Asset Allocation Using ETFs

Stracia, LLC
This report was

prepared by:
Asset Allocation Using
Troy Peery, CFA
Exchange-Traded Funds
(917) 626-4827
[email protected]
Equity Research 18 August 2009
Please contact me
with any questions
or comments.
Your feedback
is appreciated.
Contents page
Outline................................... 5
ETFs 101................................. 6
Portfolio Strategy.................... 7
Asset Allocation.................... 11
Selection Preferences ........... 16
Risks and Drawbacks............. 20
Benchmark Selection ............ 23
Risk Management ................. 24
Crisis of Confidence .............. 28
Economic Diagnosis .............. 29
Overview
Whither the Dollar................ 37
The Housing Market ............. 45
• We are launching coverage of select exchange-traded funds.
Asset Classes ........................ 48
Sectors ................................. 55
• Equity-centric portfolios have disappointed investors for a decade. ETFs of-
Geographic Regions .............. 94 fer a low-cost, tax-efficient, multi-category alternative that allows investors
Fixed-Income...................... 109 to shed the false expectations of equities investing.
ETNs................................... 123 • ETFs provide exposure not just to equity, but to commodity, currency, fixed-
ETFs and Taxes.................... 125 income and international categories.
Dividends and Shorting ....... 128 • The number of ETF offerings has more than doubled in the last 18 months,
Price and Yield.................... 129 providing unique opportunities for portfolio diversification and risk man-
ETF Creation Process .......... 131
agement. However, vehicles must be selected with caution.
Specialty ETFs ..................... 132
Active ETFs ......................... 133
• We recommend vehicles and portfolios for different investment objectives
Statistics of Allocation......... 137 and risk tolerances, and discuss our custom analytical services.
How to Use Our Research ... 139 • Our approach focuses on comprehensive portfolio strategy, tactical deci-
Custom Services ................. 141 sion support for rebalancing, and risk management.
Stracia, LLC
See the Important Disclosures section on 329 East 5 Street, Suite 4A
page 143 for required disclosures, including New York, NY 10003
potential conflicts of interest. www.stracia.com
Note: All price, P/E, current-yield, NAV-per-share, aggregate net-asset,
expense-ratio, and average-daily-volume (ADV) data is as of market close on
Monday, 17 August 2009, unless otherwise stated.
The name “Stracia” is a registered trademark belonging to Stracia, LLC, and may not be used without written permission.
All other trademarks and service marks mentioned herein are the property of their respective owners.
Copyright © 2009 by Stracia, LLC. All rights reserved.
No part of this work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic,
mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United
States Copyright Act, without the prior written permission of the copyright owner.
Requests to the copyright owner for permission or further information should be addressed to Troy Peery, 329 E. 5th St. #4A,
New York, NY 10003; e-mail: [email protected].
While the author has used his best efforts in preparing this work, he makes no representations or warranties with respect to the
accuracy or completeness of its contents and specifically disclaims any implied warranties of merchantability or fitness for a par-
ticular purpose. The information and opinions presented herein are for general information use only, are subject to change with-
out notice, and are not intended either as an offer or solicitation with respect to the purchase or sale of any securities, or as perso-
nalized investment advice. The advice and strategies contained herein may not be suitable to your situation. You should consult
with a qualified professional where appropriate. The author does not assume any liability for any loss that may result from the
reliance by any person upon any such information or opinions. Please see the “Important Disclosures” beginning on page 143.
Stracia, LLC Asset Allocation Using Exchange-Traded Funds
n Contents
Outline...................................................................................... 5 We begin with a discussion
of ETFs as investment ve-
The ABCs of ETFs ....................................................................... 6 hicles and our approach to
Comparisons to Mutual Funds ............................................ 6 portfolio construction. We
then present our economic
Portfolio Strategy ................................................................ 7 outlook, followed by a dis-
Building Better Portfolios .......................................................... 9 cussion of ETFs by sector,
country/region, and other
Recommended Weightings per Category ........................... 10 categories.
How Important Is Asset Allocation?................................... 11
Equities: Still Believe the Hype? ........................................ 14
Our ETF Selection Preferences........................................... 16
Core and Satellite.............................................................. 18
How Much Diversification? ............................................... 19

Risks and Drawbacks ......................................................... 20
Benchmark Selection ........................................................ 23
Risk Management ............................................................. 24

Crisis of Confidence................................................................. 28
Economic Diagnosis .......................................................... 29
Hair of the Dog ................................................................. 31

Whither the Dollar .................................................................. 37
Cotton-Candy Economy..................................................... 37
The Housing Market.......................................................... 45

The Case for a Slow Recovery ............................................ 46
The Big Picture: Asset Classes ................................................. 48
Size & Style Exposure .............................................................. 50

Sector ETFs.............................................................................. 55
Technology ....................................................................... 57
Telecommunications ......................................................... 60
Consumer Discretionary.................................................... 66
Consumer Non-Discretionary ............................................ 69
Healthcare ........................................................................ 70
Industrials......................................................................... 72
Materials .......................................................................... 75
3
Asset Allocation Using Exchange-Traded Funds Stracia, LLC
Financials.......................................................................... 77
Energy .............................................................................. 81
Infrastructure ................................................................... 86
Utilities............................................................................. 91
Geographic Diversification ...................................................... 94
Emerging Markets............................................................100
Frontier Markets ..............................................................104
MENA ..............................................................................108
Fixed-Income ETFs..................................................................109
Investment-Grade Corporate Bonds .................................112
Municipal Bonds ..............................................................113
TIPS .................................................................................115
High Yield ........................................................................116

Commodity ETFs ....................................................................117
ETNs.......................................................................................123
Assorted ETF Topics................................................................125

ETFs and Taxes .................................................................125
Dividends and Shorting ....................................................128
A Closer Look at Price and Yield .......................................129

The ETF Creation Process .................................................131
Specialty and Active ETFs .......................................................132
Asset Allocation: The Statistical Evidence...............................137

How to Use Our Research ......................................................139
How to Use Our Charts ....................................................139
Custom Services ..............................................................141
Please contact the author to discuss how best to utilize

ETF research and ETF-based portfolio management in
your organization.
Troy Peery, CFA
(917) 626-4827
[email protected]
4
n Outline
This report describes the
Focus of This Report
This report outlines a strategy for portfolio management using ETFs. Equities have use of ETFs for comprehen-
broadly disappointed for seven of the past ten years (page 24), with the S&P 500 sive investment manage-
now nominally flat with its level of February 1998. Retail investors have wizened to ment. I am interested in
the failures of equities ownership to match the hype (page 14). deploying this approach in
a portfolio-management or
At the same time, ETFs have grown in size and variety such that even large institu-
advisory capacity.
tions can use these low-cost, transparent vehicles for allocation across a range of
asset classes (pages 6, 48). From long-term, value-oriented strategic investing to
the most tactical, short-term position management (page 26), ETFs have come into
their own as tool supporting sophisticated portfolio management and trading.
Investment Philosophy
We begin from the fundamental premise that asset allocation is one of the most
important factors affecting portfolio returns (pages 8, 137). We approach asset
allocation using a simple “show-me” framework based on the demonstrated risk
and return characteristics of ETFs.
We combine this approach with proprietary trend and cycle analyses and volatility-
adjusted stop-loss management techniques (page 139). The result is a set of instan-
taneously optimized ETF portfolios that we subject to rigorous, ongoing fundamen-
tal analysis and monitoring.
Economic Outlook
We believe the economic crisis of the last two years has revealed structural flaws in
the U.S. economy (pages 28–47). The unprecedented amount of new currency and
reserve creation in recent months (pages 35) makes it difficult to separate the ef-
fects of recent monetary policy from market performance (page 46), but guides us
toward inflationary expectations in the years ahead. What’s more, as the recent
trauma has given the country’s largest lenders pause (page 39), we discuss the de-
fensive posture suggested by a “dollar doomsday scenario” in the context of inter-
national and commodity diversification (pages 32, 37–45).
Current Recommendations
We combine our outlook for global economies and markets with our allocation and
specific ETF analyses, resulting in a set of comprehensive portfolio recommenda-
tions described throughout this report. For our current recommendations:
• by asset class ......................................... see page 49
• by size & style category .......................... see page 50
• by sector................................................ see page 55
• by geographic region.............................. see page 94
• by fixed-income category ....................... see page 109
• by commodity........................................ see page 117
• final recommendations .......................... see page 10
What to Do Next
The author is interested in deploying this research in the design and management
of globally diversified investment portfolios, in either a buy-side or sell- Troy Peery, CFA
side/advisory capacity. Please contact to discuss further. (917) 626-4827
[email protected]
5
n The ABCs of ETFs

The first successful ETF was An exchange-traded fund is a prepackaged portfolio of tradable securities, a
introduced in 1993—the “basket” of stocks (and/or bonds, commodities, etc.) that may be bought and sold
S&P 500 “sypder.” There on an exchange with a single order. ETFs are typically investable index funds. The
first successful ETF in the U.S., the SPDR S&P 500 Depository Receipts (SPY), was
are currently about 850
launched by State Street Global Advisors on the American Stock Exchange in Janu-
ETFs and ETNs on the mar- ary 1993, and still trades today.
ket.
Since then, and especially in the last several years, the ETF category has grown
phenomenally. There are now over 1,760 exchange-traded funds and notes (ETNs)
worldwide, most of which are listed on the NYSE Euronext (having recently com-
pleted its acquisition of AmEx) or Nasdaq.1 These vehicles have attracted over $860
billion in assets. (In the U.S., there are over 860 ETFs totaling $560 billion in assets.)
Recent growth in the category means ETFs now allow investors to:
• gain exposure to all major asset classes, while
• managing portfolio diversification and
• controlling risk across a range of low or negatively correlated groups,
• at low cost.
Of course, ETFs are growing not only in terms of their absolute number, but in
terms of assets under management, percentage of institutional and managed-
account allocations, and the number of advisers and sponsors that provide ETFs.
Comparisons to Mutual Funds

ETFs may be thought of as mostly passively managed, low-cost mutual funds that
trade like stocks, and whose holdings are not only perfectly transparent but dis-
closed daily. The price of an ETF closely tracks the value of its underlying assets or
index throughout the trading day, net fees and expenses.2
Mutual funds, by contrast, offer transparency only in hindsight and partially, with
regard to their holdings and relative weightings. They are priced only once per day,
by the manager—rather than through open-market arbitrage
of the fund itself—and at the close. These inefficiencies gave
rise to 2003’s late-trading/front-running scandals and the
Table 1: ETFs versus Mutual Funds current probe into the mutual-fund industry’s valuation prob-
lems. Mutual funds are also required to disclose their hold-
Characteristic Mutual funds ETFs ings only once per quarter, not daily.
Transparent û üü
Market-priced/arbitraged û üü With ETFs, there are no such mysteries or lags, though ETF
Repriced continuously û üü investors do pay half of the bid-ask spread when buying or
Marginable û ü selling the fund. This cost of trading, which is typically pennies
Optionable û ü per share, is transparent, but there is no comparable cost
Intraday stop-loss orders û üü with a no-load mutual fund. ETFs still typically boast a net
Can be sold short û ü cost advantage over mutual funds due to their lower expense
No platform intermediary û üü ratios (on average). And unlike mutual funds, ETFs can be sold
Cost advantage û üü short, traded on margin, are typically optionable (see Table 1,
Greater tax efficiency û üü left), and do not need to maintain a cash cushion to meet
Lower cash drag û üü investor redemptions, thereby freeing ETFs to invest more of
1
There are important differences between ETFs and ETNs; see page 129. We use the term
“ETF” to refer to both types of vehicles, unless otherwise specified.
2
While ETFs are priced as they trade, underlying net asset value (NAV) and intraday value
are typically published every 15 seconds. See page 42 for discussion of price and yield.
6
their holdings in actual securities (a lower “cash drag”). As such, we view ETFs as
altogether more flexible vehicles for managing risk and investment timing, while
offering significant cost advantages and tax efficiencies (see page 125).
Portfolio Strategy
But by themselves, such benefits are insufficient to begin the long-term reparations
and rebuilding of value that many portfolios require after nearly two years of un-
precedented downside. As we discuss beginning on page 28, we expect that the
monetary-policy responses to the recent economic crisis and follow-on effects from
that crisis to continue sending shockwaves through the economy for some time.
Jumping back into the U.S. equity market is especially risky, given our outlook for
the dollar (discussed below). We recommend that investors instead pursue a multi-
category approach with strict risk-management protocols.
This is where ETFs come in. In our view, these vehicles’ greatest advantage is in the
construction and allocation of total portfolios. Allocation is the most important
factor impacting long-term investment perfor-
mance; below, we discuss a variety of ETFs span-
ning sector, geographic, style and other catego-
ries. The goal is to deliver superior risk-adjusted Exhibit 1:
performance over periods as short as several Model Framework
months (and beyond), through the construction
of liquid, scalable, tax-efficient portfolios that are
inexpensive to build and maintain.
Our approach is simple. We begin by forming a

general investment policy, based on a fundamen-
tal analysis of global macroeconomic and market
Market
factors, drilling down to the economic-sector lev-
performance
el. (See exhibit 1.)
The next step is actual ETF selection. We use a

number of criteria including fund size, liquidity,
tracking error, and correlation with other vehicles, ETF selection
to develop a “short list” of funds that offer expo-
sure to the countries and sectors we have identi-
fied as attractive. (We discuss these criteria on
page 16.)
Optimization
To this point, all of our work is fundamental. The
next two phases, allocation and risk management,
are more quantitative. We define and examine a Allocation
set of hypothetical portfolios that have historically
“dominated” in terms of risk-adjusted perfor-
mance.
Our expectations for changes in performance and Risk

volatility inform our final recommendation, and management
are based on our fund-specific and macro analys-
es. (See page 24 for discussion of these methods
in the context of the recent failures of so much
financial risk management.)
7
Volatility-Adjusted Stop-Losses
Finally, we determine trailing stop-price targets for all of the vehicles that we rec-
ommend and update them continuously. The goal is to expose investors to upside
from a diversity of high-quality vehicles while protecting against the dual threats of
whiplash trading and double-digit drawdowns.
We have designed our strategy and recommendations for:

• investors of any size interested in dynamic risk management;
• institutional investors (for whom ETFs were originally designed) seeking ex-
posure to unique asset classes;
• institutional investors using ETFs for securities lending or options trading;
• retail investors interested in managed-portfolio services; etc.
Over the next several pages, we discuss our process for constructing our portfolio
recommendations. Sell-side research has traditionally focused on providing one-off
stock ideas, with analysts concentrating on the narrowest of nuances among peer
companies in well-defined industry categories. The appeal of this silo approach is
that analysts’ “industry expertise” adds value to the stock-selection process. But it
has been recognized for decades that investment policy is a more important de-
terminant of portfolio performance than stock selection. That is why analysts’ in-
dustry expertise does not help investors make money, however appealing it may
seem as a research-product “differentiator.”
What matters is investment policy and position management—that is, asset alloca-
tion, risk parameters (maximum drawdown, volatility), target portfolio metrics
(holding period, turnover), and other investment constraints. Obsessing over indi-
vidual companies, the body language and travel plans of corporate executives, and
so on, may add market efficiency over the long-term (and noise in the short), but
the S&P 500 is trading at the same level it was twelve years ago. While flat index
performance does not necessarily impugn active management strategies, the in-
flated importance attached to corporate minutia increasingly seems an affectation
of research and media marketing, rather than a factor that has much to do with
actual portfolio performance or variability.
There’s no reason Wall Street research can’t be actionable and differentiated while
adding value to institutions’ and brokerage clients’ investment strategies. But to do
so it has to be smarter: it has to recognize that equity is but a single investable as-
set class, and that the compulsive categorization of companies into end-market
silos risks deëmphasazing factors that are often more important to portfolio per-
formance than stock-specific nuances.
Research has to be smart not just about stocks, companies and peer groups, but
about sectors, inter-market relationships, macroeconomic fundamentals, and tech-
niques for reducing risk at the portfolio level. At all of these categories of concern
must be integrated into an approach for providing recommendations that is at once
comprehensive and flexible. It is a tall order, but the recent performance of global
capital markets demands nothing less than a rethink of traditional methods.
Investors are already looking to other markets, and to superior portfolio-

management techniques, for capital preservation and growth. In the next section,
we describe our approach to constructing ETF portfolios.
8
n Building Better Portfolios

This report describes our new ETF research platform, explaining how to use these ETFs can be used to increase
vehicles in the context of comprehensive portfolio management. We graft ETFs diversification and decrease
onto a strategy designed to achieve exposure to various asset categories, styles, volatility at low cost.
and economic regions and sectors. Our investment policy, the “beta decision,” is
therefore based on analyses of traditional macroeconomic and country/region fac-
tors; the specific ETFs that allow us to affect that policy comprise the “alpha deci-
sion.” We analyze specific vehicles using a combination of fundamental and market
analyses, as described in this report.
The goal is to achieve superior performance through diversification, risk budgeting,

tax efficiency and low-cost account maintenance. While most investors would
agree that these are worthy objectives, there is no “one-size-fits-all” portfolio suit-
able for all clients. With that in mind, we recommend several different portfolios in
this report, spanning a range of risk objectives, liquidity constraints, number of
holdings, etc. We view our “anchor” portfolio (next page) as the most broadly suit-
able for long-term investors. We recommend monthly rebalancing of core positions
as well as allocations to more nimble, “satellite” positions (see page 18). We can
construct any of the recommendations in this report as a managed portfolio,
tweaking them on the basis of specific objectives. Once constructed, we can also
handle the rebalancing automatically as market conditions, our own expectations
and the client’s needs evolve.
As elaborated below, asset allocation is simply the most important investment de-
cision you can make—more important than market timing and yes, even more im-
portant than stock selection (see page 137). ETFs are uniquely well suited to sup-
porting allocation and market-/sector-rotation decisions. ETFs allow investors to
rebalance exposures inexpensively and, thanks to their recent growth, with ever
sharper definitions of size & style, sector, and industry categories and geographies.
Even alternative-investment structures such as private equity are now exchange-

tradable—with transaction costs typically measured in basis rather than percen-
tage points. Indeed, there are so many types of vehicles to choose from that it can
be a paradox of choice, representing a hurdle not just to maximizing performance
but to beginning the allocation and rebalancing processes.
That is the first problem our new platform solves. We sort through the growing
number of ETF options to identify those we expect to maximize intermediate- to
long-term returns while minimizing downside risk, transaction costs, and expenses.
We then make recommendations not in a stock-picking or industry-coverage silo,
but in the context of a comprehensive portfolio strategy, using historical and ex-
pected measures of risk-adjusted return to deliver the most competitive asset-class
and securities mixes. This new coverage may be used to complement existing stock
and industry research—either to broaden its scope or to provide clients or other
constituents with:
• risk-based parameters for targeting investment categories and actual ve-
hicles, and
• supporting buy and sell decisions in an investment environment that is in-
creasingly volatile and noisy.
The exhibits on the next page depict our per-category and “anchor” portfolios.
(Note that no tickers are given under “asset categories” in Table 2 as we are mea-
suring allocations to categories rather than to specific ETFs.)
9
Table 2: Recommended Weightings per Category

Asset categories Weight Global sectors weight Global equities weight
Stocks .................................. 25.0% Technology (XLK) .................. 20.0% Australia (EWA) ................... 14.2%
Bonds................................... 35.0% Telecommunications (IXP) .... 10.0% Brazil (EWZ) ......................... 10.7%
Commodities........................ 10.0% Cons. disc. (XLY) ................... 10.0% Canada (EWC) ..................... 0.0%
Cash..................................... 30.0% Consumer staples (XLP) ........ 12.7% Chile (ECH) .......................... 7.3%
Total 100.0% Healthcare (XLV) ................... 0.0% China (FXI) ........................... 5.3%
Energy (XLE) ......................... 0.0% Euro. mon. union (EZU) ........ 0.0%
Size & style Industrials (XLI) .................... 7.2% Hong Kong (EWH) ................ 11.8%
Large-cap growth (IVW) ....... 14.8% Infrastructure (IGF) .............. 11.9% India (EPI) ............................ 7.9%
Large-cap value (IVE) ........... 10.9% Materials (XLB) ..................... 15.8% Japan (EWJ) ......................... 0.0%
Mid-cap growth (IJK) ............ 18.6% Utilities (XLU) ....................... 0.0% Malaysia (EWM) ................... 0.0%
Mid-cap value (IJJ) ................ 18.3% Financials (XLF) .................... 12.4% Mexico (EWW) ..................... 14.4%
Small-cap growth (IJT) .......... 14.5% Sub-total 100.0% Singapore (EWS) ................... 14.3%
Small-cap value (IJS) ............ 17.9% South Africa (EZA) ................ 0.0%
Private equity (PSP) ............. 5.0% Commodities South Korea (EWY) ............... 8.7%
Hedge funds (QAI) ............... 0.0% Precious metals (DBP) .......... 15.0% Sweden (EWD) ..................... 0.0%
Sub-total 100.0% Base metals (DBB) ................ 15.0% Switzerland (EWL) ................ 0.0%
Oil (USO) .............................. 10.0% Taiwan (EWT) ....................... 0.0%
Bonds Natural gas (UNG) ................ 0.0% United Kingdom (EWU)......... 0.0%
1–3-mon. Treasurys (BIL) ..... 17.2% Coal (KOL) ............................ 20.0% United States (ISI) ................. 5.4%
1–3-year Treasurys (SHY) ..... 10.5% Natural resources (IGE) ........ 10.0% Sub-total 100.0%
7–10-year Treasurys (IEF) ..... 0.0% Agribusiness (MOO) ............. 13.8%
20+-year Treasurys (TLT) ...... 0.0% Livestock (COW) ................... 4.5% International currencies
Inf.-protected Treas. (TIP) ..... 6.2% Water (CGW) ....................... 11.7% Australian dollar (FXA) ......... 40.0%
Municipals (TFI) ................... 12.2% Sub-total 100.0% British pound (FXB) .............. 0.0%
Inv.-grade corp’s (LQD) ......... 33.3% Canadian dollar (FXC) ........... 20.0%
High yield (JNK) ................... 20.6% Chinese yuan (CYB) .............. 20.0%
Sub-total 100.0% Euro (FXE) ........................... 20.0%
Japanese yen (FXY) .............. 0.0%
Mexican peso (FXM) ............ 0.0%
Swiss franc (FXF) .................. 0.0%
Source: Stracia, LLC Sub-total 100.0%
Chart 1: “Anchor” Portfolio Source: Stracia, LLC
The table above depicts

Coal allocations on a per-
10% Cons. staples
Technology
7%
category basis; the chart at
8%
left, our net recommenda-
Inv.-grade corp's tions. We expect our ma-
7%
Financials naged ETF portfolio to out-
9% perform the broad U.S. and
1-3 year T's global markets.
6%
Infrastructure
7% Muni's
6%
Natural resources
2%
TIPS
5%
Canadian dollar
6% Oil
4%
Australian dollar Water
8% 5%
Precious metals Chinese yuan
3% 6%
10
n How Important Is Asset Allocation?

