on assets is not great, but is OK. The payout ratio at 69% may be high, but it’s not dangerous.

The five-year average yield of 3.25% versus the forward yield of 5.15% indicates a future capital appreciation to lower the yield to more normal levels.

Of course some things could upset that capital appreciation assumption, such as long-term earnings being permanently impaired due to lack of an irresponsible lending market, a permanent upward shift in minimum yield expectations by investors, and adverse tax changes versus dividends.

More asset write-down shoes could drop due to defaults or a renewed market liquidity drop. Domino effects in the market are still possible due to institutional failures, or the Federal Reserve reducing its extraordinary liquidity programs.

Multi-year construction loan write-downs for large complexes may be less mature than mortgage loans. Credit card and consumer loan losses may mount, as food and energy prices continue to squeeze everybody.

The banks may raise more capital that is dilutive to existing shareholders.

We are not that pessimistic however (prior article on KBE). We think the large banks will survive and recover. In the interim, we are happy to earn an attractive dividend yield that is tax preferred and nominally higher than Treasuries, while we wait for the markets to sort themselves out.

We are overweight large banks, and plan to accumulate more.

Richard Shaw
QVM Group LLC

[bank stocks mentioned in this article: WFC, JPM, BAC, C, WB, PNC, BBT, USB, NTRS, COF, STT, BK, STI, MTB, RF, KEY, FITB, ZION, CMA, PBCT, WM, MI, NCC, HBAN]

REIT vs REAL ESTATE FUNDS:

The problem with publicly traded securitized real estate is that it takes on some of the characteristics of stocks, and loses some of the distinctions of the direct real estate asset class. Except in bubble times, the yield of REITs also tends to make them trade a bit like bonds. Overall, REITs are hybrid in nature, but still generally thought of as a separate asset class more than as a separate sector within the stocks asset class.

Because REITs are not as widely authorized internationally, and because of investor demand for international real estate, a number of “world ex US” (international) real estate funds have arisen in recent years. However, those funds contain real estate management companies, land developers, builders, brokers and other non-REIT entities — making them less distinct from stocks in general than a pure REITs fund. For the time being, they are the best alternative available, but be careful about how correlated they might turn out to be with overall stocks for the same regions.

For that reason, we are currently inclined to use a US REIT class in an asset allocation program, but are reluctant to use a non-US real estate asset class pending development of more REIT-like opportunities for international real estate.

With that caveat expressed, this article compares four leading international real estate funds with a US REIT index fund.

INDICES TRACKED BY THE FUNDS:

• VNQ: MSCI US REIT Index
• RWX: Dow Jones Wilshire ex-US Real Estate Securities Index
• DRW: WisdomTree International Real Estate Index
• WPS: S&P/Citigroup BMI World ex-U.S. Property Index
• IFGL: FTSE EPRA/NAREIT Global Real Estate ex-U.S. Index

RELATIVE PERFORMANCE

These charts present the performance of the four international real estate ETFs against the performance of VNQ, an ETF tracking the MSCI US REIT index.

One-Year Chart Comparing VNQ, RWX, DRW, WPS and IFGL:

click for enlarged image updated to most recent full market day

Three-Month Chart Comparing VNQ, RWX, DRW, WPS and IFGL:

click for enlarged image updated to most recent full market day

INDEX COMPONENTS AND WEIGHTS:

The index component weights (as represented by the holdings of the passive index funds that track them) are shown in the graphic table. It provides the top 10 countries and top 10 company holdings for each fund, as well as the total number of countries and the total number of companies in each fund.

click image to enlarge

EXPENSE RATIOS:

The expense ratios range from 0.48% to 0.60%. If the indices were the same or substantially the same (as with two S&P 500 funds), we would recommend the fund with the lowest expense ratio. However, in this case, the component weights indicate that the indices are not substantially the same. Therefore, we would recommend not factoring the expense ratio differences into the fund selection decision.

YIELD

As with P/E ratios, yields are calculated in different ways. It is often possible to find widely variant reports of yield for stocks (examples: SEC 30-day yield; yield based on 12 month trailing dividends to current price, and annualized last dividend to current market price). Here are the yields currently reported (as of June 4, 2008) on the web pages for each fund — they are not calculated with the same methods:

• VNQ: 4.25
• RWX: 3.50
• DRW: n/a
• WPS: 2.04
• IFGL: 2.25

CORRELATION OF RETURNS:

The funds haven’t been around long enough to develop useful statistical correlation data between them, but a visual inspection of the 1-year and 3-month performance charts suggests their returns are highly correlated.

TAX LOSS HARVESTING
These four international real estate funds may be suitable substitutes for temporary or permanent replacement of each other in tax loss harvesting actions. You should ask your tax advisor what he or she thinks, but here is our logic:

• provide by different sponsors (except WPS and IFGL)
• track different indices
• hold different numbers of companies
• hold common companies in different proportions
• invest in different numbers of countries
• hold key countries in different proportions
• incur different expense ratios

Those attributes are consistent with our working rules for tax loss harvesting substitution. We believe those four funds are not “substantially identical” and that they provide different “economic position and risk exposure” for IRS purposes. However, they are sufficiently similar to allow a reasonably continuous asset class exposure in a tax loss harvesting-substitution action within an asset allocation program.

FUND WEB PAGES:

You can currently access the main webpage from the sponsor for each fund at:

• VNQ
• RWX
• DRW
• WPS
• IFGL

As always, research before you invest.

Richard Shaw
QVM Group LLC