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What We Read Today 02 April 2014

Econintersect: Every day our editors collect the most interesting things they find from around the internet and present a summary "reading list" which will include very brief summaries of why each item has gotten our attention. Suggestions from readers for "reading list" items are gratefully reviewed, although sometimes space limits the number included.

  • What Michael Lewis Gets Wrong About High-Frequency Trading (Matthew Phillips, Bloomberg Businessweek) Phillips has a point that HFT does skim much smaller margins from retail investors than the huge bid-ask spreads of three decades ago. But he does not mention the points that (1) the operations amount to front-running and (2) market price manipulation, in some cases larger than the bid-ask spreads of the old days. Phillips ends up sounding like an apologist for HFT in this piece.

"We don't know of course, exactly what they have signed up for, we don't know how many have paid. What we do know is that all across the country our constituents are having an unpleasant interaction with Obamacare. Whether they can sign up for a policy or not, they are discovering, of course, higher premiums, a higher deductible. Many of them are losing their jobs and so it is really a catastrophe for the country both for the healthcare providers and the consumers."
  • GE should put itself up for sale (Rob Cox, Reuters) That is an investor sponsored proposal on the ballot for the annual meeting this month. Cox discusses why the proposal makes no sense at all.
  • An Overview of the Ryan FY 2015 Budget (The Committee for a Responsible Federal Budget, 01 April 2014) Hat tip to Roger Erickson. The prescription from Rep. Paul Ryan (R, WI) for cutting our way to prosperity. Let's see, what's the logic? If we have less money it will cause less trouble? Read the full budget document.

Today there are 15 articles discussed 'behind the wall'. The first 6 concern "smart beta" investment strategies and the next 6 are discussions about deflation.

  • Smart Beta (Research Affiliates) This report looks at the cases of non-price-weighted indices as a special case of smart beta processes. Shown are the excess returns for a number of such strategies over long periods of time. These returns need to be evaluated against the implementation costs (management fees, transaction costs, realized tax payment costs, etc.) before the value of implementation can be assessed. For example, if added costs average 2% a year the strategies lose to simple capitalization weighted passive index investing. If costs average 2.5% a year none of the strategies offer an advantage. But if costs average only 1% a year the implementation of a 1.7% excess return strategy is worth an added 32% over 40 years. And if an excess return exceeds added costs by 1.5% the accumulated excess return over 30 years is 56% (35% over 20 years, 16% over 10 years).


Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. It therefore costs less than active management, since there is less day-to-day decision-making for the manager, but since it will, at the very least, have higher trading costs than traditional passive management (which minimizes those costs), it is a pricier option.

Among the best known alternatives to market cap weighting are the fundamentally weighted indices developed by Research Affiliates in 2005 which rank their constituents by book value, dividends, sales, and cash flow.

However, even a naive weighting scheme such as equally weighted indices can be described as smart beta.

Interest in smart beta indices has been fueled by the global financial crisis of 2007-08 which prompted many investors to become more focused on controlling risks than simply maximizing their returns.

  • How Smart is 'Smart Beta' Investing (David Blitz, Rebeco Quantitative Equity Research) This is a white paper for institutional investors. The seven page paper concludes that many smart beta programs are designed for their simplicity and not for effectiveness. To maximize the effective use of smart beta requires active management which is missed in the simplest applications.
  • Is 'Smart Beta' an Improvement Over Standard Indexing? (A. Raymond Benton and Rick Ferri, The Wall Street Journal) One is pro and the other con. Benton says it is an effective way to deal with "momentum, value, size and volatility" on a "risk-adjusted basis". Ferri, on the other hand, says it is a gamble that "higher risk and higher cost" will yield "higher returns after expenses".


  • Rob Arnott and the Rise of Smart Beta (James J. Green, ThinkAdvisor) This combination of active management strategy with indexing has adherents and critics (see next article). Arnott himself argues that the strategy provides a more equitable allocation among value stocks.
"'Smart beta' is like saying 'smart manager.' Everybody wants a smart manager, but the average manager on average is average. So, it's a marketing gimmick, I would call it."
  • Are you ready for deflation? (Brett Arends, Market Watch, The Wall Street Journal) U.S. prices are tracking eerily with 1990s Japan. In the 1990s and first half of the 2000s conventional wisdom had Japan on the verge of an inflationary cycle and sharply rising interest rates. Japan was considered a "bug looking for a windshield".



  • Understanding Deflation (Deflation) Hat tip to John O'Donnell. This is a complete and straightforward definition of deflation and its ramifications. Visit also the page Leading Deflationists, a short list than includes three who have contributed multiple times to Global Economic Intersection (Van Hoisington, Lacy Hunt and Steve Keen).


Oculus provides Facebook with the opportunity to build a presence in virtual reality, and gain control of the hardware its software will run on, providing more lucrative opportunities for advertising.
  • Why China will come up short in the currency battle (Fergus Ryan, China Spectator) The author sees the renminbi accounting for 5-10% of international exchanges over the next couple of decades but it will a long time before sufficient trust is built to consider more.


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