The benefits of a managed-portfolio strategy based on ETFs include the ability to Allocation is the
attain whatever level of diversification or concentration may be desired. Below, we
critical factor impacting
discuss what this means in terms of selecting an adequate number of portfolio
portfolio performance.
holdings. More basically, let us examine the importance of diversification as a fac-
tor impacting investment strategy itself—the design of investment policy. Just how
important is allocation?
The Most Important Single Factor

Practitioner experience and financial research have for decades recognized the
critical significance of asset allocation to long-term portfolio performance, though
there remains a good deal of controversy over just how important it is. A sample of
peer-reviewed and practitioner studies attributes, on average, about 80% of the
“shared variation” in portfolio performance to allocation decisions.
This means that how much portfolio returns change has more to do with the port-
folio’s relative exposures to its individual holdings than with any other factor an
investor can control. The variability of returns is not the same thing as returns but,
of course, how much the value of something changes helps measure and deter-
mine where its future value may end up. (We discuss the statistical evidence in
detail beginning on page 137.)
The point is worth emphasizing because it is not one that research based on the
“great man” theory of stock-picking has been particularly good at advancing: Asset
weighting is the critical factor determining portfolio performance—more important
than any other factor. This is not a message that the sell-side, by and large, has
received. At a time when so much about security selection and investment strategy
has been called into question, we believe it is important to recognize the singular
role of allocation policy.
It’s time for a wake-up call:

• allocation matters more than stock-picking;
• security selection is not an investment strategy;
• investment policy matters more than industry expertise, valuation, or “hot
stock tips.”
Our new ETF coverage provides decision support where it’s most needed.
Stock Selection Is Not Enough

“The only thing wrong with security selection is that… for those who have tried, it’s
3
been fatal.” Viewing a company’s equity shares in isolation, or in the context of
industry “silos,” leaves too much correlation risk unaccounted for. We would argue
that this is true in normalized investing environments and not just during periods of
severe market turmoil (“when all correlations go to one”). During times of crisis
and to nearly everyone’s frustration, the ability of fundamental company research
to add value to investment decision-making often takes a backseat to macroeco-
nomic analysis and even technical considerations. It is a lesson we are all, by now,
too familiar with.
To a large extent, balancing traditional sell-side research with more rigorous tech-
niques for risk management has been the job of the institutional portfolio manager,
3
Page, Sébastien and Mark Kritzman. “Asset Allocation Versus Security Selection.” State Street Associates, August 2002.
11
just as it has been the broker’s job to balance the relative risk profile and expecta-
tions of recommendations made for individual clients. The case might be made
that institutional managers’ risk-management techniques have grown “too sophis-
ticated,” or faux-sophisticated—leaving more risk on the table than was intended
or understood; and that clients could benefit from broker recommendations made
in the context of the whole portfolio—rather than primarily on the basis of isolated
stock “calls” or casual/undisciplined sector diversification.
Connecting the Dots in a Complicated Matrix

Our ETF platform connects the dots, helping not only institutional clientele but
retail investors better understand the risk metrics underlying allocation scenarios in
rapidly changing markets. Stock selection is an important part of the equation, but
it is not enough.
If asset allocation is the most important component of an investment strategy, why

have investors been left to tackle it on their own? The exhibit on the next page
depicts the basic building blocks of investment policy. The exhibit is at once too
complex and as simple as we could make it. While no portfolio must contain expo-
sure to all of the categories and vehicles depicted, all of them should be considered
in portfolio construction.
Traditional Sell-Side Focus: Out of Focus

How is an individual investor (a) to determine which categories represent the best
value, given the ability of vehicles in that category to reduce risk, at any point in
time; (b) design a strategy incorporating those elements; and (c) select appropriate
vehicles representing each component? We have not even begun to discuss the
fundamental economic, investment-timing, and position-management considera-
tions involved; the forecasting strategies supporting such considerations; early in-
dications of system crisis; etc.; and yet the basic building blocks of diversification
already overwhelm.
No strategy that excludes these building blocks is minimally competent in the con-
struction and maintenance of a retail portfolio, in our opinion. Yet traditional sell-
side research often focuses on a few narrow slices of the equity part of the equa-
tion, as if the other elements are not important or do not exist—even though the
performance relationships among these elements have long been recognized as
the key to performance.
Wake-Up Call for Investors

Perhaps the global financial meltdown of the last two years will wake investors to
the realization that something is missing from the traditional research equation,
and that that something is asset allocation, hiding in plain sight. Investment policy
matters not just for institutions, but for retail investors; and it matters more than
any other single component.
The myth of individual stock-picking has recently been more beneficial to profes-
sional traders, brokers, and the media’s “equity infotainers” than to the individual
investor. We recommend implementing a multi-asset-category approach based on
a stated investment policy, as outlined in this report (or paying an advisor to im-
plement a similar strategy; or at the minimum, buying passively managed index
funds representing a mix of asset categories, as discussed below).
12
Exhibit 2: Portfolio Building Blocks Source: Stracia, LLC
13
n Equities: Still Believe the Hype?

Will the stock market’s turbulence over the last two years skew investors’ percep-
Equities investing inspired
tion of equities investing for years to come? Has it skewed our own recommenda-
a new “shareholder de-
tions against stocks? Are investors too negative on equities right now—possibly
mocracy,” but a decade of setting up ideal conditions for a contrarian call on the stock market?
underperformance later,
the well of expectations Just as the “great recession” has taught shareholders hard lessons about the down-
has been drained. side of stock ownership, market history can help develop a better sense of the role
of this asset class in normal investing environments. Maybe stocks, as an asset
class, really are worth all the storm and stress, the hype and focus they receive
from media and the “equity-industrial complex” that sells you not bonds (too safe,
not sexy on TV), not commodities (too difficult to artificially inflate or pump and
dump)—but stocks, stocks, and more stocks.
The Long View

So let’s step back and take a long-term view of the equity market. Looking at the
category’s history in real terms may provide a useful counterweight to recent expe-
rience, which has been more bad than good for mainstream investors.
The charts below show the S&P Composite, on both a nominal and inflation-
adjusted basis, from January 1871 to May of this year. The chart at left compares
the inflation-adjusted performance of the S&P Composite to the “headline” or un-
adjusted price.4 We see the last decade’s familiar zigzag, with peaks in 2000 and
2007—representing volatility not seen since the Great Depression and the greatest
volatility-spike ever. And this from a large-cap index representing a long-term, pas-
sive investment strategy. Unadjusted for inflation and ignoring the last decade,
stocks appear to be efficient, effective vehicles for generating long-run portfolio
returns.
Charts 2 and 3: Equities Investing over the Long-Term
S&P Composite Adjusted for Inflation S&P Composite Adjusted for Inflation
(Indexed to 1871 = 1) (Logarithmic; 1871 = 1)
400 1000
350
300 100
250
200 10
150 Are stocks worth all the
hype and risk?
100 1
50
0 0
1871 1891 1911 1931 1951 1971 1991 1871 1891 1911 1931 1951 1971 1991
Unadjusted Adjusted Unadjusted Adjusted
4
All figures have been indexed to January 1871. The data and inflation-adjustment calcula-
tions were obtained from the Web site of Robert J. Shiller, Yale professor and author
(www.econ.yale.edu/~shiller). It is the same data used in his book Irrational Exuberance
(Princeton University Press; 2000, 2005.)
14
But both of those assumptions ignore the effects of inflation. The red lines in both
charts show equity performance on an inflation-adjusted basis. (See corroborating
exhibit, showing global inflation in 2009, below.)
Inflation Too Often Ignored

It is not just the last decade that calls equity-centric investing into question, but the
history of the asset class—even when we fail to take risk into account! And it is not
that all asset classes carry as much exposure to inflation’s eroding effects as equi-
ties; gold, commodities, natural resources and inflation-protected securities can all
provide natural (if never precision-perfect) inflationary hedges.
By themselves, stocks have demonstrated an impressive ability to add volatility and

destroy wealth over short time periods, and to underperform most investors’ ex-
pectations and perceptions over the long-term, in our view.
An Opportunity for Wall Street, Too

We therefore think the equity-centric investing thesis makes little sense, especially
with an ever-growing range of transparent securities available that provide access
to other asset classes. This report is dedicated to demonstrating how these vehicles
may be used in globally diversified, risk-managed portfolios of any size.
Wall Street has an opportunity to leverage the benefits of ETFs for clients of various
degrees of sophistication. Many of these clients, disappointed not just in the per-
formance of their portfolios, but in the recommendations of analysts and advisors,
are looking for either for new solutions or a whole new strategy for managing in-
vestments. Wall Street’s traditional, equity-centric research machine is out of date
and out of touch with a growing portion of disaffected investors. ETFs are not a
magic bullet, but can help bridge the gap between the sell-side and its traditional
client base.
Exhibit 3:
Global Inflation 2009
0–2%
2–5
5–10
10–15
15–25
25%+
Source: CIA World Factbook 2009; Stracia, LLC
15
n Our ETF Selection Preferences

We prefer ETFs that are Investors must consider the ongoing viability of an ETF before investing. Vehicles
that are unable to attract a critical mass of assets may offer insufficient liquidity or
true survivors, and suffi-
even be pulled from the market.
ciently liquid for even large
institutions to trade. First-to-Market Advantage
While being first to market in a category often helps a fund attract more assets
(increasing its long-term viability), it is important to consider the depth and
breadth of investor interest. While a vehicle that fails to catch on in the market may
not remain viable, a fund that follows a well-established category leader may also
be doomed in terms of asset accumulation.
First-Mover Case Study

So the trade-off is often between being the first to enter an untested market and
thereby gaining competitive advantage, or following the leader in a proven catego-
ry—and quite possibly forgoing the opportunity to dominate that category. For
example, Victoria Bay Asset Management introduced the United States Oil fund
(USO) in April 2006, just three months before Barclays5 introduced the iPath S&P
GSCI Crude Oil ETN (OIL). Today, USO has net assets of $2.3 billion, or three times
as much as the larger (and later) firm’s assets.
So while first-mover advantage is important, we typically want a fund to be of suffi-

cient size as well as “vintage.” New funds typically fail to pass our screen both for
lack of track record and because they have not had time to attract sufficient assets.
Warning Signs
Separately, there have been an increasing number of high-profile closures across
the ETF universe due to flaws in the design of the fund:
• the fund is too narrowly focused;
• there is a disconnect between back-tested and realized results;
• structural flaws, such as running out of new shares to issue (which may pre-
vent a fund from trading at NAV).
Sponsors may also fail to adequately market a fund during the launch stage, keep-
ing it from reaching critical mass. Funds may also be at risk due to poorly timed
market entry.6 At minimum, we want to avoid owning a vehicle that offers insuffi-
cient trading liquidity or is even at risk of being delisted.
See the discussion beginning on page 134 for an overview of some of the major ETF
providers and managers.
Minimum Requirements
Our bias tends toward funds with track records of at least six months (the longer
the better) backed by well-known, stable sponsors. For ETNs, the sponsor’s finan-
cial and operating stability is also critical. Trading liquidity, as measured by average
daily volume (ADV), is also important, as we want to recommend portfolios that
can scale and be rebalanced competitively.
5
BlackRock has announced its intention to purchase Barclays’s iShares unit—the bank’s ETF
business; see the “ETF Families” section (page 138) for discussion.
6
Carty, C. Michael. “Taking Out the Trash—Which ETFs Don’t Work and Why?” Presented at
meeting of the Quantitative Work Alliance for Applied Finance, Economics and Wisdom
(QWAFAFEW) meeting of the New York chapter on 21 July 2009, in New York City. Carty is
a Principal at New Millennium Advisors, LLC.
16
We favor vehicles with net asset values sufficiently large to withstand a panicky
bout of redemptions. Any fund that has accumulated at least $200 million in assets
while avoiding the structural flaws outlined above may be considered viable in
terms of size (and probably volume, though that must be considered separately).
Liquidity
Lastly, much ETF research tends to focus on expense ratios. We consider expenses
too, of course, but believe the risk of paying up for liquidity outweighs a few dozen
basis points of overhead expense. ETFs are not mutual funds, and while it is more
difficult to measure trading costs—and to compare these costs across alternative
vehicles—than it is to measure a fund’s (published) marketing, management and
administrative costs, the impact of trading liquidity can be the more important fac-
tor, in our opinion.
This is especially true for active rebalancers, with expense ratios across the ETF
universe currently averaging well below a percentage point. It is the hidden costs of
trading that deserve attention, in addition to whether a fund charges, say, 0.5% or
0.6%.
Liquidity has different meanings in different contexts. Market analysts and traders
typically talk past one another when discussing liquidity, because the term is broad
enough to encompass a range of concerns more or less unique to different consti-
tuents. Basically, we think of liquidity in terms of the following factors:
• price: ability to build or reduce a position in size without moving the market;
• availability: ability to purchase enough of a position to achieve the target
ownership stake; that is, the availability of shares, whatever the price;
• redeemability: the ability to withdraw funds and make redemptions;
• spread: the bid-ask spread and where and order gets filled in the context of
the other factors.
All of these considerations are important when recommending ETFs to institutional

and high-net-worth client basis. We look at a fund’s average daily volume (ADV),
bid/ask spread, and assets represented, in order to gauge fund liquidity for our
purposes.
Novelty
While the focus of this report is on the vehicles we currently recommend, we have
analyzed and rejected a host of competitive alternatives, and discuss only some of
the more robust alternatives herein. But new vehicles coming to market are also of
interest, as are those that may provide unique exposures. Examples of novel ETFs
include:
• the ALPS Equal Sector Weight (EQL, page 56)
• the Claymore Ocean Tomo Patent ETF (OTP, page 132),
• the ProShares Credit Suisse 130/30 fund (CSM, page 54),
• the JPMorgan Alerian MLP Index ETNs (AMJ, page 124).
We weigh the novelty of an offering against its recent risk-adjusted performance

relative to “core” holdings and the other factors listed in Table 3 on page 23—
especially its trading volume, a measure of liquidity—and would view ETFs like the
patent fund as appropriate for consideration only as “satellite” holdings and/or in
retail accounts. Next, we discuss this core-and-satellite approach.
17
n Core and Satellite

In the core-and-satellite model, a diverse basket of assets, representing the “core”
of the portfolio, is designed to minimize risk through broad exposure to economic
or end-market demographic or demand trends, for example—and are ideally low-
cost. The manager then builds “satellite” positions through:
• individual security selection,
• trading positions,
• adjustment of long/short exposure,
• derivatives strategies, etc.
The satellite positions are chosen based on the manager’s estimation of their abili-
ty to add non-systematic characteristics (alpha) to the portfolio. Core positions may
also include so-called “gamma” assets—an investor’s nondiscretionary holdings.
(These may include real estate, for example, that the investor has no intention of
trading and which represents sufficient exposure to the real-estate category.)
Our approach may be applied using the core/satellite model by “setting aside” pre-
determined allocations representing satellite positions, and then constructing the
core portfolio using ETFs. The satellite “set-aside” can either be a portion of total
portfolio value that the investor wants to trade speculatively, a portion in each cat-
egory set aside for non-discretionary or purely speculative assets, etc.
The exhibit below represents a hypothetical core/satellite strategy. (Note that the
categories are not necessarily to scale.) The investor has set aside a portion of the
portfolio for pure speculation; any such positions will
represent satellite trades. Most of the allocation to
stocks and commodities will be achieved through core
ETF positions, as will all of the allocations to the bond
Exhibit 4: Core/Satellite Model and currency categories.
Finally, the investor chooses to diversify in real estate,

perhaps by adding some exposure to international
properties. The large satellite portion of the real-estate
allocation probably consists not of speculative trades
but of non-discretionary holdings (e.g., one or more
mortgages).
The value of non-discretionary asset holdings and the

desired level of speculation (if any) are different for
each investor. There is no such thing as a one-size-fits-
all efficient portfolio of market assets when we take
individual portfolio/estate parameters into account.
We can do just this in order to design market-efficient
ETF allocations on an individual basis.
The same technique can be used on a more dynamic

basis for institutional investors, to design efficient allo-
cations around long-term positions, such as allocations
to private-equity partnerships, real-estate or develop-
Source: Stracia, LLC ment deals, etc.
18
n How Much Diversification?

We know that obtaining “sufficient” diversification through an ETF strategy is not a In terms of number of hold-
problem; the problem, as is often the case with pure equity strategies, is knowing
ings, we view 10 to 15 as the
when to stop. How many holdings are enough to protect the portfolio from specific
risk? We want to avoid “over-diversification” and the mediocre returns and higher “sweet spot” for an all-ETF
transaction costs associated with it. portfolio.
The consensus thinking is that more than ten7 and up to 208 randomly selected
stocks provide an investor with sufficient protection against non-systematic risk.
While even the narrowest ETF typically carries exposure to dozens of assets, it is
important to remember that funds’ asset groupings are designed to be anything
but random. Holdings are generally selected precisely because they have similar
characteristics that tend to generate high beta correlations.
Unfortunately, the consensus thinking with respect to diversification in pure equity

portfolios is not directly applicable to portfolios containing exposure to multiple
asset classes (or at least, not obviously so), for at least two reasons. First, while the
beta correlations of assets held by ETFs may be high, they are not 1. Second, a glo-
bally diversified portfolio by definition seeks exposure not just to multiple asset
classes, but to multiple equity sectors, global bond markets, geographic regions,
and alternative-investment categories. Many of these markets and categories are
expected to carry unique (though again, not perfectly unique) systematic risk in
normal investing environments. The multi-category investor generally seeks some
degree of diversification in all targeted categories, as well as across the portfolio.
But we can take some lessons from equity diversification. If we are seeking expo-
sure to each of the major asset classes (stocks, bonds, commodities and cash) then
20 funds is almost certainly too many for an individual investor; and we might view
8 or 10 as a hard minimum. The “sweet-spot” number of ETF holdings for this in-
vestor probably lands in the range of 10 to 15—and is partly a function of the final
constituents’ correlations. Any more than that and we risk paying commissions for
the privilege of “chasing alpha away.”
For institutional investors, the problem quickly grows more complicated, such that
it is difficult to generalize by rules of thumb. The size of assets under management
and the breath of desired category exposure may produce liquidity constraints for
large and/or narrowly focused portfolios. These constraints may trump the trade-
off between more holdings and less idiosyncratic risk. Given the broad range of
portfolio strategies and characteristics, target markets and categories, and available
ETFs, there is no single answer that is correct at all times and in all market condi-
tions.
It is for these reasons that we seek to recommend vehicles with liquidity sufficient
for even large investors and that we give special consideration to some of the more
novel funds available—such as the Claymore Ocean Tomo Patent ETF (OTP). Where
a strong thesis justifies their inclusion, low-beta “satellite” holdings such as these
can help to minimize the number of total positions and transaction costs.
7
Evans, J.L. and S.H. Archer. “Diversification and the Reduction of Dispersion—An Empirical Analysis.” Journal of Finance,
December 1968.
8
Malkiel, Burton G. “How Much Diversification Is Enough?” Proceedings of the AIMR seminar, The Future of Equity Portfolio Construc-
tion, pp. 18-28; March 2002.
19
n Risks and Drawbacks

The major complaint ETFs have certain risks and drawbacks. Tracking errors are inevitable, due not only
to expense ratios but to the inability, in some cases, to adequately replicate an un-
against ETFs is that some
derlying index or commodity. High portfolio turnover, the resulting transaction
generate wide tracking er-
costs, and lack of liquidity can all exacerbate tracking error.
ror. This must be considered
when selecting the most There may also be a disconnect between the kind of exposure an investor seeks—
appropriate vehicle in a to the equity markets of certain Asian tigers, for example—and the actual stock
category. markets represented by an emerging or frontier fund. And though some might not
consider it a weakness, the first actively managed ETFs based on manager discre-
tion are only now available. (Active, “algorithmic” ETFs first came out in April of last
year; see discussion on page 133.)
Leveraged ETFs
Leveraged ETFs seek to magnify the gains or losses of an underlying index. These
vehicles are controversial in a number of ways. First, they are most appropriate for
managing exposures on a daily or intra-day basis. They do not track their index at
the stated multiple (which is often from one to three times the change in the un-
derlying index) with any fidelity over extended periods, and tracking errors can be
significant even over periods as short as several days. They may not even provide
directional fidelity to their target index over periods of weeks.
Recently, the Financial Industry Regulatory Authority (FINRA) discouraged brokers

from offering these instruments to retail investors, due to their unsuitability for
long-term investing. Brokers including Edward Jones and Ameriprise have banned
their use as recommended investment vehicles.
We recommend the use of leveraged ETFs by investors sophisticated enough to

manage portfolio exposure on an event-driven basis, for periods of hours or days.
Their use as satellite vehicles (see page 18) may allow a portfolio manager to avoid
adjusting core positions in anticipation of or reaction to market events, including
economic releases, earnings reports, changing expectations for financial and other
industry regulation, etc.
See discussion in the section on “Institutional Trading with ETFs” (page 26).
Not Available through All 401(k)s

Mutual funds definitely have a stronghold in the 401(k) market. Most retirement
plans do not currently offer ETFs as an investment option to plan participants,
though that is starting to change. In our view, many indexed ETFs are as suitable for
owning through retirement plans as mutual funds.
There have been two main hurdles to ETFs penetrating the 401(k) market thus far:
certain incompatibilities in the record-keeping and processing systems designed for
mutual funds, and transaction costs. Service providers and other parties have ad-
dressed many of the back-office issues that originally kept ETFs out of organized
retirement accounts, and the portion of participants holding ETFs in these plans is
rising. ETFs now account for as much as one-fifth of the assets held in retirement
accounts brokered by some of the larger firms serving this market. New vehicles,
such as target-gate funds (which we do not view as particularly successful) are de-
signed to increase this penetration.
20
Classification Schema Sometimes Too General

ETFs do not provide access to all markets, sectors or geographic areas, and the ex-
posure they do provide is sometimes too general. It is still too difficult for U.S. in-
vestors to target developing countries in Asia and South America, for example.9
With sector-based ETFs, which are broad by definition, the classification of core
businesses often relies on systems as loose as the Standard Industrial Classification
(SIC) codes. Sponsors are making more instruments available to the market, but
seem to resist more sharply defining the real activities of cross-competitive firms or
the roles they play in specific product markets. So we end up with a software ETF,
like the iShares S&P North American Technology Software Fund (IGV), that contains
everything from Oracle (ORCL) to Concur (CNQR). The former is an enterprise data-
base vendor and one of the world’s largest software companies; the latter is a
small-cap provider of travel-and-expense management solutions. In some cases,
gaining exposure to both of these firms through a single vehicle may be exactly
what is desired; but the ability to target more narrowly defined peer groups is also
of interest. (Of course, if an ETF that tracks an index is too broadly defined, it is the
underlying index’s classification scheme that is to blame, not the ETF’s. But the end
result to fund investors is the same.)
Just as investors benefit from a software ETF as broadly defined as the IGV, we be-
lieve that access to more specific industry sub-categories—defined by firms’ prod-
uct markets, customer demographics and competitors—would also be useful. For
example, in the software industry:
• global small-cap vendors;
• large-cap enterprise resource planning (ERP) companies;
• makers of anti-virus and security software; etc.
An ETF for enterprise software would look very different from a retail-software
fund. Both could contain dozens of holdings. At some point, of course, definitions
become “too fine”—as we recognize with our own asset-size and liquidity criteria.
There needs to be sufficient trading volume and demand for an ETF to make it via-
ble, and that is the balance that must be struck—between narrowness of definition
on the one hand and breadth of appeal on the other.
Sponsors are beginning to recognize the need for niche offerings. TXF Funds, based
in Oklahoma City, has requested SEC permission to launch an ETF that would invest
in the largest public companies in Texas, and plans to follow up with filings for mid-
and small-cap Texas firms. (The funds would be listed on the NYSE Arca.) An ETF
targeting community banks and bank-holding companies has also been announced,
and there is plenty of room in that industry for offerings that vary by their holdings’
geographic region of focus, asset size, etc.
But we think the industry could do more to offer investors better access to viable
funds defined by size & style characteristics as well as product end-markets. In our
view, more uniqueness and security-specific savvy in the development of new ETFs
is preferable to yet another sector fund that invests on the basis of SIC or NAIC
codes, and the industry is catching on.
9
Our favorite example of an investable country that could not be accessed by U.S.-based ETFs was Vietnam, until the introduc-
tion of the market vectors Vietnam ETF (VNM) several days ago. Deutsche Bank’s FTSE Vietnam “db x-tracker” ETF (TFVTTU) is
listed on several European exchanges but not in the U.S.
21
Manager Risk versus Benchmark Risk

Investors should also be aware that following a strategy based on recommended
allocations introduces manager risk into the equation, in a way that simply using
ETFs to track one or more benchmarks does not. (This is not a deficiency of ETFs
per se, but a basic decision between passive or active investing.)
It is a trade-off—either choose a passive index strategy and hope you picked the
right benchmarks (broad market or sector-specific? large-cap or small? growth or
income?, etc.) in the “right” proportions, or choose to allocate among a set of ETFs
based on expectations for their risk-adjusted performance.
In our judgment, prudence advises opting for manager risk with periodic rebalanc-
ing over a nondiversified, buy-and-hope strategy that ignores the allocation deci-
sion. Seeking to avoid manager risk by adopting even a perfectly passive strategy
just shifts some of that risk to the index-selection decision.
A Host of General and Specific Risks to ETF Investing

Like any security, ETFs can decline in price on a host of economic, market and com-
pany-/issuer-specific factors. Indeed, just as ETFs are designed to provide invest-
ment results that generally correspond to the price and yield performance of their
underlying holdings, they likewise subject shareholders to many of the same risks
associated with direct ownership of those holdings—including:
• sector and geographic risk;
• asset-category risk;
• the risk that market sentiment in general, or performance expectations for
the fund’s actual holdings, will erode; etc.
A host of other risks abound. ETNs, for example, carry unique sponsorship risk (see
discussion on page 123 and the Important Disclosures section on page 143). Over
the next several pages, we discuss some of the nuts and bolts of ETF investing, in-
cluding tax efficiencies, our portfolio-construction process and techniques for risk
management, and benchmark selection.
22
n Benchmark Selection
For comparison purposes, we think the S&P 1500 Super Composite (SPSUPX) The benchmark for our
represents an appropriate, if imperfect, benchmark for our recommended ETF
“anchor” portfolio is the
portfolio. It nicely satisfies most of the criteria for benchmark selection: It is invest-
S&P 1500 Super Composite.
able and specified in advance; it is transparent and passively managed; and we
have an “informed opinion” about it.
But it is not a “perfect” benchmark (there is seldom such a thing) for two reasons:
• There is a systematic risk differential between our ETF recommendations
and the S&P 1500 (the relative beta ¹ 1.0).
• As an equity index, it does not reflect all of the characteristics of our ma-
naged portfolio—which also contains exposure to underlying fixed-income,
commodity, and currency assets.
We actually view the first item, if not as a strength, then as a shortcoming we

should tolerate on the basis of our target audience’s pre-existing exposure bias,
which is U.S.-centric. We could reduce this risk differential by using the Vanguard
Total Stock Market Index Fund (VTSMX) instead of the S&P 1500, but we view the
latter as more appropriate for our client base: If we can’t demonstrate outperfor-
mance relative to our clients’ existing strategies, the fact that we may outperform
some index that is less relevant to them (but more statistically appropriate for
measuring our management skill) may be of little consequence to that audience.
So the S&P 1500 is really a proxy for our clients’ current portfolios—it
represents the starting point from which we are trying to move them in the
direction of smarter diversification, better risk management, and better per-
formance. Since the question is whether to increase diversification geographi- Table 3: Evaluating the S&P 1500 as
cally and by asset class, our competition is not just other managers but en- Our Benchmark
trenched practices.
Selection criteria
As for the second item above, we are aware of no global benchmark that is Investable ü
multi-category, multi-style and multi-cap. Even the now-retired MSCI Global Appropriate ~
Capital Markets Index only captured the equity and fixed-income categories. Passive ü
We have created a proprietary global capital-markets index that is back-filled Relevant (informed opinion) ü
to the beginning of 2000, but it is unsuitable as a benchmark because it is not Beta (risk differential) ~
transparent. Some generally useful global-market indexes are listed in the Unambiguous (transparent) ü
table below. Specified in advance ü
Table 4:
Tracking Global or Multi-Class Markets
Index Ticker
• MSCI All Cap World Index. ............................................................ ACWI, ACWX
• S&P/Citigroup BMI World Index (ex–US) † ..................................... SCWY
†
• Dorchester Capital Markets Index ................................................ CPMTKS
†
U.S.-only
Institutional clients that want to benchmark our anchor portfolio against the ACWI
are encouraged to do so, and we are happy to provide the same kind of historical
data and side-by-side comparisons that we use to measure our recommendations
against the S&P 1500.
23
n Risk Management
Brokerage research traditionally focuses on one-off stock picks. Research analysts
Quantitative techniques for
bring deep expertise into the industries and companies they cover, and individual
risk management have been
rep’s may make recommendations in the context of loose (and typically unspeci-
used poorly, even by sophis- fied) investment policy; but more often the focus is on divining the future of indi-
ticated investors. More in- vidual share-price performance as a proxy for corporate fundamentals. Macroeco-
tuition and less obedience nomics often takes a back seat to sector and market dynamics. It’s an approach
to “black boxes” is one pre- based on the “great-man” theory of investing (writ small), and it doesn’t work. It
scription. also fails to take allocation into account in any rigorous way.
Because we recommend portfolios of ETFs, our recommendations involve not just

security selection but asset weightings. We must therefore take into account a host
of portfolio-level considerations; indeed, a basket of related picks balanced on the
relative merits of each is one of the key benefits of our approach.
In this section, we discuss the risk-mitigation strategies we use in arriving at our

final recommendations.
Ragione Oscurata
For decades, Wall Street has applied ever more
sophisticated quantitative techniques to prob-
Exhibit 5: lems in portfolio- and risk-management. The level
S&P 500: Real Returns in the New Millennium of “quant” knowledge at work in financial servic-
es has never been greater; the number of profes-
1873
sionals laboring away at these tasks, never higher.
1881 Never have we had more technological tools and
1882
1883 training at our disposal. Yet, as shelves fill with
1884
1888 studies of “what went wrong” during the recent
1895
1886
market crisis, quant models in general and risk-
1896
1899 1897 modeling techniques in particular have earned
1902 1898
1906 1900 their share of vilification, and rightly so. Every
1910
1927
1901
1904
global economic crisis in the last decade was fo-
1925 1872 1905 mented in the U.S. financial-services industry.
1923 1874 1924
1921 1875 1925
1919 1877 1938 The perceived value of advanced risk-
1923 1889 1943
1929 1892 1944 1879
management techniques having been so high for
1932 1894
1909
1949
1950
1880 so long, one might expect average investment
1876 1934 1885
1887 1939 1911 1951 1891 performance to show the benefits—more consis-
1890 1942 1926 1952 1915
1893 1947 1959 1963 1921
tent and competitive returns, say, than in the
1903 1948 1965
1968
1964
1967
1922 primitive times, or less pain for the quantitative
1913 1953 1936
1940 1956 1971 1972 1945 managers during the recent downturn.
1957 1960 1982 1976 1955
1962 1970 1988 1980 1961
1920 1966 1978 1992 1983 1975 1908 But this has not been the case. The exhibit at
1907
1931
1930
1941
1969
1977
1979
1984
1993
2004
1986
1991
1985
1989
1927
1928
right depicts the real returns of the S&P 500 from
1937 1946 1981 1987 2005 1996 1997 1935 1871 to the present. Annual returns for the last
1917 1974 1973 1990 1994 2006 1999 1998 1958 1933
2008 2009 2002 2001 2000 2007 2003 1878 1995 1954 10 years (through May 2009, calculated on a
year-over-year basis) are highlighted. The abys-
mal results have been even worse for quant
strategies in recent years, as investment manag-
ers and analysts have often come to rely on over-
Annual percentage change
engineered frameworks built on unrealistic, just-
Note: Monthly year-over-year returns shown. 2009 returns so assumptions about the behavior of markets, in
calculated year-over-year through August (not year-to-date). our view. The math behind such models often
24
looks great on the blackboard; let’s leave it there. In effect, it’s a question of what
models can do and how to use their output. Our approach to risk management
recognizes the primacy of cutting losses before they run, without getting stopped
out of targeted positions in volatile markets.
“Back to Basics”
Because the returns show above are index returns—pure beta—one might argue
that recent history actually demonstrates the importance of risk mitigation in the
face of unprecedented downside. After all, poor index performance does not imply
poor investment management, and active managers’ claim to fame hinges on just
the opposite expectation: that skillful security selection and risk management will
separate you from the herd.
We won’t belabor the point; the patients have taken over the asylum and the way
to regain control, in our opinion, is through a greater reliance on macroeconomic
and investment intuition and the demotion of impenetrable quantitative strategies
and assumptions that sacrifice pragmatism at the altar of elegance—reliance on
which has at the very least contributed to a decade-long string of broad underper-
formance.
True, one never sees the returns that didn’t get printed, but failures of portfolio
engineering have exacerbated risk where they were supposed to tame it. Bad intui-
tion alone doesn’t get you a 44% drawdown.
Practical Quantitative Techniques

Risk management in the context of asset allocation is tricky, in part, because of the
difficulty of forecasting expected returns, standard deviations, and correlations for
both the broadest investment categories or for specific instruments. The most ele-
gant frameworks are often great at describing theory but impractical in the imple-
mentation of real-world investment decisions—e.g., mean-variance optimization
(MVO), in our opinion and to take but one example.
More broadly, average hedge-fund performance would not have been –20% in
2008 if the world’s most sophisticated investors had had any idea what range of
inputs to use in their models in 2007.
To make matters worse, allocation models typically require relying on the persis-
tence of historical trends in the estimation of parameters. But such assumptions
break down going into or coming out of fat-tail markets, like the recent one.
Table 5:
Some Leveraged ETFs
Index Ticker
• PowerShares DB Agriculture Double Long ETN.............................. DAG
• PowerShares DB Crude Oil Double Long ETN ................................ DXO
• ProShares Ultra Financials ............................................................ UYG
• ProShares Ultra Gold.................................................................... UGL
• ProShares Ultra Semiconductors .................................................. USD
• ProShares Ultra Yen...................................................................... YCL
• ProShares UltraShort FTSE/Xinhua China 25 ................................. FXP
• Rydex Inverse 2x S&P MidCap 400 ................................................ RMS
25
We use a comprehensive approach to risk management that analyzes volatility in

several separate but related ways:
• in absolute terms (i.e., for each target security);
• relative to other securities;
• as volatility changes over time; and
• by publishing stop-loss targets that take changing volatility into account.
Position-Management Techniques
Our fundamental and quantitative risk measures inform both the selection of indi-
vidual ETFs and their weightings in the recommended portfolio. These measures
are designed to limit drawdown and the likelihood of getting stopped out of de-
sired positions.
We use quantitative techniques to analyze the expected volatility of investment

returns and to derive volatility-adjusted stop-loss targets (see page 139). Our non-
deterministic quant methods support recommendations that, in our judgment, are
more practical and actionable—which in turn increases our confidence in these
recommendations.
From Vehicle Selection to Allocation

We begin by determining the specific mix of stocks, bonds and commodities that
have recently resulted in optimal risk-adjusted performance; and proceed by divid-
ing the problem into ever smaller and more manageable pieces, deriving useful
insight into the relative risk/reward trade-offs implied by different investment poli-
cies at each step.
That is, we repeat the process in order to better to understand risk/return payoffs
by size and style classifications, sectorally, and by geographic region and country—
approaching the problem in the order described in Exhibit 6.
At this stage, the results are purely normative—we are deriving the portfolios we
would construct if all we cared about was obtaining the proper sector mix, or geo-
graphic mix, etc.
These are steps in the process, rather than recommended portfolios. Once we have
determined that a 30% allocation to equity is justified, for example, determining
the mix of growth stocks to value stocks that will ultimately get us to that 30% is
just another repetition of process.
Institutional Trading with ETFs

As discussed on page 20, leveraged ETFs are designed to support tactical trading
decisions, rather than to track a target index over periods even as short as several
days. The objective of the Direxion Daily Financial Bear 3x Shares fund (FAZ), for
example, is to return three times as much on a daily basis as the Russell 1000 Fi-
nancial Services Index (RIFIN), but in the opposite direction. If the index is up 2% on
the day, the FAZ seeks to decline by 6% (before fees and expenses).
But no such performance expectations should persist over periods exceeding one
day, and examples of broad disparities between the performance of leveraged ETFs
and their target indexes over longer periods are not hard to come by. For example,
during the first quarter of this year, the Russell 1000 Financials fell 25.4%. The ex-
pectation would therefore be that the FAZ return roughly +76% during that period.
26
But the FAZ’s actual performance was –42%. It provided Charts 4 and 5: Leveraged ETF (FAZ) versus Its Index
neither three-times leverage nor inverse returns over
the course of the quarter.
13 Mar '09
23 Mar '09
11 Feb '09
21 Feb '09
12 Jan '09
22 Jan '09
3 Mar '09
1 Feb '09
2 Jan '09
What went wrong? Well, nothing. As the charts at right
show, FAZ did more or less what it was designed to do
in Q1. It tracked daily changes in the underlying index 1,100
by negative 300%, typically with fidelity. Though it 900
sometimes missed its daily target (on one day, by as
much as 8.6%), on average it came within 30 basis 700
points of the targeted daily change.
500
Better Disclosures Needed 300
Leveraged ETFs might better be called “leveraged daily
ETFs,” given that they achieve their performance by 100
resetting their exposures to a variety of options, fu-
Russell 1000 Financials FAZ
tures, swap and forward contracts, reverse repurchase
agreements, etc., on a daily basis.
5%
In our view, these vehicles are totally inappropriate for
long-term or retail investors, but can help institutions 0%
and tactical traders manage short-term exposure with- -5%
out (necessarily) subtracting from the available reserve
capital required to trade on margin. -10%
We think that the information some of these funds pub- Daily fidelity
lish regarding their true performance objectives needs
to be clarified for the sake of retail investors and their
advisers.
Exhibit 6:
Decision Process: Adding Return, Shedding Risk
Class Size & style Sectors Geography

• Stocks • Capitalization • Healthcare, tech, • Developed and
• Bonds • Growth and value energy, etc. emerging
• Commodities • Dividends • Cycle exposure • Country and region
• Cash
Source: Stracia, LLC
27
n Crisis of Confidence
As long as the U.S. economy Current sentiment has it that the mortgage-cum-liquidity crisis of the last two years
is based on seigniorage, has subsided—that the crisis has passed and that it’s only a matter of time until the
financial crises will be the recession passes, too. Our philosophy is not to argue with the market, though we
do think that the U.S. economy carries greater systematic risk than is widely appre-
norm, not the exception.
ciated. Specifically, we think the potential for economic fallout resulting from misal-
locations in the financial system has not only been shown, but persist despite the
monetary-policy responses to date. What’s more, we think those responses, com-
bined with our fiscal policies, raise the likelihood of a repeat of the kind of coun-
terparty panic that repeatedly gripped markets over the last two years.
Constructing this argument—understanding why systemic risk has not only been
managed away, but increased dramatically in the last year (in our view)—requires
briefly replaying the catastrophe and market and government responses to it.
Brief Synopsis
There was never a liquidity crisis, except in the sense that the entire debacle from
summer 2007 to early this year was created by too much liquidity. It was a crisis of
confidence: Participants did not want to deploy available capital because the per-
ception of the discount rate (the risk assessment) attached to most investments
was so high, because of the succession of traumas originally inspired by mortgage
defaults. For this reason, we think the monetary-policy response has only delayed
the inevitable reckoning. The crisis has been managed but it is not over.
By now, investors are familiar with the mainstream version of “what went wrong”
with the global financial system over the last two years. The brush strokes are as
follows:
• “Reach for yield” drove an over-extension of credit, made possible by weak
lending standards, poor risk management and ineffective regulation…
• … until the growth of debt instruments finally outstripped the growth of in-
come available for debt service.
• The integration of financial institutions and the modern securities-
distribution model caused widespread contagion throughout financial mar-
kets…
• … with staggering mark-to-market write-downs resulting in massive gov-
ernment bailouts globally, at the risk of sponsoring new moral hazard.
So the trauma resulted “as all bubbles do” from a misallocation of resources that,
once triggered, kept expanding, erasing bigger chunks of value from nearly every
corner of the market—save gold, asset-backed lending, and volatility itself.
A Man Falls off a Cliff…

This is the mainstream analysis, and it is correct as far as it goes. But in our view, it
does not get to the root cause of the recurring crises that have rained down on
global markets with increasing frequency over the last decade. It’s a bit like diag-
nosing a patient by noting he has three symptoms—shortness of breath, rapid
heart rate, and anxiety—but leaving out the part where he was just pushed off a
cliff. Did he jump? Was he pushed? And how far to the bottom?
Or to put it another way, why are global, monetary-expansionist market economies

proving increasingly erratic? They are crashing with greater frequency and the
28
crashes are getting worse, getting closer together, and last year—for the first time
in modern history—did not just affect politically unstable or economically develop-
ing nations. The storm rained down on the world’s most riskless lender, such that
markets still question whether anything, anywhere deserves a triple-A rating.
Poor lending standards and nonsensical risk-management models are only part of
the problem. The recent global turmoil should be understood not just in the con-
text of housing-market dynamics, or reach for yield, or the overuse and abuse of
derivatives overleveraged to other derivatives, in our view. Yes, phony metrics and
bad modeling can be found at the heart of Long-Term Capital Management, the
dot-com bubble and the “liquidity crisis.” In the mainstream telling, it’s all just a
kind of tulipomania—over and over every few years—three financial crises in the
last decade. In this telling, some tulips are fancy models with faux-sophisticated
assumptions, some are Internet stocks, some are houses. Every thirty-six months or
so it’s a different soon-to-be rotten bunch.
Understanding the recent crises as separate, one-off events, each with its own
unique and unrelated causes, might allow us to use standard models and assump-
tions to forecast the end of the current recession—a return to historically normal,
stable economic growth. But we do so at the risk of ignoring not just the frequency
with which crises now occur, but the commonalities among them. In our view, the
common factors have more power to explain global markets’ turbulence over the
last decade, and the next, than looking at each crisis as an unconnected, sui generis
enterprise.
Increasingly, it looks like what we have is a global crisis economy, and we must at
least analyze the possibility that the endgame is a dollar crisis. We therefore rec-
ommend, at the minimum, building a portfolio strategy that acknowledges the re-
cent dominance of secularly abnormal market dynamics, while girding for the pos-
sibility that the next bubble (or the next after that) is a dollar bubble.
Economic Diagnosis
Let’s begin the diagnosis with a few simple observations, at the risk of turning on
its head the mainstream telling outlined above. Indeed, the most basic framework
for describing the crisis of the last few years seems to have things backwards. Too
much credit was extended? It’s a “credit crunch.” Too much money chasing too lit-
tle value? It’s a “liquidity crisis.” Creating too much currency to stop the falling knife
of asset prices? Watch out for deflation. We look forward to the day when scotch
and pizza is health food.
Typically, confusing things for their opposites is a sign that effects have been con-
fused for causes. It’s not so much that our patient is short of breath, it’s that he got
pushed off a cliff. The confusion is not merely semantic: it guides monetary policy
and its contingencies, including investors’ expectations for and pricing of risk. It’s in
this vein that inflation is typically misunderstood as higher prices, and therefore
misforecast, when higher prices are but a single result of inflation—itself caused by
a leveraged money supply growing faster than market participants’ ability to pro-
duce and to consume. We are there now. So let’s set the record straight on some of
the crisis terminology that confuses cause for effect.
Green Shoots, Green Tulips

First, there was always plenty of liquidity about—trillions of dollars’ worth pledged
by governments or (mostly) sitting idle in private, sideline capital around the world
29
well into the onset of the mortgage meltdown and throughout 2008, when the
meltdown had spread marketwide. In fact, there was far too much liquidity for all
the value that market participants could divine in the real economy, and there had
been for some time. We will argue that there still is; that the problem of a capital
surplus is worse than ever, in fact.
Second, the crisis—even counting from the time where market events began to feel
like a crisis—did not start with credit suddenly tightening. That would be like sug-
gesting the dot-com bubble burst when Internet stocks became scarce (if we insist
on calling it a credit crisis). The squeeze started when credit simply could not get
any looser for all the risk that had been creditized. Just like our patient’s problems
start well before he hits the ground.
To be sure, credit did tighten in 2007 and 2008—access to capital was temporarily
withdrawn on a widespread basis due to general counterparty risk. Our point is
that the problem lies not with such a perfectly rational reaction to that risk (tempo-
rarily withdrawing credit), but with the underlying causes leading to what has been
misinterpreted as a negative reaction (the misallocation of over-levered resources).
Real economic crises never begin with a credit squeeze.
Misunderstanding these dynamics in their opposite sense risks mistaking the pre-
scriptions offered to date for something like a cure—including the GDP-sized pat-
chwork of bailout programs that far exceed (in constant dollars) the cost of all U.S.
wars ever fought, plus the space program, the New Deal, the Louisiana Purchase,
the Marshall Plan, etc. there's her —combined.10 This kind of confusion has in-
spired all of our monetary-policy responses to date.
For example, the Fed’s policy of quantitative easing and the explosive growth in
bank credits are but two manifestations of the response. The Bank of England has
entered the consumer credit-card business, started buying business-equipment
leases, and—for the first time in 165 years—stopped publishing a weekly account
of its balance sheet. (The policy was enacted in January, when the bank cut interest
rates to the lowest level since its founding in 1694.) While we are all for reducing
government expenditures, stopping the publication of M3—the least restrictive
measure of the money supply—impresses no one as a cost savings.11 We are dig-
ging a hole, fast and deep, on the expectation that we can dig fast enough to save
the falling man.
We expect such responses to aggravate and prolong the core problem, papering
over the vast misallocation of real, productive resources that exists in many devel-
oped economies relative to both the value of our purely financial assets and to the
value of productive assets in the developing world. It is on this basis that we view
the market rally that began in March as just that—a sharp but short-lived rally in a
secular bear market.
10
A novel comparison, but a telling one. Historical estimates for military expenditures are
from figures prepared by the Congressional Record Service. We think it not a coincidence
that, according to Alan Greenspan, there has been $12 billion in “newly created corporate
equity value”—roughly equal in size to all bailout dollars so far pledged or committed.
Greenspan, Alan. “Inflation—the real threat to sustained recovery.” Financial Times, 25 June
2009.
11
M3 items not captured in M2 included large-denomination time deposits, institutional mon-
ey-market balances, repo’s, and certain Eurodollars balances. The Fed stopped disclosing
M3 in February 2006.
30
Hair of the Dog Charts 6, 7 and 8: An Unhealthy Economy

It’s not semantics when the gears of global policy spin
for real. We must ask how policy makers and common Federal Funds Rate
wisdom have come to understand these dynamics in a 6%
way that confuses symptoms for causes, and lets the
brief intervals between market crashes pass for normal. 5%
The only way to address the kind of misallocations we 4%
have inherited and promoted is to rely on the same
blunt monetary-policy tools that allowed such condi- 3%
tions to fester in the first place, then to predominate. 2%
(Outlawing short sales doesn’t really do the trick.)
There are basically two monetary-policy tools available 1%
for redressing these misallocations in the normal 0%
course of the business cycle, for managing stresses in
Apr '07
Apr '08
Apr '09
Jun '07
Jun '08
Aug '06
Oct '06
Feb '07
Aug '07
Feb '09
Dec '06
Oct '07
Feb '08
Aug '08
Dec '07
Oct '08
Dec '08
the economy: increasing or decreasing interest rates
and the money supply.
Usually, these tools are sufficient, as for example when Source: Economagic
normal, cyclical dynamics cause inflation or unem-
ployment to rise to undesirable levels. In the former
U.S. Monetary Base since World War II
case, the policy response would be to raise the cost of
120%
credit in order to limit borrowing by businesses and Recent = 109.3%
consumers and to incentivize greater savings. In the year-over-year change 100% (May 2009)
latter case, credit would be made cheap to aid compa- 80%
nies’ expansion of productive capacity and new hiring.
60%
In essence, we think the recent fixes have successfully Average = 5.5%
addressed the normal cyclical elements of the econom- 40% (Sep 1946–Aug 2008)
ic crisis, but that it’s not a historically normal cycle at 20%
all; and have worsened the fundamental gap between
0%
the actual and financial values of our economies, as
measured in dollars, pounds, etc. -20%
Sep '45
Jan '51
May '56
Sep '61
Jan '67
May '72
Sep '77
Jan '83
May '88
Sep '93
Jan '99
May '04
Doubling Down
But is it really any different this time? Can’t we expect
the same policy tools to have the same effect as in Source: Federal Reserve Bank of St. Louis
2001, for example? Well, yes—to a point; and that’s the
problem. Like an addict, it takes more and more of the
same “medicine” to provide the same relief, and with U.S. Government Spending as Percent of GDP
more frequent dosages. Here, the medicine is money— 60%
more of it when credit is tight (goes the textbook), less
of it when credit becomes too loose. 50%
The problem is that, at globally uncompetitive levels of 40%

consumption and the production side of GDP lagging,
we have come to rely too much on our ability to create 30%
money, take on debt, and export inflation, relative to a
20%
somewhat diminished ability to create sustainable
wealth. To put it simply, the market crisis was driven by 10%
too much loose money, and we addressed the crisis by
making money even looser. 0%
1903
1910
1917
1924
1931
1938
1945
1952
1959
1966
1973
1980
1987
1994
2001
2008
This hair-of-the-dog cure can work for a time, but not,

we think, indefinitely. Markets broke down in 2008 as a
Source: usgovernmentspending.com
31
reaction to the oversupply of credit made available to risky mortgage borrowers,

multiplied by high leverage ratios, multiplied again by derivatives contracts that
contained more risk than was priced in. It was quite simply a credit bubble, but we
addressed it as if it were a credit bust—by lowering interest rates, creating curren-
cy and encouraging consumption. We made credit cheaper and easier to obtain
when a surplus of cheap and easy credit was the underlying economic ill, and we
hoped that the misallocations would work themselves out of the economy.
Monetary policy thus addressed the bust but not the bubble, and to an extent
without precedent in U.S. history, as measured by the explosive growth in the
monetary base (see middle chart on previous page). In the year through May, the
monetary base increased by 109.3% versus the post-war average of 5.5%—almost
20 times the average annual change and by far the greatest increase in history (da-
ta go back to January 1918).
Economic Sustainability
We think the problem is simple to understand, if difficult to address. The United
States became the largest economy in the world on the basis of its productive-
manufacturing ability. The transformation from an agrarian to an agrindustrial
economy supported a level of debt issuance that, while high, was backed by a real
and competitive productive capacity, especially in comparison to global trading
partners. A gradual transformation from traditional, export-fueled competition to
capital surpluses ensued, in which we began to lever our status as global currency
hegemon the better to fuel consumption, no longer paid for by exporting produc-
tive capacity or manufactured goods as much as by exporting financial services,
financial engineering, and inflation.
It is a recipe for bubbles, misallocations and crises; the gap between what passes
for financial value and underlying economic value has grown too wide, in our view.
For sure, the economy has stepped back from the precipice of late last year and
rebounded from its March lows. Well over a trillion dollars in new Federal Reserve
lending programs and emergency facilities has expanded the institution’s balance
sheet to unprecedented size, with at least one estimate of potential exposure as
high as $23.7 trillion—just as a result of managing the crisis.12
We view this estimate as a measure of how far the Fed is willing to go to contain
fallout wrought by widespread, indiscriminate financial-services practices. Once
out of the bottle, however, the genie of crisis management may prove difficult to
contain. Willingness to extend this level of credit in order to address problems
caused by the over-extension of credit may have begun to undermine our primary
lenders’ confidence in the competitiveness of U.S. credit markets, our ability to
repay outstanding or incremental debt while preserving lenders’ purchasing power
or, most worrisomely, the dollar regime itself.
We think the U.S. financial system may be dangerously unstable, and discuss the
possible ramifications of the crisis in terms of economic and dollar stability begin-
ning on page 37.
How to Play a Weakening Dollar in Normal Markets

Changes in the value of foreign exchange rates are driven by shifting expectations
for a country’s general economic health, with the currency of a country that expe-
12
Office of the Special Inspector General for the Troubled Asset Relief Program.
32
riences relatively strong economic fundamentals or growth, low inflation, and high
interest rates generally appreciating versus the currency of a country with deteri-
orating fundamentals. The primary factors influencing changes in direction of a
currency’s value include:
• GDP. As mentioned, strong economic fundamentals are associated with a
currency’s appreciation, and deteriorating economic health or growth, de-
valuation.
• Interest rates. Loose central-bank policies are associated with a currency’s
devaluation relative to stable currencies backed by higher interest rates. This
is true in part because investors can implement carry-trade strategies to
profit from the difference between countries’ overnight lending rates. All
else being equal, an investor would choose to purchase the currency of a
country about to raise its interest rates, while simultaneously selling that
country’s bonds and stocks.
• Inflation. The higher a country’s inflation, the weaker the international pur-
chasing power of its currency.
• Unemployment rate. An increasing unemployment rate is also associated
with a currency’s devaluation, with employment serving as a proxy for over-
all economic strength.
• Balance of trade. All else being equal, the currency of a country with a
strong current-account surplus will enjoy a stronger valuation.
• Fiscal regulatory environment. Policies that attract new investment, lower
effective tax rates, or increase investors’ sense of economic safety will tend
to strengthen a nation’s currency. In addition, trading volumes on a coun-
try’s national exchanges, which are typically conducted in the local currency,
signify the level of demand on the part of stock- or bond-market investors to
hold the currency enabling such transactions.
• Geopolitical events that tend to decrease investors’ (or the population’s)
sense of economic safety with regard to a specific currency will lead to its
devaluation.
The trick is to understand which of these various factors may be significantly im-
pacting specific foreign-exchange relationships at any given moment; how long
such relative priorities will endure; what might happen to perpetuate these relative
priority rankings, or reorder them; when those events would occur; and which fac-
tors will determine relative price movements over the course of the next trend.
Directional Strategy
U.S. companies benefit from a weak dollar primarily in two ways: from the curren-
cy-translation effect (when the restatement of revenue and/or earnings in the base
currency results in a gain), and by foreign customers’ greater demand for U.S.
goods at lower exchange-adjusted prices. A weak dollar benefits:
• U.S. exporters, as foreign customers can purchase U.S. goods with less for-
eign currency;
• foreign consumers of U.S. goods;
• foreign travelers to the U.S., and the domestic operations of related U.S. in-
dustries, such as tourism, hotels, etc.; and
• U.S. investors who own foreign assets, which are worth less in dollar terms.
33
All things being equal, a weak dollar also encourages new foreign in-
“The U.S. is the only nation in the world, as vestment in the U.S., as more foreign currency is required to buy the
the key currency nation, to have privileges to same amount of U.S. assets. Foreigners who invested in the U.S. when
earn huge seigniorage.” the dollar was weaker suffer, as they now receive more of their own
– Iwao Nakatani, economist currency in exchange for their U.S.-based dividends, interest or rent
Why Did Capitalism Self-Destruct? payments, capital gains, etc. Other parties interested in dollar strength
include foreign exporters to the U.S. (they prefer their customers use
strong dollars to buy more, say, yen-denominated goods), U.S. con-
sumers of imported goods, and U.S. travelers abroad.
Oil-producing countries benefit from a strong dollar on the supply side, but not the
demand side, because a strong greenback makes oil convertible into larger
amounts of foreign currencies “on sale.” However, oil demand from foreign con-
sumers will suffer at the margin when the dollar is strong.
Sectors and Styles That Benefit from a Weak Dollar

The information-technology and pharmaceuticals sectors benefit from a declining
dollar, as these firms enjoy significant competitive advantages versus foreign com-
panies, and substantial sources of foreign revenue.
Basic industries, commodity producers and manufacturers also benefit, including

for example makers of specialty chemicals, construction equipment, and pulp &
paper producers (including lumber), which tend to have large overseas customer
bases. These companies will sell more of their dollar-denominated products as it
becomes cheaper in real or foreign-currency terms. Gold stocks benefit from a de-
clining dollar, as gold is priced in USD terms (investors use the weak fiat currency to
buy the true global “reserve currency”).
Finally, companies with global operations are more exposed to foreign-currency

risk (either upside or downside) than smaller names focusing exclusively on domes-
tic markets. Thus, ETFs representing large-cap stocks in the sectors mentioned
above can provide upside exposure to a declining dollar trend. (Though the capita-
lization factor alone does not equate to exposure to foreign purchasing markets, of
course.) As a rule, given two companies with equal revenue exposure to foreign
markets, the one with a lower portion of overseas operating costs will benefit more
from a weak dollar. The firm with principally domestic operations (but overseas
customers) realizes the benefits of currency translation, while the firm with inter-
national operations meets some portion of its foreign obligations with a depreciat-
ing dollar.
Conversely, utilities, domestic telecom and financial services companies provide a

hedge against a strengthening dollar, as these groups offer little top-line interna-
tional exposure (recently about 9%, 3% and 6% of the top line, respectively, for
those S&P 500 groups).
Money Supply and Prices

Having set the table for how to play expectations for the dollar, we move to a dis-
cussion of a principal factor impacting its direction: inflationary expectations.
Let’s be clear that when we speak of inflationary monetary policy, we are not talk-
ing about the monthly CPI or PPI figures. These figures measure the prices that
consumers and producers pay for certain goods and services, with the CPI compiled
monthly by a dedicated army of part-time assistants working for the Bureau of La-
bor Statistics (BLS).
34
These assistants troll thousands of points-of-sale across the country, such as gro-
cery stores and retail outlets, individually pricing items in the CPI product basket.
Each assistant works through a checklist, recording the prices of items electronical-
ly for transmission to BLS, along with any special, more granular observations—
such as the unavailability of a product, discounts for volume purchases, and so
on—that add color to the data. About 400 people price approximately 80,000
items each month in this fashion.
The CPI figures are an invaluable metric for measuring monthly changes in the gen-
eral price level, or would be if the raw data were not undermined by arbitrary “he-
donic adjustments” that attempt to account for intangible qualities, such as a
product’s increased “comfort” or other perceived quality improvements.13
But it’s all presented purely as price data—the BLS makes no attempt to measure
the monetary base (nor would we want it to). Prices are just a single, lagged symp-
tom of inflation. The CPI is sometimes a useful proxy for discussing the first deriva-
tive of the monetary base, but often not, especially if the CPI is restated lower due
to productivity increases by way of hedonic adjustments. Recording prices is useful
but does not speak to the economy’s structure.
When that structure is changing—and undergoing radical change, as measured by

the recent, unprecedented surge in our monetary base—the price of a lollipop at
Qwik-E-Mart stands as a lagging, not a leading, indicator, and even as such only
speaks to one aspect of inflation.14
Structural Changes, Structural Flaws

In the latter half of the last century, the U.S. shifted from being a manufacturing-
driven economy to one led by the production of financial and other intellectual-
property services, including entertainment, fashion, etc., in addition to consumer-
technology and business-technology goods, most of which are now manufactured
abroad.
These industries all have the potential to add real economic value, but simply don’t
add enough competitive value to keep the U.S. afloat indefinitely in the absence of
greater real production relative to the increased manufacturing strength of eco-
nomic competitors, in our view. It’s not that this stuff is trivial or somehow “worth
less” than physical assets or assets that tend to drive productivity gains (our argu-
ment is economic, not cultural). Rather, the continued production of these goods
and services relative to our dwindling manufacturing gains are simply not worth
the trillions of dollars of debt already outstanding, and will never drive enough real
economic gain to allow us service that debt—not in absolute terms, relative to oth-
er countries, or relative to the past.
The topical case is just one form of the extreme: it is widely recognized that the
U.S. economy has come to rely on value-wrecking financial “innovation” to an un-
healthy and uncompetitive degree. But more fundamentally, there is a ceiling to
13
“In November 2002 the BLS reported that heating prices were down by 11.1 percent. Prices, in fact, were up more than 20 percent,
according to The Wall Street Journal and the markets. Similarly, the BLS reported ‘cheaper gasoline in May 2000,’ while the U.S. De-
partment of Energy reported that prices were up by more than 20 percent in May 2000. These are figures that are very easy to veri-
fy, yet Wall Street and the press accept the government figures unquestioningly...”
Rogers, Jim. Adventure Capitalist. New York: Random House, 2003; pages 328–329.
14
“Annual price inflation in the US is significantly correlated (with a 3½-year lag) with annual changes in money supply per unit of
capacity.”
Greenspan, Alan. Financial Times, 25 June 2009.
35
how much debt we can realistically pay back without driving systemic disruptions
to our standard and style of living. In our opinion, the country has far exceeded
that ceiling. These concerns must inform our asset-allocation and investment-
selection strategy.
Diminishing Strategic Debt Horizon

The migration of manufacturing construction (the building of new and the expan-
sion of existing plants overseas) is one of the developing world’s most effective
forms of advantage-seeking at the expense of the borrower economies. Low-wage
countries are not just sweat-shop bases.
They also house the most modern and technologically advanced new plants being
built. By contrast, U.S. manufacturing assets—from infrastructure to laborers and
the welfare packages supporting them—have largely started to become uncompe-
titive or even obsolete.
To be clear, the problem is not just the deficits, but the obvious inability to service
debt outstanding, even as we take on unprecedented new amounts of debt. The
U.S. could afford to run deficits for two centuries not only because we were fund-
ing growth toward future debt service through the production of goods with true
economic value, as measured both by trading value and ever-increasing, globally
competitive productive capacity.
The dollar’s standing as the de facto global currency guaranteed a “captive market”
of foreign buyers, who still need dollars to conduct global trade (which is about
two-thirds dollar-based), repay their IMF borrowings, and hold in reserve. (Dollars
also represent about two-thirds of global central banks’ reserve holdings.)
As discussed beginning on page 39, the dollar’s status as global reserve currency is
under attack not on the basis of any immediately viable alternative, but because
projections for our collateral status is under suspicion, in our view. We anticipate
that the depletion of a market willing to back our increasingly irresponsible eco-
nomic choices—and structure—would tend to limit our global status as borrowers
and consumers, with real economic consequences.
International Seigniorage Is Not Industry

That the nation shifted from manufacturing to the production of services like
finance and entertainment is incidental. As a strategy for increasing national debt,
seigniorage gain has a finite lifespan. The U.S. manufactures global financial crises
like it used to manufacture automobiles—well.
We are the world leader in meltdowns not just because ours is the largest global
economy. We have been the largest economy since World War II reduced Britain’s
fortunes (though the U.S. was overtaken by the EU in 2007), and we got to be that
way by producing better goods more competitively than other nations.
We will not continue to lead through a combination of federal borrowing, bailouts

and currency debasements, though the last ingredient may at some point be ne-
cessary to reset our balance sheet. We discuss that scenario next.
36
n Whither the Dollar

The bond market is currently indicating a defensive posture and inflationary expec- The massive build-up of
tations. The gap between 2-year and 10-year Treasurys widened to an all-time high dollar reserves appears to
in late May. Expectations for a prolonged recession have begun to moderate—with be a classic imbalance—
confirmation from several economic leading indicators—and 10-year rates are at
perhaps the fundamental
their highest levels since “Black September.” We would describe the yield curve as
normal but not healthy. trade imbalance in the
global economy today. It
The growing fiscal deficit and massive federal bailout programs call into question has placed our currency on
the long-term value of the dollar. With short rates near zero—the current interest- a pedestal that our econo-
rate target is up to a quarter point—the Fed has resorted to buying Treasurys. my cannot support.
This is a rather desperate form of quantitative easing, and it risks eroding confi-
dence in the U.S. dollar. Tax revenues are in decline. The country’s biggest bond
buyers are showing signs of skittishness. And it is estimated that $2 trillion in new
Treasurys must be sold this year—a record—to fund the country’s $1.75 trillion
deficit. Who will buy long-dated bonds when interest rates are kept artificially low
by Fed intervention? A steepening yield curve suggests playing the gap by buying 2-
years and shorting the long end.
But currently, more than half of all outstanding Treasurys are owned by foreign
investors. Inflation created by the bailout programs and signaled by current bond-
market dynamics imply these investors’ returns may be soft for years to come. The
weak dollar provides some support here but is no corrective to the structural is-
sues.
Cotton-Candy Economy
Merely recognizing the structural weaknesses of our economy is not enough, and
no amount of government intervention can redress these weaknesses. Just the
opposite: to put it simply, if an over-reliance on weak or consumption-driven eco-
nomic activity is the disease, then the reëmergence of a productive economy—and
one that relies less on the increasing specialization of foreign manufacturing—is
the cure. Not an instantaneous, 20-times increase in currency supply.15 Not quan-
titative easing on top of a negative real federal-funds rate and more unfunded,
unfundable government spending. It is hard to dispute that the world now recog-
nizes these mechanisms as “bubblenomics.”
Which brings us to where we were in the first quarter: The administration and the
Fed doing as much as possible, with the tools at their disposal, to cure the sick
economy. But this time around, the right tools lie outside the system because the
system is the problem.
Iatrogenic, money-shock responses may represent the best possible crisis-

management, but they only worsen and prolong the underlying economic ills. We
are digging a hole under the falling man; it will give him a little further to fall. But
new regulations and accounting or uptick rules won’t change the ending. We think
the U.S. economy is in for a hard landing because a fundamental trade imbalance
has accreted over decades, not only pricing much traditional U.S. manufacturing
out of global markets but regionalizing (on a global basis) the specialization of pro-
15
In the period preceding Japan’s “lost decade,” by contrast, its money supply (M3 semi-equivalent) grew by a factor of nine
(from ¥50 trillion to ¥450 trillion) in the nineteen years following the end of Bretton Woods. The result, of course, was a crash
in Japan’s stock and real-estate markets and banking sector, and a secular recession.
37
duction roles in ways that are ultimately unsustainable for the U.S. It is
“…recovery is sound only if it does come of necessary and important that China, for example, build its infrastruc-
itself. For any revival which is merely due to ture, grow its economy, and increase the size of its middle-class and its
artificial stimulus leaves part of the work of living standards. It is an economic transformation that involves shifting
depressions undone and adds, to an undi- the center of strength from administrative-agrarianism to market-
gested remnant of maladjustment, new ma- oriented industrialism. It is largely funded, of course, by the American
ladjustments of its own.” consumer, who benefits immediately and directly from the availability
of cheap goods. But for how long and at what costs?
– Joseph Schumpeter
Many commentators lament the decline of U.S. manufacturing, typical-
ly on the basis that it has been displaced by consumerism. We think
such jeremiads are overblown; they appear to be as much cultural as economic
complaints. It is true that the U.S. is no longer the world’s largest exporter (ranking
third, behind Germany and China), but its exports are still largely industrial—
aircraft, chemicals, machinery—and agricultural. But it is also true that China is
soaring in the rankings, having recorded a 26% increase in manufacturing exports
last year (according to the WTO), and that America’s exports rely more heavily than
ever on pop-culture products, including movies, video games, and fashion. This is
not the stuff of competitive dominance.
In our view, the fact that major export categories are shifting in their relative signi-
ficance, or even declining, may be problematic but is not by itself game-changing.
Economies reorganize and adjust. Underlying these ebbs and flows is a more per-
manent, structural shift that represents a secular challenge to America’s global
economic standing, in our opinion: a dangerous addiction to foreign debt funding
import consumerism, which our economic competitors use to build the same kind
of sustainable competitive infrastructure that America is increasingly offshoring.
For the first time ever, the U.S. Treasury earlier last month held four debt auctions
in a single week, and has recently started breaking weekly debt-issuance records.
We have no way of timing the tipping point; it is a “known unknown.” (See page 32
for a discussion of vehicles that help investors to diversify away from the U.S. and
the dollar.)
Charts 9 and 10: King Dollar (Two Views)
$1.20 $0.25
$1.00 $0.20
$0.80
$0.15
$0.60
$0.10
$0.40
$0.20 $0.05
$0.00 $0.00
1666
1683
1700
1717
1734
1751
1768
1785
1802
1819
1836
1853
1870
1887
1904
1921
1938
1955
1972
1989
1913
1918
1923
1928
1933
1938
1943
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
Notes: Chart on left shows value of dollar since 1666; chart on right since founding of the Federal Reserve.
Source: Robert C. Sahr, Political Science Department, Oregon State University;
data since 2007 provided by the Bureau of Labor Statistics.
38
Dollar Hegemony under Attack

The U.S. economy has structural problems that have nothing to do with subprime
lending, as evidenced by:
• the explosive growth in our monetary base at record low interest rates
(Chart 7, page 31);
• government spending as a percentage of GDP penetrating levels not seen
since World War II (Chart 8, page 31);
• unprecedented levels of quantitative easing designed to artificially lower
U.S. interest rates—the Fed directly monetizing U.S. debt;
• the weakness of the dollar, which has lost approximately 35% of its value in
the last eight years relative to a basket of foreign currencies, and almost 90%
of its absolute purchasing power since 1950 (charts on previous page).
Foreign buyers of Treasurys are beginning to voice concerns about the stability of
the dollar, which is essentially equivalent to being concerned about the viability of
the U.S. as a creditworthy winter. The symptoms listed above are compounded by
America’s growing debt burden and economic instability. Timothy Geithner tra-
veled to China in early June to assure our bond customers that we are serious
about controlling the budget deficit, his comment about the safety of China’s in-
vestments in dollar-backed assets drawing broad laughter from the audience at
Peking University. A week later, the Russian central bank announced plans to curtail
T-bill purchases, and Brazil announced an effort to diversify currency reserves away
from U.S. dollars.
The BRIC countries have begun coördinating plans to limit their Treasury purchases,
and the International Monetary Fund (IMF) appears to support such moves, having
announced in June that it will issue non-dollar-denominated bonds countable as
foreign reserves. Russia and India elevated their calls for a movement away from
the dollar-based, single reserve-currency system at the Group of Eight meeting last
month.
China’s efforts to establish the yuan as an international currency now include al-
lowing certain mainland Chinese banks (in Shanghai, initially) to clear cross-border
transactions with Hong Kong banks in yuan, rather than in U.S. or Hong Kong dol-
lars, and to write yuan-based letters of credit backing foreign companies. The Swiss
have really started taking a greater interest in their own (tarnished) tradition of
banking secrecy than in attracting U.S. clients’ dollars.
International markets still depend on the dollar and there is no viable alternative in
the immediate future. Yet these moves are designed to limit the dollar’s role in
global monetary trade. We view them as the beginning of a broader trend to limit
the dollar’s role, a sort of currency Cold War that will end either with the dollar or
some replacement currency playing a diminished role in global trade.
Of course, each of the parties mentioned above—from the BRICs to the IMF—has a
vested interest in the value of its Treasury holdings. China holds about $764 billion
in Treasurys, and our paper accounts for about a third of Russia’s $400 billion in
currency reserves. Most of India’s $265 billion in foreign reserves are held in dol-
lars. Japan is a major holder, of course, as are the Caribbean banking centers. In
total, just over half of America’s marketable Treasurys are held outside the U.S.
39
Chart 11: Current Account Balances (’08E) The value of these holdings is based in large part on the buyers’
own continued participation in our race-to-the-bottom Treasury
market (inflationary monetary policies). Acknowledging that U.S.
China
paper is at risk of default, and thus that additional paper is not
Germany worth buying, risks fulfilling just those outcomes. It appears to be a
Japan classic imbalance, in our view—and the fundamental trade imbal-
Saudi Arabia ance in the global economy today. We think the massive buildup of
Russia dollar reserves has placed U.S. currency on a pedestal that the na-
Norway tion’s economy cannot support. That our foreign-debt customers
Kuwait are hooked is key to understanding where markets may be headed;
U.A.E. dissatisfaction with this currency regime is in the air.
Netherlands
Qatar These debtholders should be concerned that the U.S., as issuer, is
Algeria pursuing a strategy of “inflating away” the value of its liabilities.
Switzerland When people speak of government debt, they are typically referring
Iran to the federal portion, which is currently about $10.6 trillion. (Add-
Libya ing state and local government liabilities increases the tally by $2.2
Singapore trillion, or about 20%.) They are generally not referring to unfunded
Taiwan contingent liabilities, like Social Security ($13.6 trillion) Medicaid
Sweden ($8.4 trillion), or Medicare (a whopping $85.6 trillion).But it’s all
Malaysia real liability, and it has little to do either with our total debt out-
Venezuela standing or our current or projected $2 trillion annual deficit. The
Hong Kong U.S. government owes at least $129.6 trillion, and there are other,
Canada off-budget federal liabilities that are not even included in this sub-
Austria total. (Private businesses, unlike the federal government, fund most
0
Vietnam of their borrowings. The private sector has perhaps half a billion in
Korea unfunded pension liabilities to its $44 billion of debt outstanding.)
New Zealand
Pakistan The bottom line is that, public and private parties in the U.S. com-
Ireland
bined have over $174 trillion in total debt, including contingent
Ukraine
liabilities and $57 trillion in securities issued and outstanding. Ac-
Mexico
cording to the IMF, the United States ranks dead last out of 181
South Africa
countries in current-account balances (we run the highest deficit in
Poland
absolute-dollar terms, though not in percent-of-GDP terms; see
exhibit on at left).
Brazil
Portugal
Depression: Tall, Grande or Venti
India As a thought experiment, let’s forgive all but the $57 trillion por-
Turkey tion, and pretend for a moment that we would need to sell goods
Greece and services abroad to fund those liabilities. (An unrealistic as-
Australia sumption, made for the purpose of stating the most conservative
Italy estimate of public debt in terms of foreign-trade activity.) How large
France a global market for U.S. goods and services is implied by our out-
United Kingdom standing debt in current-dollar terms? It is a simple calculation: we
Spain know that U.S. companies have had an average net margin of 8.3%
United States over the past 25 years and will make the necessary tax-rate as-
-750 -250 250 750
sumptions.
USD billions Global market participants would need to purchase $2 quadrillion

worth of products and services from us, so that we could (in this
Source: IMF (2008 staff estimates) thought experiment) tax net income at an average rate of 35% and
40
begin to pay back our lenders.16 Of course, this excludes the greater
“… the dollar’s privileged status as today’s
portion of debt that we owe to ourselves.
global money is not heaven-bestowed…
As described above, foreign buyers have begun to demonstrate an in- Reckless U.S. fiscal policy is undermining the
terest in diversifying away from the dollar—investing their reserves in a dollar’s position…”
way that contrasts starkly with the post-war norm. The reason is that
– Benn Steil, “The End of National
those investment patterns have been funding growth that has been
Currency,” Foreign Affairs, May/June 2007
revealed to be unsustainable. The pattern will end, we think not softly
but badly for the dollar and global financial stability.
A Monetary Do-Over…
We’re not talking about a recession, but a stagflationary depression that sees the
dollar collapse and/or replaced by an alternative nouveaux currency that trades at
a fraction of current dollar value. A hard global reset. There just aren’t enough vid-
eo-game customers, moviegoers, or Icelandic community board-run hedge funds to
help us close the debt gap. And there never will be.
Focusing on the annual deficit, occasionally reducing that portion for a year or two,
or using federal accounting gimmickry to appear to run a surplus shapes the politi-
cal discussion but does nothing to dent our liabilities. The level of GDP growth re-
quired to fund sustainable current-account surpluses is unrealistic; except for a blip
in the early 1990s, we have not managed to avoid deficits for even a single year
since 1981. At some point the jig will be up.
…The Switcheroo
Despite the staggering numbers involved, the potential outcomes are simple and
two: either the United States will continue to owe more money than it can pay
back—forever—or it will eventually default. Between these options lies a sort of
hybrid: because we control the value of the currency we owe, the U.S. will simply
deflate away its debts by inflating the dollar at a faster rate than other countries
(while still remaining either a net borrower forever, or defaulting). There’s no pay-
ing it back, in our view; the dollar could be devalued as a unilateral move or as part
of a coördinated, global intervention—perhaps involving the simultaneous devalua-
tion of the yuan. But the option is on the table.
Of course, as long as our foreign buyers continue lending—allowing us to load our-

selves with perpetual (currently interest-free short-term) debt—the U.S. consump-
tion engine that drives the global economy can continue operating as-is, if perhaps
at a slower rate.
But if our borrowers falter in support of the gradual dollar-devaluation strategy we

have adopted as an ostensibly short-term means of managing the financial crisis,
investors would be wise to consider all of the country’s options. Those options exist
along a continuum, from the incremental—a new consumer frugality and a pro-
longed “great recession” similar to that of the last two years—to the cataclysmic
extreme, in which we unilaterally Z-out the register.
In our view, the need for economic shocks exists everywhere along the spectrum.
Our foreign bond customers may be able to live with a continued, gradual inflatio-
nary erosion of our liability base even as they fund new borrowing—with the occa-
16
$1,962.1 trillion in hypothetical buying power ´ 8.3% net margin = $162.9 trillion in hypothetical revenue to U.S. companies,
taxed at 35% = our current $57 trillion deficit (which excludes $129.6 trillion in unfunded contingent U.S. government liabilities
and all private-sector debt). Net profit margin is calculated top-down: corporate profits divided by GDP. We have seen bottom-
up estimates as low as 5.6%, which would imply $2.9 quadrillion in required buying power, rather than $2.0 quadrillion.
41
sional jolt to the money supply—for the sake of the status quo and their own con-
tinued, competitive expansion. They may much prefer the status quo to the mes-
sier process of a de facto U.S. debt default, possibly in the guise of the introduction
of a new currency and associated repayment terms.
The latter option essentially represents a change of monetary regime, at least in

the U.S., or perhaps in synchrony with our major trading partners. The question is
how long foreign buyers will continue playing along, and to what extent they will
continue to fund new dollar-based reserve accumulation in the interval. In our
view, it’s primarily a question of timing: a dollar crisis appears increasingly realistic.
Currency Collapse: Just Do It?

By comparison to the nation at large, California’s recent budgetary shortfall, say,
was slight and manageable. The state takes 40% of its taxes from the top 2% of
earners, a strategy that wins votes and fills the coffers during cyclical booms but
lags accretive state spending; no one seems to mind much except during busts.
While politically difficult, state taxation and spending policies can be modified.
Of course, the problems are different at the national level, where the situation is
more akin to what California might face if it could have printed its own global-
reserve currency for half a century. Such “spendthriftability” does not engender
economic or monetary discipline. It’s just easier to consume through borrowing
than to throw a tarp over the printing press, compete with a world now teeming
with accessible, inexpensive labor, and work rather than print our way out of debt.
In these terms, the status quo actually favors America’s creditors. What’s a few
hundred billion dollars to China or India, with U.S. consumption funding the con-
struction of their durable infrastructure and other long-lived assets? It’s not like
they’re blowing it on convenience, stylish but shoddy consumer goods, or substan-
dard materials for the manufacture of structurally unsound homes that their own-
ers can ill afford. America feels wealthy because we borrow to the gills, but Ameri-
cans do expect the government and even banks to be
forces for stability.
The boom/bust cycles of the last decade have one foot in

Chart 12: Currency Composition of Forex Reserves the financial-services sector, its cultural excesses and fail-
ures of risk management. But recurring global crises are not
born in the U.S. financial sector, time and again, for reasons
of Wall Street culture alone. In our view, the U.S. economy
is fundamentally unstable because our money supply is (a)
Euros unstable, (b) outsized relative to our real productive capaci-
26% ty, and (c) highly leveraged to consumption-driven federal
Other
borrowing.
2%
For all that, the system is performing pretty much as should
Japanese yen be expected: bubble machines blow bubbles. We expect
3% U.S. dollars the cycle to continue and see no reason why future busts
Pounds sterling 65% should be any less painful than recent ones.
4%
Impossible to Time
But if we are talking about a doomsday scenario, an ob-
vious question is—when? A forecast with no expiration
Note: Portion held in Swiss francs too small to be seen. date seems wanting. Yet it is impossible to time the
Source: IMF doomsday scenario with respect to those (behavioral) ele-
42
ments that are not strictly controllable.
So we invest based on what’s happening now, favor a higher allocation to hard as-
sets, and adhere to a volatility-adjusted strategy for controlling risk and timing ex-
posures—with the awareness that when and if there is a “downside discontinuity”
in the strength of the dollar, prices will adjust quickly across all asset classes and
liquidity will be dear. The strategy for such expectations favors hard assets—gold,
silver, oil, land, water. These are the same kinds of assets that we would expect
large, foreign holders of U.S. dollars to purchase in connection with a loss of confi-
dence in U.S. economic credibility.
Of course, we hope that we’re wrong—that docile lenders will continue to view
Treasury debt as acceptable collateral for Federal Reserve notes, now that that
precedent has been established; that the Fed can successfully contract the money
supply, perhaps halving it, without driving a step-function decrease in dollar value,
though nothing like this has ever happened before; and that the Fed can get the
timing of such a decrease just right, so as not to risk “deep recession”17 or worse if
too early, or inflation, if late.
Recent Stock-Market Strength Is Not Secular

But if the U.S. is unstable then the global economic system is unstable. After a 50%
increase from the March lows, the question may be has the storm passed, or are
we in the eye of it?
Overnight LIBOR spiked in mid-September and again in early October, the collapse
of Lehman Brothers, the folding of Merrill Lynch from, and the federal takeover of
Fannie Mae and Freddie Mac having increased lenders’ (and other market partici-
pants’) risk aversion across the board. Taken together with the TED spread—which
is calculated by subtracting the rate on three-month T-bills from three-month LI-
BOR18—these two short-term indicators have served as useful barometers for the
availability of liquidity and the market’s perception of counterparty risk throughout
the economic crisis.
The charts on the next several pages therefore tend to explain much of the equity
market’s recent performance, in our view. The TED spread has fallen to levels we
might call appropriate and overnight LIBOR, even further. Confidence has returned
to the system. In early June, three-month Libor touched its lowest level since the
British Bankers Association began publishing those numbers in 1986. Finally, the
implied volatility of options on the PowerShares U.S. Dollar IDX Bearish Fund (UDN)
serves as a proxy for dollar exchange-rate risk, because it measures the cost of
hedging the dollar—the cost of instability. It, too, has declined dramatically from its
fourth-quarter highs.
Yes, the market may be flooded with dangerous levels of cheap capital; but for the
time being, central bankers and investors alike prefer this temporary respite to
markets gripped by counterparty panic and other fallout. In the short-run, we all
prefer a “melt-up” to a meltdown, not least because it buys time to adjust portfolio
exposures.
With the panic having subsided, many investors have begun to discount expecta-
tions for an economic recovery later this year or in 2010. Our concern is not so
17
Yang, Jia Lynn. “Bernanke's $1 trillion hangover. “ CNN Money.com/Fortune, 6 July 2009.
18
TED is an acronym for T-bills minus Eurodollars, the ticker root for Eurodollar future contracts being ED. Eurodollars have been used
in the calculation since the CME stopped offering T-bill futures.
43
Charts 13–15: Liquidity Panic and Aftermath much that employment and production are down, or
that leveraged consumption is high in an environment
Overnight LIBOR of quantitative easing—though these factors do con-
8.0 cern us. It’s that the economy is careening into un-
7.0 charted territory on the fumes of an unprecedented
Spike in mid-September monetary debasement.
6.0 on Lehman collapse
5.0 How do we count on the market to properly discount
the “stickiness” of inflation expectations, for example,
%age
4.0
when the fundamental driver of price changes has
3.0 increased by an order of magnitude versus the histor-
2.0 ical norm, then doubled again? And why would we?
1.0 Our recommendations seek to reflect the market’s
Return to calm
0.0 expectations for a recovery—to invest on the basis of
Jan Jan Jan Jan Jan Jan Jan Jan Jan
what’s happening now—while skewing exposures to
'01 '02 '03 '04 '05 '06 '07 '08 '09 hard assets and natural resources, adhering to strict
stop-loss targets, and putting on as few positions as
required to diversify risk.
TED Spread That said, should a dollar-doomsday scenario unfold,

5.0 we would expect investors to flock to securities listed
4.5 in Table 6 below. (This report analyzes only second-
4.0 ary-market securities, not physical assets.)
3.5
3.0
%age
2.5 Table 6:
2.0 Securities for Our Dollar-Doomsday Scenario
1.5 Precious Metals
1.0 • DB Gold Double Long ETN ............................... DGP
0.5 • PowerShares DB Gold ..................................... DGL
0.0 • iShares SPDR Gold Trust .................................. GLD
Jan Jan Jan Jan Jan Jan Jan Jan Jan • PowerShares DB Silver .................................... DBS
'01 '02 '03 '04 '05 '06 '07 '08 '09 • iShares Silver Trust.......................................... SLV
Currencies
• Market Vectors-Renminbi/USD ....................... CNY
Mortgage Delinquency Rates: 90+ Days
• PowerShares DB U.S. Dollar Bear .................... UDN
Broad Equities
• Rydex Inverse 2x S&P 500 ETF ......................... RSW
• Rydex Inverse 2x S&P MidCap 400 .................. RMS
• UltraShort Dow 30 ProShares.......................... DXD
• UltraShort QQQ ProShares .............................. QID
Financials
• Financial Bear 3x Shares.................................. FAZ
• ProShares UltraShort Financials ...................... SKF
Note: Red signifies that conditions have worsened;

green, improved; white, no change. (Comparisons are over
previous four quarters.) Source: Federal Reserve
44
n The Housing Market

While new-home construction has recently fallen to new lows, the number of new We expect a wave of ad-
single-family homes under construction has stabilized—flat to mildly up from Janu-
justable-rate mortgages to
ary through May of this year. The National Association of Realtors’ (NAR’s) leading
reset at this time next year,
indicator of housing activity, the Pending Home Sales Index, has also rebounded
sharply since its January lows, pointing to an increase in signed real-estate con- indicating the need for an
tracts. The ratio of sales that represent both foreclosures and short sales (where extended period of loose
the selling price is less than the value of the mortgage) has also begun to decline monetary policy.
from its highs of earlier this year. Is the worst part of the housing crisis behind us?
The group of charts on page 47 depicts the U.S. housing situation from several an-
gles. The chart at the bottom right shows housing starts, seasonally adjusted
(“SA”). While not as stable as the single-family series, this trend and actual homes
sold (top left chart) would suggest that the housing market has veered back from
the worst extremes of the glut. But while the focus thus far in the housing crisis has
been on defaults in the subprime-mortgage category—and most of the $400 billion
in structured investment vehicles (SIVs) that took the spotlight at the start of the
mortgage crisis have now been restructured, wound down, or simply defaulted—
we expect the next wave of losses to be driven by resets in option adjustable-rate
mortgages (ARMs).
ARMs are mortgages written with low initial interest rates that rise over time. His-
torically low rates have delayed the wave of resets expected to plague the ARM
market and the foreclosures that such resets would spawn. But low rates are only a
delaying tactic; unpaid interest on the loans is simply accumulating to their original
balances.
Fed Moves (Temporarily) Arrest Further Declines

In our view, the market is experiencing the intersection of two positive but tempo-
rary dynamics. First, borrowers are benefiting from the Fed’s stranglehold on rates.
Second, a lull in the reset schedule—which is partially a function of the increasing
use of ARMs during the later stages of the housing boom—sees the current market
between “reset peaks.” Even so, over a third of outstanding “pick-a-pay” loans
were at least 60 days past due as of April, with nearly a fifth in foreclosure.19
Approximately one million mortgages are now considered seriously delinquent,

and the peak of the wave in ARMs adjustments is still about two years away.
Homeowner delinquencies continue to rise with unemployment. New job creation
in July exceeded expectations, but still pointed to a loss of 240,000 jobs. We think
the actual unemployment rate is higher than the stated 9.4% for all the people who
have given up their job search. Approximately one in nine Americans is currently on
food stamps—more total recipients than ever before.
As long as the unemployment trend fails to reverse, the backlog of delinquencies

will only grow, in our view—fomenting additional losses to lenders and suggesting
the need for still more quantitative easing. Nearly one in four mortgage holders in
this country owe more than their home is worth (negative equity), and that num-
ber continues to rise on further price declines. This suggests a continuation of the
trend in foreclosures in the second half, as well as into next year, in our view.
19
Eckblad, Marshall. “Pick-a-Pay Loans: Worse Than Subprime.” The Wall Street Journal, 13 July 2009, eastern ed.: C2. Article
quotes data from First American Corp’s CoreLogic unit.
45
n The Case for a Slow Recovery

We expect the recovery to be long and slow. The median price of homes sold and
We expect the economy to
the total number for sale (top right and bottom left charts, respectively, on the
recover in fits and starts,
next page) paint a somewhat less sanguine picture than housing starts. The num-
driving significant volatility ber of houses for sale on a seasonally adjusted basis continues to decline as prices
across our target markets. flirt with new lows, and existing-home inventories were at 9.8 months’ supply in
April, down over 13% from the peak.
It is difficult to say to what extent these dual trends, prices and inventory, are rein-
forcing one another, but the question becomes important at increasing levels of
unemployment. That is, to what extent may a backlog of homes be pending availa-
bility, perhaps on a rebound in prices? How big is the backlog? And how long can
such near-market sales hold out on growing unemployment? Whatever the num-
ber, it does not represent a hidden wave of supply, in our view, as much as a factor
that could potentially depress new construction and median prices.
New Frugality
For years, many buyers sought to get the biggest mortgage for which they could
possibly qualify. Not all of those people have lost their homes or are in danger of
losing them, of course; but people are trading down, reducing their expectations in
order to increase their buying power. We call it the “new frugality,” and expect it to
persist for some time—depressing the real-estate market in terms of new construc-
tion and pricing for longer than is broadly expected. (Personal savings rates, for
example, have already climbed from negative to about 5%.)
If you can get essentially the same home for 60% of what you paid three to five
years ago, and are willing to trade down on certain “lifestyle amenities,” why
drown in a mortgage that doesn’t meet your new, lower expectations (or employ-
ment status, or credit score)? Especially if you can do so while still qualifying for a
mortgage under the new rules—here, again, the uncertainty around employment
trends and the broader economic recovery play a role.
The slope of the equity line is steeper on the way up

(going into a peak) than on the way down. The glut
may cast a longer shadow on the housing market than
Chart 16: How to Defuse a Market Bomb a few months worth of new-construction figures re-
veals, calling into question the recent stability in hous-
9000 1850 ing starts, leading to incremental inventory surpluses,
1800 and prolonging the recovery.
8500
1750
8000 1700 Significant dislocations also exist between price trends
WSBASE
1650
DJIA
7500 in different regions, making comparisons at the na-

1600
7000 1550 tional level even more abstract than usual. We would
1500 be equally encouraged and alarmed by any rapid re-
6500 turn to robust housing-market trends, when even at
1450
6000 1400 this late stage of the crisis, the new frugality is increa-
singly being enforced by pink slips.
Jun '09
Jan '09
Apr '09
Mar '09
May '09
Feb '09
Dec '08
The best-case scenario would therefore be a sideways

consolidation in prices and decrease in the rate of fo-
reclosures, though even these best-case trends would
DJIA WSBASE
do little to correct the growing negative-equity prob-
Source: Federal Reserve of St. Louis; Stracia, LLC lem, in our view.
46
(As discussed above, this group of charts depicts U.S. earnings from several angles.
We think this portends at least a temporary stabilization in the housing market.)
Charts 17–20:
Average Earnings in U.S.: Four View
20 10% 700 12%

18 9%
Weekly dollar earnings

Year-over-year change 600 10%
16 8% 500
14 7% 8%
Change
Dollars per hour
400
12 6% 6%
10 5% 300
200 4%
8 4%
6 3% 100 2%
4 2% 0 0%
2 1%
Jun '89
Jan '64
Feb '69
Aug '99
Sep '04
Apr '79
Mar '74
May '84
Jul '94
0 0%
Apr '79
Mar '74
May '84
Jun '89
Jan '64
Feb '69
Jul '94
Aug '99
Sep '04
Average weekly earnings of production

workers (SA)
Average hourly earnings (SA)
Year-over-year change Year-over-year change
19.0 4.5% 620 6%

4.3%
Weekly dollar earnings
610 5%
Year-over-year change
18.5 4.1%
3.9% 600 4%
Change
Dollars per hour
18.0 3.7% 590 3%

3.5%
580 2%
17.5 3.3%
3.1% 570 1%
17.0 2.9% 560 0%
2.7%
Oct '08
Apr '06
Sep '06
Feb '07
Jul '07
Dec '07
May '08
Mar '09
16.5 2.5%
Mar '09
Apr '06
Sep '06
Feb '07
Jul '07
Dec '07
May '08
Oct '08
Average weekly earnings of production

workers (SA)
Average hourly earnings (SA)
Year-over-year change Year-over-year change
.
47
n The Big Picture: Asset Classes

Our investment analysis Investment policy begins with an analysis of the four or five primary asset classes
begins with the major asset (or “categories”):
categories. Inter-market • stocks,
analysis makes for better • bonds,
equity recommendations, in • commodities,
our view. • cash/currencies,
• (and sometimes real estate; see discussion below).
Retail investors not only understand the rationale for allocating among categories,
but enjoy a greater degree of freedom in this regard than most institutional man-
agers, who often operate within constraints beyond their control—constraints es-
tablished at the policy level. For example, many pro’s have no say in broad policy,
and thus cannot invest or hedge outside of a sector cog. These are simply different
audiences; there is no bridge connecting them at the asset-category level except in
Chart 21: Stocks—DJ Wilshire Global Index ($DWGT) Chart 22: Bonds—Barclays Global Bond Index (WFBIX)
Chart 23: Commodities—DB Commodity Index Tracking Chart 24: Cash—Barclays Capital Cash Comp US
Fund (DBC) ($CASHUS)
Charts produced with TradeStation
48
special cases: indeed, individual investors now have almost as much freedom and
flexibility as a global-macro hedge-fund manager who can dictate strategy as well
as “pull the trigger.” What’s missing for retail investors is some kind of information
advantage allowing them to benefit from all this flexibility. Our ETF coverage in-
tends to close that gap.
Real Estate: Category or Sector?

We have decided to treat real estate as a sector rather than an asset class, because:
• we can only speak to discretionary-investment positions, and
• our recommendations drill down to the industry level.
Though most investors’ real-estate holdings are true assets rather than secondary-
market securities, real estate is a fixed (or “gamma”) asset; by definition, investors
won’t tweak their allocation to the category based on normal cross-position fluctu-
ations. This type of treatment also allows us to recommend different corners of the
global real-estate market on the basis of geographic and other intra-sector dynam-
ics, and to tweak our recommended allocations to real estate based on changing
economic and market events.
ETFs that track the U.S. housing market include the MacroShares Major Metro Up
(UMM) and Major Metro Down (DMM) funds, which seek to deliver triple exposure
(up and down, respectively) to the S&P/Case-Shiller Home Price 10 Index, which
itself tracks U.S. residential-home prices. The recently introduced ETFs are relative-
ly pricey, in our view, with expense ratios of 1.25%.
Allocation to Asset Categories

Chart 25 depicts the starting point of our allocation
analysis: the relative weightings among asset cate-
gories. Like all of our recommendations, the analy-
sis begins with a look at the historical risk-adjusted
returns of the constituent series (wherever possi-
ble, actual ETFs). We then seek to optimize the Chart 25:
relative allocations by minimizing the amount of Initial Allocation Decision: Asset Categories
risk an investor would have been required to take
to realize the largest possible return (over a Commodities
25%
weighted-average set of hypothetical holding, or
look-back, periods). Finally, we adjust the alloca-
tions arrived at through these quantitative tech-
niques on the basis of our own fundamental analy-
sis.
We currently recommend a 35% allocation to

bonds, based on our expectation that dependable
Bonds Cash
yield may commanded a premium to equity volatil- 30% 25%
ity as the current stock rally takes a breather. (Dis-
cussion begins on page 109.) We also recommend
a significant allocation to cash (30%) for much the
same reasons. The remaining 45% of a long-only
portfolio should favor stocks over commodities, in
our view. On the next page, we begin our discus-
sion of investing across the major equity size-and- Stocks
style categories. © 2009 Stracia, LLC 20%
49
n Size & Style Exposure

We analyze the meaning of We view the size-and-style consideration as a core component of our investment
value and growth in the model. It informs our selection of sectors (discussed next) and, to some extent, our
context of sector and inter- international-equity diversification model. By size, we mean the market capitaliza-
tion of the companies captured in the equity ETFs that we consider; by style, we
national investing.
mean their value or growth orientation.
These characteristics are not just applicable to U.S. equities, but represent traits
that may be common to foreign equity markets where small-cap or growth compa-
nies dominate, for example.
The Meaning of Value and Growth

The classification of ETF holdings by companies’ value or growth characteristics can
be tricky, and for reasons discussed below, an investor cannot simply trust a fund’s
label or stated style strategy (though classifications by size are relatively
straightforward). We discuss the meaning of the “value” and “growth” labels in the
context of company growth and life-cycle dynamics, for the purpose of understand-
ing the constituents of size-and-style ETFs and to avoid some of the pitfalls awaiting
unwary investors.
A value stock is generally defined by historical and projected earnings and revenue
growth rates, as well as by P/E, price/book, and other valuation ratios that are rela-
tively low, together with competitive dividend yields. It may be useful to think of
the growth/value trait in terms of company life-cycle.
Chart 26: Recommended Allocation by Size & Style
Growth
46%
Small-cap
growth
17%
Mid-cap value
19%
Value
Small-cap value 49%
20%
Mid-cap growth
13% Large
26%
Small
37%
Private equity
5%
Large-cap value
11% Large-cap
growth
© 2009 Stracia, LLC 15%
Mid
32%
50
Company Lifecycle
Most startup firms (as opposed to spin-offs or trailing stocks) begin life as “stage-
one,” high-growth companies. Sales growth accelerates rapidly off a small base,
and earnings and cash flow may remain deeply negative for years. These are pure
growth stories, attractive to speculators, momentum traders and growth investors.
Technology and biotech stocks typically fit this stage-one profile. It can be difficult
to value early-stage names in these industries using traditional techniques, forcing
analysts and investors to resort to price/sales multiples or market-specific criteria
(famously for a time, clicks, page-views, etc.).
Shares of stage-one companies may be among the most volatile in the market, and
while the conventional wisdom holds that long-term investors are the best
equipped to “own” this type of volatility, we view such stocks as generally inappro-
priate for these investors; leave the bottle rockets to the traders.
Shifts in Institutional-Holder Demographics

The long-term risk is that a period of earnings disappointment looms over these
names, together with a commensurate shift in the stocks’ investor demographic
(from momentum to growth to GARP to value). For these reasons, stage-one com-
panies will almost certainly be cheaper “one day” than they are during the middle
or late phases of a normal business cycle. In such markets, these names are there-
fore best suited to:
• the most aggressive, short-term traders, with low trading overhead; or
• that portion of a value-oriented portfolio devoted to shorter-term ideas (of
six to 12 months out).
An investor with 20% of her holdings allocated to stage one-type ideas may be
quite successful, but she is a growth investor or speculator, rather than a GARP or
value investor.
Companies enter stage two when sales growth, while positive and even robust,
begins to decline. This may result in earnings misses that “shock” the Street, and
are met with a sell-off in the shares out of all proportion to the quarter’s so-called
“standardized unanticipated earnings” score.20 Some stage-two companies may
have accumulated deficits, but show positive earnings and/or cash flow. If so, these
names tend to boast among the highest such multiples in the market. They are
“priced to perfection,” and indeed, quarterly performance meets or exceeds expec-
tations—until it doesn’t. There are two scenarios by which the first leg of the shift
in investor demographics (from momentum/growth to GARP) takes place:
• the Street moderates growth expectations in the “out years,” and GARP
types buy from speculators in an orderly fashion as the firm performs in-line
with expectations; or
• the company misses earnings in one or more quarters and the shares get
pummeled, tracing new resistance levels and/or gapping down as holders of
all types—speculators, GARP or in between—liquidate on the bad news.
Under these conditions, the stock will begin to attract GARP investors, though the
risk remains of future earnings misses remains—even successive, severe misses.
This risk may be difficult to quantify with any certainty, and stage two is notable for
“true-believerism” and choppy trading, making the shares inappropriate even for
20
A company’s average earnings surprise versus the dispersion of analysts’ earnings estimates. SUE scores are used to quantify
the likelihood of an earnings surprise.
51
GARP investors under this scenario. (That said, hedge-funds with more or less im-
mediate speculation horizons—i.e., 48 hours to several weeks—will keep the trad-
ing volatile, and this may create especially interesting opportunities in the deriva-
tives market. Such strategies are beyond the scope of this report.)
A Further Shift—Decline
Companies in stage three of the industry lifecycle (note: not Stage 3 of the eco-
nomic cycle), which we may call the “Graham and Dodd stage,” have entered a
state of permanent growth decline—meaning that sales and earnings growth will
fluctuate within a range indefinitely.
These shares are true value material, and appropriate for cash-flow and ROI-type
analyses, which should dominate the investment decision-making process at this
point.
The Value Front

All firms eventually enter stage three, but whether a company “progresses” to
stage four is the principal concern of value investing. More than anything else, suc-
cessfully trading stocks at this point in their maturity is about determining when or
if a company’s growth decline is temporary (stage three) or permanent. Stage-four
“value destruction” sets in only if management’s strategic reactions to declining
growth are inappropriate. Indeed, value destruction may be unavoidable for cer-
tain firms, in certain markets, at certain times. These companies should be eva-
luated using conservative judgments and ROI-type comparisons, and stocks in stage
four are generally to be avoided, in our opinion.
That said, companies with earnings growth that will remain essentially flat for an
indefinite period may present excellent value opportunities for years, as the market
occasionally misprices these opportunities, undervalues cash-rich or dividend-
yielding stocks, or misunderstands the nature or level of a firm’s growth prospects.
Don’t Trust the Label

A word of caution is in order whenever one seeks to
compare the relative valuations of style-based in-
dexes either:
Chart 27:
• to one another; or
Fund Flows: Equity Capitalizations ($m)
• to individual equity plays with a growth or
700,000 200,000 value bent; or when
600,000 180,000 • applying the style decision in the context of
160,000
500,000 140,000 choosing a “growth” or “value” ETF.
400,000 120,000
100,000 Growth ETFs are typically expected to have exposure
300,000 80,000 to sectors or industries with high price-to-book val-
200,000 60,000
40,000
ue ratios, but because of the nature of their busi-
100,000 20,000 ness models, even slow-growth consumer-staples
0 0 companies may have high price-to-book values.
Jun '08
Jan '08
Feb '08
Apr '08
Jul '08
Aug '08
Sep '08
Mar '08
May '08
Oct '08
Jan '09
Feb '09
Apr '09
Nov '08
Mar '09
Dec '08
In such cases, an ETF that delineates growth or val-

ue based on such considerations may misrepresent
or misallocate to certain sectors. It is not enough
All ETFs (left axis) Large Cap merely to take the fund’s label at face value; we look
Mid Cap Small Cap under the hood and question whether the product
Source: ICI is appropriately labeled.
52
Size-and-Style Families
PowerShares, Russell, Morningstar and iShares all offer ETFs that provide exposure
to the major size and style categories listed in Table 8 (page 54). Among these
choices, we prefer iShares’s S&P-branded family of funds for their higher trading
volumes and product consistency (the delineations between small-cap and mid,
and mid-cap and large, are clear and without overlap).
Alternative Investments
We include private equity and hedge funds in the size & style category because we
do not view these alternative-investment structures as distinct asset classes. To
take the former case, leveraged buyouts, mezzanine financing, and venture-capital
investments are better delineated by the actual investment strategies and objec-
tives of the funds than by their structure, in our opinion. Likewise, hedge funds are
better delineated in terms of their investment strategy than their limited-
partnership structure—especially when investing through ETFs.
Private Equity
One of the challenges inherent in devising an allocation strategy that takes private
equity (PE) into account is the difficulty of measuring the category’s historical re-
turns. Not only are there different types and styles of private-equity investing—
leveraged buyouts, turnarounds, venture capital—but the lack of a secondary mar-
ket, until recently, and the lack of a robust set of performance statistics spanning
economic cycles and secular investing climates, makes PE still seem somewhat of a
stealth category.
Further complicating the analysis is the lack of a passive benchmark. By definition,

PE is a skill-based management style. Even if comparing the performance of the
universe of private-equity managers to one another were trivial, investors would
still have to address the issues of performance attribution and skill measurement.
The introduction of listed PE shares over the last several years (see table below)
made it possible for investors to add firm-specific exposure, and the PowerShares
Listed Private Equity ETF (PSP) takes management-company selection (and related
risk) out of the process. Private equity’s unique investment style, emphasizing both
manager skill and company-specific risk, means that incorporating PE into a well-
diversified portfolio of secondary investments can be attractive, in our view.
Table 7:
Tracking Private Equity
Index Ticker
• PowerShares Listed Private Equity ................................................ PSP
†
• American Capital Strategies ......................................................... ACAS
†
• Apollo Investment Corp. ............................................................. AINV
• Blackrock† .................................................................................... BLK
• Blackstone Group†........................................................................ BX
• Boston Private Financial Holdings† ................................................ BPFH
†
• Fortress Investment Group .......................................................... FIG
†
• KKR Financial Holdings ................................................................ KFN
†
Not an ETF
There are a number of hedge-fund ETFs available. Later this year, we plan to in-
clude the IQ Hedge Multi-Strategy Tracker ETF (QAI) in our line-up, representing
53
Table 8: the hedge-fund category. The ETF was introduced in late March, so there
Size & Style: Allocations and Vehicles is not yet six months worth of data available; as noted in the section on
our “ETF Selection Preferences” (page 16), we prefer a slightly longer
• Large cap growth (IVW) .......... 14.8%
history for the purpose of back-testing the performance of our allocation
• Large-cap value (IVE) .............. 10.9% recommendations (using the techniques described on page 7).
• Mid-cap growth (IJK) .............. 18.6%
• Mid-cap value (IJJ) .................. 18.3% Some New, Novel Offerings
• Small -cap growth (IJT) ........... 14.5% Last month, ProShares launched a new ETF family under the “Alpha Pro-
• Small-cap value (IJS) ............... 17.9% Shares” label, including a fund that implements a 130/30 strategy (the
• Private equity (PSP) .................. 5.0% ProShares Credit Suisse 130/30 ETF, ticker CSM). Popularized by some
• Hedge funds (QAI) .................... 0.0% hedge funds a couple years ago, this strategy invests 130% of portfolio
• Total..................................... 100.0% value on the long side while maintaining a 30% short position.
In the case of the CSM, which tracks the Credit Suisse 130/30 Large-Cap
Index, stocks are ranked by a set of quantitative criteria and bought or
shorted based on their ranking. Top holdings currently include Exxon
(XOM, at 3%) and Procter & Gamble (PG) on the long side and Nicor (GAS, 1.3%) on
the short side. The expense ratio is relatively low at 0.95%, in our view.
The CSM is an interesting vehicle: a large-cap, actively/quantitatively constructed

ETF with a novel net-exposure strategy. Other 130/30 funds include the KEYnotes
First Trust Enhanced 130/30 Large Cap ETN (JFT), which tracks a similarly named,
equal-weighted total-return index of large-cap U.S. names.
Style Rotation in the Business Cycle

Following a recession, bond yields, healthy dividend yields and reasonable valua-
tions favor a conservative investment style during early recovery. The recent bruis-
ing of the stock, bond and commodity markets also mean that many investors will
find it “too soon” to own more speculative names in size.
In our view, economic fundamentals have begun to justify taking some degree of
beta risk, albeit with tight stops—economic growth has not yet been confirmed as
strong and general. We favor small- and mid-cap value names.
Indeed, mid-cap indexes have significantly outperformed the large and small cate-
gories year-to-date, with the iShares Midcap S&P 400 ETF (IJH) up 17.6% versus just
under 9.1% for the iShares S&P 500 Index Trust (IVV) and iShares S&P Small Cap
600 Index (IJR).
The fund flows shown in the chart on page 52 confirm this preference among in-
vestors. The recommendations that appear on page 50 may be achieved using the
vehicles shown in the table at left above (tickers in parentheses).
Private Equity PowerShares Listed Private Equity (PSP)

Price: $8.22 Net assets: $87 million Expense ratio: 0.71%
NAV: $8.52 P/E: 6.4x Turnover: 30%
Yield: 9.8% ADV: 128,000 Inception: 24 Oct ’06
Tracks the Red Rocks Listed Private Equity Index, which is comprised of several
dozen publicly-listed PE firms.
54
n Sector ETFs
Sector ETFs track companies by (typically broadly defined) economic category, and A wide array of sector ETFs
thus are useful in sector-rotation and other top-down approaches once the more provides investors with
basic question of equity exposure has been addressed. By organizing even a por-
exposure to major U.S. and
tion of the vast array of available equity ideas on a sector-by-sector basis, there are
international economic
fewer steps and less time lost between receiving new, incremental economic or
market information, adjusting our investment policy, and tweaking exposures trends.
through satellite positions.
The bond market also informs our sector positioning. As analyzed above (page 37),
the wide gap between long and short rates suggests not so much an “all-healthy”
signal, but a defensive posture emphasizing sectors that can withstand the corro-
sive effects of inflation over the next decade, in our view.
ETFs provide exposure to every sector of the U.S. economy, as listed below. While
we’re at it, let’s categorize each industry’s dominant characteristic as a
growth/value play, as determined by its current representation in funds designed
to provide exposure to each category.21
• technology (growth, page 57) • industrials (value, page 72)

• telecommunications (growth, page 60) • materials (growth, page 75)
• cons. discretionary (growth, page 66) • financials (value, page 77)
• consumer staples (value, page 69) • energy (growth, page 81)
• healthcare (growth, page 70) • utilities (value, page 91)
Sector Rotation in the Business Cycle

During a normal recession, the market troughs
before a reversal of negative economic indicators.
The consensus is that the U.S. economy is current-
ly at this stage of recovery—that is, in the early
Chart 28: Sector Allocation
stages of an upcycle. Here, high-beta, cyclical, and
small-cap stocks are expected to outperform. Consumer Industrials
Infrastructure
These include technology and telecom services & Staples 9%
5%
equipment companies (not telecom utilities) as 10%
well as consumer discretionary. To avoid false
starts in IT (discussed in depth below), we rec-
Consumer Materials
ommend focusing on deep-value tech. We also Discretionary 24%
expect small caps, being more nimble and less 13%
bureaucratic, to outperform as long as the fun-
damental recovery does not stumble.
Based on early signs of recovery, we recommend Telecom

overweighting materials, which we expect to out- 6%
perform as new orders start to ramp. The mate-
rials groups is highly sensitive to GDP trends (as
are gold stocks, but we prefer to manage expo- Technology Financials
sure to the commodity directly). Incidentally, we 16% 18%
view LEAPs as cheap with long-term upside poten- © 2009 Stracia, LLC
21
The ultimate determination of style for an individual company cannot be made at the sector level; that is, we do not believe that a
company can adequately be categorized as growth or value based on its sector. But since we will be selecting ETFs, not companies,
by both sector and size/style classifications (among others), establishing rule-of-thumb characteristics for the sectors simplifies the
portfolio-construction process.
55
tial, but those vehicles are beyond the scope of this report.
While we think it is too soon to call the start of a new bull market (that is, a secular
one, as distinct from the strong rally in equities since March), it is useful to be
aware of market indications for a sustained consensus end of the recession. Upon
the beginning of such a recovery:
• Industrials outperform because they carry high fixed costs but have not had
time to expand capacity; thus, margins benefit immediately from new or-
ders.
• Energy benefits from higher natural gas prices and greater demand (oil &
gas consumption correlated with GDP growth).
• Commodity (e.g., aluminum, copper, forest products) and chemical firms see
price increases. Canada is heavily weighted toward basic materials and
energy stocks; Australia toward commodities.
• Investment banks and brokerages would be expected to benefit from in-
creasing economic and corporate activity, outweighing their sensitivity to in-
terest-rate changes. (Other financial services groups, e.g., insurance, are
more rate sensitive and may underperform during periods of rising growth.)
• Trends unique to any given cycle may drive outperformance in growth
stocks at the start of a bull run. But firms in a steep growth phase tend not
to pay dividends; as a result, they are interest-rate sensitive and may suffer
later in the cycle, as monetary policy starts to constrict.
• Investors would avoid be expected to avoid stocks with cost-exposure to
commodity prices.
• Finally, small-caps outperform.
Each of these trends potentially provides confirmation of a sustained economic

recovery. By contrast, if investors begin to find utilities (which have underper-
formed in the rally) attractive on the basis of dividend yields and interest-rate sen-
sitivity, it would increase our concern regarding economic fundamentals—
especially in light of current risks to the traditional utilities paradigm (discussed
below). In a normal cycle, the same would be true of healthcare—though
the unique regulatory proposals now being considered remove this con-
sideration from the picture—as would a marked increase in a preference
Table 9: among investors for dividends (which we saw last year and early this year).
Sector Allocations and Vehicles
• Technology (XLK) .................... 20.0% A New ETF Autopilot Option
• Telecom (IXP).......................... 10.0% Early last month, ALPS launched an “ETF-of-ETFs” called ALPS Equal Sector
• Cons. discretionary (XLY)......... 10.0% Weight (EQL). It is designed to provide exposure to U.S. economic sectors
by taking an equal-weighted position in each of the nine Select Sector
• Consumer staples (XLP) .......... 12.7%
SPDR ETFs, with quarterly rebalancing. The equal-weighted strategy is de-
• Healthcare (XLV) ....................... 0.0%
signed to avoid allocating on the basis of recent performance. Annual ex-
• Energy (XLE) ............................. 0.0%
penses are 0.55%. While inappropriate for most institutional investors,
• Industrials (XLI)......................... 7.2%
retail investors who do not wish to perform their own periodic rebalancing
• Infrastructure (IGF) ................. 11.9% by sector may find this somewhat novel new product useful.
• Materials (XLB) ....................... 15.8%
• Utilities (XLU) ........................... 0.0% Current Recommendations
• Financials (XLF) ....................... 12.4% The recommendations that appear on page 55 may be achieved using the
• Total ..................................... 100.0% vehicles shown in the table at left (tickers in parentheses).
56
Technology
We currently view technology as a relatively strong growth sector. Annually,
worldwide technology spending almost always outpaces growth in U.S. nominal
GDP—with the notable exception of the period from early 2001 to early 2004,
when consumers had pulled back following the dot-com bubble and recession, and
companies were digesting the massive “shelfware” inventories built up during the
boom. Year-to-date, technology has been the second best-performing sector glo-
bally, closely tracking materials, with the Nasdaq up 22.4% (versus 9.1% for the S&P
1500).
Follow the Current Entry Signal

We look to the bond market for entry and exit signals for the tech sector. Following
a period during which bond prices, stocks, and commodities have declined for
some time, bond prices will normally be the first to reverse course, signaling a
possible end to the contraction. When it occurs, this turnaround may provide an
entry signal for the sector. And because technology is volatile, it can be among the
first to participate in an upcycle; gains during the early stages of an economic re-
covery can be substantial, as relative year-to-date performance has shown.
For this reason, we recommend participating in the current strength in informa-

tion-technology (IT) and—should our secular economic outlook prove either incor-
rect or untimely (see discussion beginning on page 37)—we would look to increase
positions on continued signs of an economic rebound. That said, the tech sector
can be given to “false starts.” Without strong confirmation of a real, sustained
pickup in trend, “being early is a lot like being wrong” in IT.
Favor Value over Growth

We therefore recommend exposure through value and deep-value tech exposure:
At worst, we have not exited the recession and at best, are early in the cycle (see
chart below). Our preference is for ETF exposure to firms with solid positions in a
growth market and which trade at comparatively low price/earnings and
price/sales ratios, or at low multiples of book value. Remember also that IT compa-
nies often benefit substantially from a weak or declining dollar, which is due to the
significant competitive advantages enjoyed by U.S. firms and the resulting exposure
to foreign revenue sources. Many mature U.S.-based software companies, for ex-
ample, generate one-third to one-half of their total revenue abroad.
We advise staying in tech until the “late-expansionary” phase, while adhering

strictly to our established risk-management parameters. Though volatile, the sector
is relatively upside-biased during the expansionary phase.
Indeed, a strategy that calls for long-term exposure based on
fundamental business-cycle dynamics is designed to maximize
exposure to such price swings while limiting downside volatili- Chart 29: Technology Is Procyclical and Growth
ty. In our view, the risk from following a long-term investment
campaign is less than that from attempting to time the mar- Expansion
ket, or any given sector, on a short-term basis—and this is X
especially true for some of the most volatile ETFs in the mar-
ket.
Watch for the Exit

As with the entry signal, bond prices help to indicate when to
exit. As a normal cycle nears its peak, bond prices turn down,
signaling greater demand for the safety of promised yields Recession
ahead of contractionary expectations. At that point, we would
57
begin unwinding tech positions and rotating into consumer staples (as discussed
beginning on page 69). So the strategy for tech involves maintaining exposure for
over half of the business cycle; since the end of WWII, this duration has averaged
approximately 60 months.
Some Tech Industries May Have Bottomed

Enterprise-software companies have been performing well as companies continue
buying software in pursuit of increased business efficiencies and operational cost-
savings. We think the group can also outperform on any sustained pickup in eco-
nomic activity, benefiting from latent demand for non-mission-critical expendi-
tures.
By contrast, Internet companies have been hampered by weak consumer spending,

which has negatively impacted product and ad revenues; the same trend is impact-
ing non-tech groups including publishing and entertainment. In the latter case, cor-
porate spending is moving increasingly to tech-based outlets, such as the Web (so-
cial media) and video games. We therefore want to capture these enterprise-
software, Web and video-game trends in our ETF selection.
Semiconductor and semi equipment providers have been performing extremely

well, with the iShares Goldman Sachs Semiconductor ETF (IGW) up 43.4% year-to-
date. Semiconductor inventories have been broadly reduced, but may have bot-
tomed after a 15.1% plunge in Q1. The year-over-year decline last quarter was a
relatively flat 1.5%.
Many fabs are running at low capacity, indicating the road ahead could be steep for
the semi group, but we think inventories may have over-corrected to the downside
and expect to see more stable comparisons in the second half. In particular, the
computer and cellular-phone markets have been supporting positive month-over-
month sales comparisons.
Chart 30: Chart 31:

Technology (Weekly)—S&P Select Technology SPDR (XLK) Technology (Daily)—S&P Select Technology SPDR (XLK)
58
Table 10: Technology ETFs

Index Ticker
Global
• iShares S&P Global Technology Sector Index Fund ........................ IXN
Broad U.S.
• iShares Dow Jones U.S. Technology Sector Index Fund .................. IYW
• iShares Goldman Sachs Technology Index Fund ............................ IGM
• Technology Select Sector SPDR Fund ............................................ XLK
• Morgan Stanley Technology ETF ................................................... MTK
• Vanguard Information Technology ETF .......................................... VGT
• First Trust NASDAQ-100-Technology Sector Index Fund ................. QTEC
Equal Weight
• Rydex S&P Equal Weight Technology ETF ...................................... RYT
• PowerShares FTSE RAFI Telecom & Technology ............................. PRFQ
Quant Strategy
• First Trust Technology AlphaDEX Fund .......................................... FXL
• PowerShares Dynamic Hardware & Consumer Electronics ............ PHW
• PowerShares Dynamic Networking Portfolio ................................. PXQ
• PowerShares Dynamic Semiconductors Portfolio .......................... PSI
• PowerShares Dynamic Software Portfolio ..................................... PSJ
• PowerShares Dynamic Technology Sector Portfolio ....................... PTF
Leveraged and Inverse
• ProShares Ultra Technology .......................................................... ROM
• ProShares UltraShort Technology.................................................. REW
Industries
• iShares S&P GSTI Software ........................................................... IGV
• Merrill Lynch Software HOLDRs .................................................... SWH
• PowerShares Dynamic Software ................................................... PSJ
• Merrill Lynch Internet Architecture HOLDRs.................................. IAH
• PowerShares Dynamic Hardware & Consumer Electronics ............ PHW
• iShares S&P GSTI Networking ....................................................... IGN
• Merrill Lynch Broadband HOLDRs ................................................. BDH
• PowerShares Dynamic Networking Portfolio ................................. PXQ
• iShares S&P GSTI Semiconductor .................................................. IGW
• PowerShares Dynamic Semiconductors ........................................ PSI
• SPDR S&P Semiconductor............................................................. XSD
• Merrill Lynch Semiconductor HOLDRs........................................... SMH
• First Trust Dow Jones Internet ...................................................... FDN
• Merrill Lynch Internet HOLDRs ..................................................... HHH
• Merrill Lynch Internet Infrastructure HOLDRs ............................... IIH
• Merrill Lynch B2B Internet HOLDRs............................................... BHH
• PowerShares Lux Nanotech .......................................................... PXN
Source: SeekingAlpha
Technology Technology Select Sector SPDR (XLK)

Price: $19.24 Net assets: $2.9 billion Expense ratio: 0.22%
NAV: $19.75 P/E: 15x Turnover: 9%
Yield: 1.7% ADV: 8 million Inception: 16 Dec ’98
An ETF that tracks the gross performance of tech industries, including Internet and
telecom, software, computer hardware and peripherals, semiconductor equip-
ment, etc. Also includes IT consulting and diversified telecom services. Highly liq-
uid. Holdings include Microsoft (MSFT), AT&T (T), and Cisco (CSCO).
59
Telecommunications
Telecommunications is a broad category that encompasses telecom services and
equipment companies, handset manufacturers and resellers/distributors, infra-
structure equipment makers and OEMs, gear makers and service providers for ca-
ble and satellite industries, and so on.
Though one could argue that a mobile phone is really a consumer device, the con-
ventional approach is to group the handset makers—e.g., Nokia (NOK), Motorola
(MOT), Samsung (Korea: 005930.KS), etc.—together with their supply-chain cousins
in the telecommunications group, in order to understand and discuss the group
top-down. This is our approach when analyzing available telecom ETFs, as well.
Convergence Trend
One could also argue that cable-service providers, such as Comcast (CMCSA) and
Time Warner Cable (TWC), more firmly belong in the broadcast group than lumped
in with handset makers. But as we discuss below, the dominant trend among these
companies (however you group them) is convergence, or toward providing the
“triple-play” of voice, video, and high-speed data through all-digital networks. The
convergence trend is accelerating and we expect it to continue for years. As such, it
is best to simply realize that cable providers are increasingly not just programming
but content providers, and to approach the ETF selection process for this sector
accordingly, in our view.
ETFs to the Rescue

Indeed, in addition to being fragmented—or possibly because of its fragmenta-
tion—telecommunications may also be one of the most frustrating sectors to ana-
lyze, in our view. With oligarchies for service provisioning in many markets, there is
significant customer concentration for the suppliers. Quarterly results for many
equipment providers are often driven by the changing capital-expenditure plans of
a single large customer, such as Time Warner. This revenue-concentration effect
can be exacerbated for a smaller firm, such as ARRIS Group (ARRS), which relies
largely on sales to a few customers such as Comcast and Time Warner.
Is In-House Telecom and Cable Expertise “Worth It”?

Complicating matters further, fundamental analysis of telecom and cable compa-
nies’ stocks requires tracking a vast amount of customer-specific data points that
are only narrowly applicable. For example, the number of multi-room DVR installa-
tions expected by satellite service provider DISH Network (DISH) can significantly
impact revenue expectations for CalAmp (CAMP), a supplier to DISH. The cost of
gathering, processing and understanding this drum roll of data points—and the
incremental insight into CalAmp gained thereby—may not generate sufficient port-
folio returns to fund the effort. This was especially true in the market environment
of the last two years, which was characterized by high correlations among a broad
22
range of global assets.
It is a question of cost versus benefit. No investor’s or analyst’s resources are unli-

mited; we must carefully decide what to care about. If we choose to track funda-
mental financial and market trends in the telecommunications or cable industries
(or peripheral industries), then we must dedicate a portion of our resources (time,
effort, attention) to just that.
22
One might argue that information that can generate incremental insight is of most value in
just such an environment. We do not disagree, only question whether that incremental val-
ue is worth the cost in normal and abnormal trading environments alike.
60
Some investors, and thus some analysts, find this cost/benefit trade-off attractive
for companies in these industries. (And of course if fewer did, the cost/benefit ratio
would decline in favor of bringing such expertise in-house.) But other investors
recognize that the time-and-resource commitment required to gain competitive
expertise here may not worth it. It is these investors who may benefit the most
from managing exposure to this industry using ETFs, in our view.
The Technology History of Telecom

It is not only thee information flow in telecom and cable that is daunting, but the
industry’s long and hyper-regulated history. A description of the evolution of mod-
ern telecom technology could fill a book shelf, but our interest is to understand the
current landscape from an investment perspective. Thus, it may be useful to reduce
this long history to its bare bones in order to “catch-up” to current trends and un-
derstand the direction of future evolution.
Over the next several pages, we discuss the joint technology and regulatory histo-
ries of telecommunications as a primer for investors new to the sector. (Other
readers may skip ahead to page 65).
“What Hath God Wrought?”

The history of mass-communications systems is replete with patterns of technology
creation, deployment, and obsolescence.23 The telegraph was invented by William
Cooke and Sir Charles Wheatstone in England, patented in 1837, and first commer-
cially deployed in 1839. The first U.S.-based telegraph was implemented by Samuel
F.B. Morse, creator of the Morse code, in 1844.
For the first time, people could communicate across vast distances instantaneously,
inexpensively, and without having to physically move people or material. By 1861,
governments had deployed almost 20,000 kilometers of submarine telegraph ca-
ble, of which only 5,000 kilometers actually worked. Engineers had just begun to
solve problems of signal attenuation and dispersion experienced by transmission
over vast distances. (The heading of this paragraph represents the first message
sent by electric telegraph in the U.S.)
After America’s Civil War, which stalled advancements in submarine telegraphy,

Alexander Graham Bell set out to increase the capacity of the telegraph system.
Instead, he ended up inventing the telephone, or “electric speaking machine,” re-
ceiving a patent in March 1876. By the mid-1870s, Thomas Edison, Joseph Stearns,
and others had devised methods for transmitting 500 bits per second (bps) over a
single telegraph line. Thanks to harmonic telegraphy, a method by which different
tonal sounds could be used to transmit multiple signals over a single line, one tele-
graph wire could support up to four telegraphic signals.
Wireless (radio) technology was productized in 1896, when an Irish-Italian named

Guglielmo Marconi invented a radio signaling device. Shortly thereafter came the
invention of the electronic vacuum tube, which enabled broadcasting—or the am-
plification of radio signals across vast distances. Within a few years, Marconi’s de-
vice could transmit over distances of several hundred miles and, by 1901, across
the Atlantic Ocean—from England to Newfoundland. This wireless telegraphy was
the first application of the new radio technology.
23
The following discussion relies on: Amos, Joel. Telecommunications and the IEEE Communications Society. Accessed 13 August
2009. <www.comsoc.org/livepubs/ci1/public/anniv/joel.html>
61
RADAR technology (for “radio-aided directivity and ranging”) advanced during

WWII, was in commonplace use for military applications by 1943, and led to the
development of FM radio, television, and microwave communications. But it was
not until 1947 that wireless communications began to show practical applications
in conventional telephony.
That year, AT&T constructed a “highway service” between New York and Boston
that operated in the 35 MHz–44 MHz range. The system was power-hungry and
cost-prohibitive, and it was not until 1978, when AT&T began to trial analog-based
cellular technology in Chicago, that the modern era of wireless communications
began. This was the birth of 1G—Advanced Mobile Phone Service (AMPS).
Regulation Changes the Game

Because the taxonomy and terminology that characterizes discussions of the tele-
communications industry can be exclusory, it may be useful to begin at the begin-
ning and quickly summarize the long history of telecom regulation, which still de-
fines the industry (especially in the U.S.) to this day. The technological
development of the industry is a function of and cannot be separated from its long,
winding regulatory history.
As mentioned, Alexander Graham Bell patented the telephone in 1876, founding

Bell Telephone Company, which issued stock the next year. Nine years later, the
American Telephone and Telegraph Company (AT&T) was established as a subsidi-
ary of what was then called the American Bell Telephone Company. It was charged
with operating the long-distance connections among various companies that had
been established to provide local service—the Bells. In 1900, AT&T was itself reor-
ganized. It became a holding company, the Bells became its subsidiaries, and West-
ern Electric was made its exclusive equipment manufacturer.
However, Alexander Graham Bell’s original patents expired and the U.S. saw an
explosion in telephone competition around the turn of the century, incentivizing
AT&T to go on an acquisition binge. The company grew to the point where, in 1910,
the Interstate Commerce Commission initiated the first antitrust investigation of
AT&T (the FCC would not be established for twenty-four years, in 1934).
In 1913, AT&T settled with the Justice Department, which had filed an antitrust
suit. Under the agreement, which was called the Kingsbury Commitment, AT&T
agreed to:
• divest its controlling interest in Western Union, a telegraph company,
• connect approximately 1,500 independent phone service providers to its
large network, and
• refrain from further acquisitions.
The Kingsbury Commitment gave AT&T a legally sanctioned monopoly on U.S. long-
distance services. Over the years, AT&T’s dominance of the telecom market occa-
sionally raised antitrust concerns. In 1956, the Justice Department finally:
• forced the company to restrict its activities to managing the national phone
system, and
• issuing royalties to any applicant in exchange for its patented technology;
• it also barred the Western Electric subsidiary from any activity other than
telephone equipment manufacture.
62
Thus AT&T and its various subsidiaries (Western Electric, Bell Telephone Laborato-
ries or “Bell Labs”) continued to drive the creation and penetration of copper-
based (and other) telecommunications technologies.
The invention of microwave technology described above was especially impor-

tant—it promised a method for delivering telephone service that did not rely on
AT&T’s circuit-switching network monopoly. On the circuit-switched front, competi-
tion among IXCs (inter-exchange carriers) began heating up in the 1960s; but as
one can imagine, AT&T was in no hurry to surrender the use of its central offices,
and the technology that resided in them, to upstart competitors.
And even though the new technologies coming out of Bell Labs was innovative, and
actually lowered the barriers that would–be competitors faced entering Ma Bell’s
market, AT&T wasn’t the only company that wanted to drive innovation in the tele-
com industry. The problem was that AT&T not only owned 22 Bell operating com-
panies (BOCs), but that in addition to providing local and long-distance phone ser-
vice, these BOCs continued to provide everything relating to phone service—
including phones, switches, yellow and white pages, etc. AT&T also owned the
network’s “central offices,” so that even long distance calls placed on other carriers’
networks had to travel the “last mile” through these points in order to reach cus-
tomers’ premises.
Entrepreneur versus Monopoly

Then along came Tom Carter, a Dallas businessman who invented a custom device
that he wanted to attach to his telephone to vastly increase its utility, and no such
device was available from AT&T (which, recall, had a monopoly even on the equip-
ment that attached to its network). Carter sought to attach his improved phone to
AT&T’s lines. The monopolist declined; Carter sued and won in 1969.
The case punctuated years of complaints by makers of customer premises equip-

ment (CPE) and local exchanges to the Federal Communications Commission (FCC),
claiming that AT&T refused to buy competitive equipment and effectively blocked
customers from buying it themselves. So the case attracted widespread attention
from entrepreneurs and investors who began to wonder at the potential for intro-
ducing extra-monopolistic innovation to the industry (such as Interview, which
named a building after Carter in 1993, at its Dallas business park off Waterview
Parkway).
However, Carter’s legal victory notwithstanding, AT&T won the battle inasmuch as
the FCC struggled to monitor AT&T’s crumbling monopoly throughout the early
1970s. Because of complex pricing strategies, as well as accounting and technology
issues, the monopoly wasn’t crumbling fast enough and the task proved over-
whelming. Ultimately, the FCC turned its focus to lowering the regulatory hurdles
to competition.
While competitive progress was slow, by the mid-1970s, companies were actually
competing to provide long-distance service in the U.S., albeit still under AT&T’s
monopolistic umbrella. By 1974, there had been so many complaints by long dis-
tance carriers about AT&T’s unwillingness to supply connections that the Justice
Department filed an antitrust suit against AT&T on 20 November 1974.
This was the impetus that finally broke AT&T’s stranglehold on telephony. It also
helped to create the confusing, alphabet-soup taxonomy of service provider cate-
gories that characterizes the telecom industry today.
63
In the suit—which was eventually resolved as the “Modified Final Judgment” (dis-
cussed below)—the government claimed that AT&T had:
• used its legal monopoly over local exchanges (operated by the BOCs) to mo-
nopolize long-distance or interexchange services, harming potential IXC
competitors; and
• blocked the usage and sale of customer-premises equipment not manufac-
tured by AT&T, harming potential equipment manufacturers.
AT&T denied all charges, but the judge who was assigned the case, Judge Harold
Greene, would later rule that AT&T did, in fact, refuse to publish technical specifi-
cations by which would–be competitors could determine or prove technological
compatibility with its nationwide circuit-switching network.
Following the ruling, Sprint and MCI (now part of Verizon Communications) began
to offer long-distance service in competition with AT&T, but it still had to pay AT&T
to access its central-office technology. These players were therefore dubbed IXCs
because, as mentioned above, they had no lines to individual customers’ homes, so
that any call placed through an IXC to a home or business (that is, any long-distance
call) had to travel through AT&T’s exchanges, in addition to the local exchanges of
the company originating the call, and the exchange that hands it off to the final
destination. (To the extent that a company—including a BOC—provides local calling
services, it is called a local exchange carrier, or LEC. IXCs provide inter–LATA service,
or service between LATAs. LATA stands for Local Access and Transport Area; it is a
service area defined by specific geographic boundaries, and the network that sup-
ports it.)
The DOJ’s case sat basically inert in U.S. Federal Court from 1975 until 1978, when
the case was reassigned to Judge Greene. He established a schedule for discovery
and trial preparation. Opening arguments finally began on January 15, 1981. The
very next day, both parties requested a recess in order to settle the case. Settle-
ment talks failed on February 23 and the trial resumed on March 4. On 29 July
1981, the Justice Department requested an eleven-month delay so that Congress
could consider amendments to S.898, the “Telecommunications Competition and
Deregulation Act of 1981.” While this request was denied, the case was ultimately
dropped on 8 January 8 1982, when AT&T accepted the government’s proposal for
settlement.
A consent decree on 31 December 1983, called synonymously the “Modified Final

Judgment” (MFJ) or divestiture, was the death blow to the Bell System and the
birth of the Baby Bells. By this decree, which settled the Justice Department’s case
against it, AT&T was broken up into itself plus seven holding companies or Regional
Bell Operating Companies (RBOCs), also called Baby Bells:
• Ameritech (based in Chicago),
• Bell Atlantic,
• BellSouth (based in Atlanta),
• NYNEX,
• Pacific Bell or “PacBell” (later, Pacific Telesis),
• Southwestern Bell Communications, and
• U.S. West.
Today, these seven RBOCs have themselves merged so that only two remain (fol-
lowing the mergers of AT&T/SBC and Verizon/MCI, discussed below). The decree
64
essentially separated competition/service in the long-distance and local phone

markets by government fiat.
Immediately following the divestiture, an entity named AT&T remained, but it was
no longer the world’s largest corporation (as it had been the day before). Its assets
dropped from $150 billion to $34 billion in one day, and its headcount from one
million to 373,000. Over time, its market share in long distance would plummet
from a high of 90%; prices for local and long-distance services declined; volume
increased; etc. The divestiture essentially demonopolized and regionalized AT&T,
hence the term RBOC (pronounced “ar-bock”). But each RBOC was also considered
an ILEC (pronounced “eye-leck”), or incumbent local exchange carrier. They were
incumbents because they had been serving the phone market, as BOCs, before the
breakup of AT&T. Finally, the RBOCs/ILECs were also called Baby Bells, for the ob-
vious reason that they were smaller, fractionalized versions of the original AT&T or
Ma Bell system.
For the record, the Baby Bells operated in the following geographic areas: Ameri-
tech and BellSouth in the Midwest; Bell Atlantic in—you guessed it—the “Atlantic”
region, meaning the Southeast and corridor; NYNEX in New York and New England;
and PacBell, Southwestern Bell and U.S. West in California and Nevada. The RBOCs
were allowed to provide local-exchange services and sell customer-premises
equipment, but were subject to significant “line-of-business restrictions”—basically
they were forbidden from providing long-distance service, manufacturing phone
equipment, and providing yellow or white pages.
As holding companies, each of the Baby Bells (RBOCs) owned at least two BOCs. By
the MFJ decree, even the smallest BOCs were given the right to provide local phone
service, while AT&T was allowed to continue providing long-distance services. A
company that provides purely local phone service operates within a single LATA.
LECs provide service in a single LATA, ILECs between and across and LATAs.
Another way to look at the distinction between providing local and long-distance
service is to realize that phone lines from homes and businesses all terminate at a
local “central office” or exchange. These local exchanges are connected to other
local exchanges within a LATA, as well as to IXCs. So the breakup of AT&T killed the
Bell System and created the RBOCs/ILECs—the incumbent, regional phone compa-
nies (or their successors) that began to compete to provide ILEC services and,
through their BOCs, LEC services. AT&T exited the residential-voice business for
good in July 2004, citing regulatory reasons, after 120 years in the business.
Recent Performance
The telecom sector was bested only by healthcare and consumer staples in 2008
(and performed about even with utilities), and while it has remained among the
least volatile global sectors this year, performances flat year-to-date. Second-
quarter earnings results were mildly positive, showing signs that top-line spending
has stabilized. We expect the sector to benefit from stimulus plans in the U.S. and
abroad, especially programs targeting the development of Internet infrastructure.
We favor exposure to providers of more advanced telecom equipment and services
(e.g., wireless infrastructure, 3G providers) with solid balance sheets and low leve-
rage, as well as exposure to international markets.
We recommend a 10% exposure to telecom relative to other global equity sectors

and no allocation overall, except through the purchase of high-grade corporate
bonds (or as part of our recommended tech allocation of 20%).
65
Consumer Discretionary
This highly cyclical group has rebounded sharply since March, with strength in the
auto parts and retailing industries (including apparel). The sector in general faces
continued pressure on weak consumer spending, though we do expect Christmas
sales in some categories to exceed expectations. Credit standards have tightened
versus previous years and already debt-burdened consumers are beginning to save
more. Low-cost consumer staples categories (discussed below) are relatively more
attractive than the big-ticket consumer-discretionary industries such as home fur-
nishings and appliances, in our view.
Luxury goods have suffered tremendously on the meltdown in home prices and
investment portfolios, and due to high unemployment. Hotel and leisure services
have suffered the double-whammy of recession and corporate angst at the “optics”
of spending on out-of-the-way (or over-the-top) employee junkets.
Except for video games and Internet-based media, including social media such as
YouTube and MySpace, weak ad spending has hurt the publishing and newspaper
industries—with the outlook for the latter remaining totally uncertain, in our view.
As for the advertising industry itself, difficulties in the financial-services and auto
industries have curtailed revenues.
Restaurants, which provide a service that may range from basic to luxury, have
shown strength in the casual-dining and fast-food segments, but rising input costs
may provide a new headwind. Of even greater concern is the risk of negative year-
over-year comps, as these companies have declined the rate at which they open
new chains. We therefore think the group could get pinched on both the top and
bottom lines, even as other sectors show improvements from a strengthening
second-half economy.
Consumer-technology companies that drew down inventories during the recession

may face shortages against stronger-than-expected consumer demand in the
Christmas shopping season. Signs in certain product categories, such as flat-screen
TVs and cellular handsets, is encouraging, in our view.
Charts 32 and 33:

S&P Select Consumer Discretionary SPDR (XLY)—Weekly (Left) and Daily (Right)
66
Looking to the end of the year, certain consumer-electronics categories face easy
year-over-year comp’s, in our opinion following last year’s drop-off in sales. We
expect certain high-and electronics categories where products have come down in
price, such as flat-panel TVs, personal GPS navigators, and computers, to show
strength in the holiday season.
Consumer Sentiment
There are two primary indices that purport to measure how consumers feel: The
consumer sentiment index is constructed each month by the University of Michi-
gan, based on surveys of 500 consumers. The other most-watched measure is the
Conference Board’s consumer confidence index. (A third measure, the
ABC/Washington Post U.S. Consumer Comfort Index, is less closely followed.) The
Michigan index consists of five questions:
• two about personal finances,
• two about future income and job growth (the economic outlook), and
• one about spending conditions, which attempts to capture how price and in-
terest-rate trends will impact respondents’ purchase plans.
Somewhat contrary to its intention, in our view, the index better reflects gyrations
in market sentiment than it supports the forecasting of actual trends in consumer
spending (much less market direction). And while consumer sentiment is largely
considered a contra-indicator, based on the notion that increased consumer pes-
simism increases the chances of Fed rate cuts, we have conducted regression ana-
lyses that reveal that the index’s correlation with the S&P 500 is positive or insigni-
ficant over most time periods.
Our recommendation is therefore that consumer sentiment not be used as a con-

tra-indicator so much as a “contra-contra-indicator.” That is, given its ability to gen-
erate massive amounts of volatility in the market—but its relative insignificance as
an economic or financial forecasting device—investors should interpret the index’s
event-driven market swings as short-term in nature, and use such swings to time
contrarian decisions.
It is important to understand why the consumer-sentiment index’s impact on equi-

ties can often be so counter-intuitive. The common wisdom, cited above, is that
higher (lower) expected sentiment readings correlate with decreased (increased)
probabilities of future Fed rate cuts. This explanation addresses the market-
psychology aspect of the volatility surrounding the release of monthly consumer-
sentiment data: why traders react the way they do shortly following the data re-
lease. But the machinations and interpretation at the macroeconomic level must
often be interpreted through a different screen.
Our historical analyses of the data reveal that stocks have shown weakness follow-
ing sentiment levels that reflect euphoria, while depressed sentiment signals an
impending turnaround in the market. Consumer sentiment can therefore be used
as a long-term contra-indicator revealing market turning points, as it tends to re-
flect recent past (not future) conditions. At new extremes, then, the index can sig-
nal a critical mass of extreme opinion, and thus possibly signal important reversals.
In short, high sentiment levels reflect euphoria, while depressed levels typically
correspond with market bottoms. Consumer sentiment is therefore an important
tool for both identifying prevailing market trends and trend reversals.
67
Chart 34: Compared to the Conference Board’s measure of con-

U.S. Retail Sales (nominal, SA, $b) sumer confidence, the Michigan index is thought to be
more sensitive to recent changes in energy prices. The
400 15% reason is that the Michigan survey focuses more on per-
10% sonal financial matters (versus expectations for business
350
conditions and so on), giving respondents a greater op-
5%
% change
portunity to communicate their reactions to high/low
$ billions
300
0% gasoline prices.
250
-5% Adds Lots of Heat, Not Light
200 -10% As a contra-indicator, the index shows no meaningful
correlation with short-term market returns, though its
150 -15% monthly release can generate substantial volatility. As
Jan '92
Apr '94
Jul '96
Oct '98
Jan '01
Apr '03
Jul '05
Oct '07
explained above, investors attribute the ability to correct-

ly anticipate future Fed decisions and subsequent market
moves (at least in part) to the sentiment reading—
U.S. retail sales Year-over-year change sometimes without significant basis. As such, we view a
significant change in market prices related to the senti-
ment report as noise.
The index should be discounted as a short-term contra-

indicator because it actually lags the market, rather than leading the consumer
spend-trend. As a leading indicator it is useful only on a secular basis, and then
primarily to signal reversals—rather than a continuation of the dominant trend.
Media reports about changes in the price of oil and what that may mean to con-
sumers during summer driving months, and so on, can also influence reported opi-
nion wildly, in our view—with implications not just for equity prices but for the U.S.
dollar.
Because of course, the consumer is the driving force in the U.S. economy. The new
trend toward frugality discussed earlier (pages 41–46) tends to limit our expecta-
tions not just for the consumer-discretionary sector, but for a GDP dominated by
such transactions.
Follow Spending, Not Surveys

Ultimately, retail spending is driven more by consumer cash flow than the bogey-
men of shoppers’ hopes and fears—which is what the Michigan survey best meas-
ures, in our view. A weak consumer confidence report should typically be viewed as
an opportunity to build long positions when our models signal bullish, or increas-
ing, allocations to stocks.
Likewise, we are more apt to consider recommending tactical short positions fol-
lowing a strong consumer confidence report, during periods when our models and
other analyses signal a bearish or weakening long-term investment environment.
Current Recommendation
We recommend 10% exposure to the consumer-discretionary sector (relative to
our total sector recommendation) through the iShares S&P Global Consumer Dis-
cretionary ETF (RXI), and no allocation overall due to broad consumer and econom-
ic concerns discussed at length.
68
Consumer Non-Discretionary
The consumer non-discretionary sector has performed in-line with the market
year-to-date, which reinforces our cautious stance on expectations for a sharp re-
covery. But as expected given the market’s recent strength, the sector has slightly
underperformed consumer cyclicals.
Favor Stability
We think consumer staples offer some attractive opportunities to add yield on the
basis of stable growth rates in the food and beverage industry, for example—
growth rates that, without adding a lot of volatility, are now recognized as being
about as competitive as long-term equity returns.
The sector could also benefit from a fourth-quarter flight from cyclical names,
which may disappoint versus expectations modified throughout and following the
strong summer rally. The possibility for such a seasonal play exists year-in, year-
out, and we think may prove especially interesting this year.
An Economic Call
Largely, it comes down to the economic recovery: we view consumer non-
discretionary as defensive and like the must-have categories. Negatives (from an
investment standpoint) include recent tax increases and high-profile product-
liability losses in the tobacco industry, which have picked up following the 2006
Engle decision that opened the industry to additional class-action lawsuits and in
some cases made those lawsuits easier to prosecute. (Most such cases are return-
ing verdicts favorable to the plaintiffs.) Increases in federal excise taxes are also
expected to damage the outlook for this normally defensive industry, in our view.
Current Allocation
As part of our global-sector focus, we recommend a 12.7% allocation to consumer
staples by way of the S&P Select Consumer Staples SPDR (XLP). Our anchor portfo-
lio would hold 7% of total assets in staples.
Charts 35 and 36:

S&P Select Consumer Staples SPDR (XLP)—Weekly (Left) and Daily (Right)
69
Healthcare
Healthcare expenditures tend to track the trend in GDP growth—the faster the
economy is growing, the more corporate America spends on healthcare for its em-
ployees. When unemployment is low, a greater number of insured workers con-
sume healthcare benefits. Especially for managed-care providers, we would expect
a return of positive economic growth supporting increased earnings and new job
creation to result in higher Medicare enrollments and greater health care expendi-
tures. In our view, the long-term outlook for the healthcare sector is only positive
assuming that the economy rebounds strongly throughout the second half of this
year.
Big Positive: Baby-Boomer Demographics

The demographics supporting the sector are compelling as aging baby boomers will
consume more care. But changing government regulatory policy represents a wild
card, and all of the winners and losers are not yet clear. That said, we would avoid
exposure to health-maintenance organizations (HMOs) on the basis of proposed
regulatory changes and add exposure to direct-care providers, such as hospitals.
Medical Devices
Year-to-date, medical-device stocks have fared better than the overall market, up
22.8%. We continue to recommend that investors focus on companies providing
life-sustaining products (versus elective services).
We like the medical-devices group on the expectation for continued strong de-
mand, whatever the regulatory backdrop. We prefer exposure to larger-cap, less
volatile makers of medically necessary devices. Product sales in this category tend
to be more stable, and for the same reason, we like medical software providers.
Biotech
Biotech firms are naturally volatile—many of them are loss-making and burn cash
in order to develop a single drug or single type of therapy for a specific end-market.
Success or failure is often binary for these firms, especially the small-caps, with
expected future cash flows revolving in large part around a single drug trial or FCC
approval. Volatility is magnified for small-cap biotech firms that focus on a single
end-market, are unprofitable, may need additional cash infusions from new inves-
tors, etc. But early in an economic cycle, equity portfolio managers may be wise to
prune cash-flow positive biotech firms and favor loss-makers with asymmetrical
upside potential.
In addition, tend to outperform in the fall, during the height of conference season
in the industry. Companies announce good news in conjunction with these confe-
rences and, because most biotechs operate at a loss and represent “bottle-rocket”
bets on one or two individual drugs, these expectations can have a large, positive
impact on stock prices in the sector. The effect is so strong that one is best served
only holding biotech ETFs during the second half of the year, in our opinion.
Big Negative: Uncertain Regulatory Backdrop

Current legislation represents a risk to the managed-care and HMO industries, in
our view. Unlike in a normal recession, where healthcare can provide investors with
the safe haven, the recent recession was marked by concern over a proposed regu-
latory overhaul in which the winners would almost certainly not be the pharma-
ceutical companies, biotech companies, or managed-care providers.
70
But while the winners and losers from the ongoing regulatory shake-up are not yet
clear, the extent to which price controls for drugs and services in general may be
regulated has given investors pause. In our view, regulatory reform will certainly
see its share of winners in the industry. Aggregate spending on healthcare may
increase depending on the number of currently uninsured people that join the
rolls. The obvious risk is that these patients would certainly be less profitable to
serve, in our view.
It may take several quarters to see any clarity on the regulatory overhaul, with in-
creased volatility in the shifting raft of expected winners and losers, in our opinion.
In the interim, we expect makers of generic drugs to outperform specialty pharma-
ceuticals should a sweeping regulatory mandate gain traction. Most biotechs are
altogether too volatile to be purchased without more clarity at the regulatory level,
in our view.
Large-Cap Pharmaceuticals
Offsetting these risks somewhat, large-cap pharmaceuticals firms enjoy substantial
upside potential from a weak or declining dollar. Like the information-technology
sector, U.S. pharma names enjoy competitive advantages relative to their foreign
peers and typically offer significant top-line exposure to foreign buyers.
Managed Care
For managed-care providers, sources of revenue and medical costs can be broken
down into four categories: inpatient, outpatient, physician, or pharmacy.
Based on a plan provider’s exposure to each category, trends in that category may
significantly impact its performance relative to the sector at large. The key metric
for these names is the premium rate—revenues from plan members less the costs
of providing members with healthcare, i.e., reimbursing doctors, hospitals, etc. This
rate represents a gross margin or “spread.” That said, earnings reflect both pre-
miums and costs and remain the single best metric for analyzing the performance
of managed-care providers, in our view. As discussed at length above, the regulato-
ry and economic risk that we see looming represent significant headwinds to ma-
naged-care companies’ bottom lines, in our opinion.
Table 11:
Healthcare ETFs
Index Ticker
• iShares DJ U.S. Healthcare Providers ............................................. IHF
• iShares DJ U.S. Medical Devices .................................................... IHI
• iShares DJ U.S. Pharmaceuticals.................................................... IHE
• iShares S&P Global Health Sector Index ........................................ IXJ
Healthcare iShares Dow Jones U.S. Healthcare (IYH)

Yield: 1.7% ADV: 117,000 Inception: 12 Jun ’00
Tracks the gross performance of the Dow Jones U.S. Health Care Index (DJUSHC),
which currently tracks 136 companies, including Abbott Laboratories (ABT), Am-
gen (AMGN), and St. Jude Medical (STJ).
71
Industrials
The industrials sector, sometimes referred to as capital goods, includes companies
that manufacture and distribute non-commodity products used in engineering ap-
plications and construction, or which provide transportation services (e.g., airlines,
trucking and freight companies, couriers) and commercial services—such as print-
ing, office products and services, etc. (Note that commodity manufacturers are
classified in the materials sector.) The sector also includes the aerospace & de-
fense category—though high-tech defense firms may sometimes be considered
technology plays. Bellwether industrials firms include Deere (DE), Fluor Corpora-
tion (FLR), and Caterpillar (CAT). Some industry ETFs are listed in the table on the
next page.
Transportation
Railroads and air-freight shares have generally outperformed other sub-categories
in transportation. Demand for passenger-airline travel has fallen dramatically on
global economic weakness, more than offsetting the fall in fuel prices.
Baltic Dry Index

The Baltic Dry Index (Bloomberg: BDIY <Index>) is a commodity-freight index that
measures the level of seafaring shipping rates for metal, energy, and agricultural
commodities like steel, iron ore, coal, and grain. Because firms do not charter
freighters unless they have actual goods to transport, the Baltic Dry Index is a use-
ful leading indicator of worldwide economic activity.24
Generally, an increase in the index implies an increase in the level of worldwide

shipping and, hence, economic activity, and thus may be considered a bullish eco-
nomic indicator. However, stronger levels of shipping activity also mean higher
transportation costs, which can pinch the margins of companies or industries that
traditionally pay shipping costs, such as manufacturers of steel, chemicals, or con-
sumer durable goods (e.g., appliance makers, chemicals manufacturers), as well as
customers that rely on these goods as manufacturing inputs (or resell them).
The index increases or decreases primarily as a function of global economic de-

mand, especially for steel. Other building materials commonly transported by bulk
carriers (as opposed to container-based shipments) include cement and iron ore;
and other commodities include coal and grain. But demand for shipping services
itself can fluctuate as a result of increases or decreases in the availability of freight
ships.
A shortage of such services can drive steep price increases. What’s more, day prices
for chartering shipping services can be volatile, as the users of global, sea-based
transport often wait on the sidelines when freight shipping prices are in decline, in
the expectation that they will continue to fall—which can be a self-fulfilling proph-
ecy that pushes shipping fees even lower.25
24
The index, which was previously called the Baltic Freight Index, is compiled by The Baltic
Exchange and distributed by it and Commodity Markets Services. It is a composite of the
Baltic Capesize, Handymax, and Panamax indices, and has a base value of 1,000 as of 4
January 1985. The Baltic Exchange compiles the index based on daily responses from par-
ticipants in several routes shipping routes. The Baltic Exchange Panamax Index tracks pric-
es for dry-bulk transportation.
25
Aeppel, Timothy. “Commodity-Freight Rates Slip As Global Growth Slows Down.” The Wall
Street Journal, 13 June 2005, eastern ed.: A2. The article stated, “More than half of all so-
called dry-bulk cargos—items shipped in bulk on huge ships—is steel-related, either raw
materials for steel’s production or final goods. So a global slump in that sector has a huge
impact on shipping.” The article also provided detailed pricing information for global ship-
72
In any case, the Baltic Dry Index is a useful raw-materials-by-sea index for tracking
trends and turning points in the level of global import/export activity. The index
has rebounded from its end-of-year lows, providing some confirmation to expecta-
tions that the economy has found its floor—at least in the near-term, as well as
support for dry shippers. But the index has stagnated since June; we do not rec-
ommend an allocation to transportation at this time.
We currently recommend an 11.9% allocation to industrials relative to our aggre-
gate global-sector focus, but industrials do not comprise any of our recommended
anchor portfolio.
Table 12:
Industrials ETFs
Index Ticker
Broad
• iShares S&P Global Industrial Sector ............................................. EXI
• Vanguard Industrials ETF .............................................................. VIS
Industry-Specific
• iShares DJ U.S. Aerospace & Defense ............................................ ITA
• iShares DJ U.S. Basic Materials...................................................... IYM
• iShares DJ U.S. Home Construction ............................................... ITB
• iShares DJ U.S. Industrials ............................................................. IYJ
• iShares DJ Transportation Average ................................................ IYT
• PowerShares Aerospace & Defense .............................................. PPA
• SPDR S&P Homebuilders .............................................................. XHB
Industrials iShares S&P Global Industrial Sector (EXI)

NAV: $40.11 P/E: 14.2x Turnover: 11%
Yield: 3.03% ADV: 29,000 Inception: 12 Sep ’06
Uses a representative sampling strategy to track the S&P Global Industrials Sector
Index, which consists of over 170 companies. Sub-industries include capital-goods
manufacturers and distributors, transportation and commercial services compa-
nies, and industrial suppliers.
Industrials DIAMONDS Trust Series, Series 1 (DIA)

NAV: $93.40 P/E: 13.8x Turnover: 11%
Yield: 3.38% ADV: 13.5 million Inception: 13 Jan ’98
Highly liquid, low-cost ETF that tracks the Dow Jones Industrial Average (DJIA).
ping by sea: “At the peak of the market last year [i.e., circa November 2004], it cost more
than $100,000 a day to charter a ship to carry material from Brazil to China. That same
ship cost about $80,000 a day in mid-April and now can be had for $31,000 a day.”
73
Industrials WisdomTree International Industrial (DDI)

Price: $19.16 Net assets: $13.7 mil. Expense ratio: 0.58%
NAV: $19.59 P/E: 12.9x Turnover: 43%
This ETF uses a representative sampling strategy to track the WisdomTree Interna-
tional Industrial Sector Index. The index itself tracks dividend-paying, international
industrial companies in developed markets. Sub-industries include aerospace &
defense, electronic components and equipment, building materials and construc-
tion, machinery, etc. While this ETF offers a high yield and allows investors to di-
versify away from the U.S., it is small and illiquid.
Industrials Industrial Select Sector SPDR (XLI)

Yield: 3.26% ADV: 12 million Inception: 16 Dec ’98
Large, liquid industrials ETF. It provides exposure to U.S. industries including aero-
space & defense, construction and building products, electronic equipment, etc.
While our preference is for global industrials exposure through the higher-yielding
DDI (above), that ETF does not see sufficient volume for institutional investors, in
our opinion.
Industrials iShares Dow Jones U.S. Industrial (IYJ)

This ETF tracks the Dow Jones U.S. Industrials index. Its yield is similar to the VIS
(below) and it is more actively traded—appropriate for institutional investors, in
our opinion.
Industrials Vanguard Industrials ETF (VIS)

NAV: $46.70 P/E: 10.5x Turnover: 47%
This ETF tracks the MSCI U.S. Investable Market Industrials index. It is traded ac-
tively enough to be appropriate for high-net-worth individuals, in our view, but we
do not recommend it for institutions looking for sizable exposure to the industrials
sector.
74
Materials
Companies in the basic-materials sector manufacture or mine commodities. Basic
industries (not to be confused with the industrials sector; see page 72) include
firms that produce steel, iron, other metals, and mining/minerals companies; as
well as chemicals, glass, forest products, and other packaging materials. The group
is highly cyclical, and thus tends to perform best when end-market demand for
basic manufacturing inputs is strongest. We can measure this demand using the
trend in raw materials’ prices and inflation.
The pronounced cyclicality of the basic materials sector also allows certain sector-
specific trends to inform our understanding of the business cycle at large (i.e., its
timing and dominant trends). Key sector trends to look at include:
• inventory levels: Is the cycle slowing, or is inventory simply be destocked?;
• new orders: point to underlying strength in manufacturing trends;
• box shipments: indicate the underlying trend in end-market demand;
• PVC shipments: point to strength in the construction industry; and
• magazine ad pages: may indicate strength or weakness in the consumer
economy.
Materials Sector as Proxy for Commodities

While commodity stocks may be used as proxies for investing in the commodities
sector, they are just that—and often weak proxies, at best, due to corporate hedg-
ing strategies and other company-specific issues.
This materials sector typically performs well during that portfion of a cycle when
commodities have started to increase but bond prices have not yet turned down.
Downstream from the mining category are companies that produce mining equip-
ment (e.g., Caterpillar [CAT]), which tend to see an increase in equipment orders
coming off of troughs in the mining business.
Mining & Minerals

Despite the wide divergence in inflation expectations, precious metals have recent-
ly outperformed base metals by a wide margin, as a defensive hedge. The former
have seen major high’s in February and again in June, with gold holding most of its
value since then (unlike silver or palladium, which have been more volatile), sup-
ported by strong jewelry demand from India late last year. (The wedding season in
India runs from September to December.) The key mineral extraction companies
include BHP Billiton (BHP), Freeport-McMoRan Copper & Gold (FCX), Joy Global
(JOYG), Manitowoc (MTW), Rio Tinto (RTP), and Terex (TEX).
Uranium
Among the base metals, uranium is interesting as a long-term power play and on
the basis of severe contango, in our view. Unfortunately, no uranium ETF has yet
been introduced. The closest such vehicle may be the Market Vectors Nuclear
Energy ETF (NLR), introduced in August 2007. It tracks the DAXglobal Nuclear Ener-
gy Index and contains several dozen global uranium miners, enrichers, and nuclear
power plants—as well as an array of companies not directly tied to uranium.
We allocate to the mining & minerals industry through our recommended com-
modity and materials vehicles, though we may occasionally use more focused ETFs
(such as the NLR) for satellite recommendations.
75
Water
Lack of access to clean water is a crisis in much of the world, and one of the largest
killers of children globally. Various organizations (the World Bank, the World Health
Organization) estimate that between 1.2 billion and 2 billion people currently lack
access to clean water, and expect that number to expand to roughly 2.5 billion
people in the years to come. Another 500 million to 1 billion people currently lack
the means to sanitize their available water resources.
Water collection, sanitation and distribution is not only one of the world’s largest
industries, but one of its biggest problems. Demand for water supplying thermoe-
lectric power and irrigation systems far exceeds the commodity’s domestic uses
(e.g., public supplies for people, maintaining livestock). Water is therefore an eco-
nomic play, an environmental play, a commodity and infrastructure play, a third-
world development cause, and (as an investment category) passes the social-
responsibility screen, in our view. We currently recommend a 5% allocation to the
CGW overall, and 11.7% as part of a commodities portfolio.
Our top pick in the category is the Claymore S&P Global Warder ETF (CGW; see box
below). It has recently traded only 65,000 shares per day, which is less than we
prefer for a recommended vehicle. But it is summer and trading is light; average
daily volume (ADV) in the CGW has regularly exceeded twice its current level year-
to-date. The deciding factor here is yield: 8% for the CGW versus less than 0.6% for
the most liquid ETF in the category, the PowerShares Water Resources fund (PHO).
Water Claymore S&P Global Water ETF (CGW)

NAV: $16.46 P/E: 15.0x Turnover: 38%
Yield: 8.0% ADV: 65,000 Inception: 14 May ’07
An ETF designed to track the gross performance of the S&P Global Water Index,
which contains about 50 stocks. While smaller than we normally like to recom-
mend to institutional investors, we think exposure to the water industry is impor-
tant, and likeness vehicle’s global coverage. We currently recommend a 5% alloca-
tion to this fund overall, and 11.7% as part of a commodities-focused strategy.
Water PowerShares Water Resource ETF (PHO)

NAV: $15.78 P/E: 17.4x Turnover: 23%
Yield: 0.55% ADV: 331,000 Inception: 6 Dec ’05
Tracks the gross performance of the Palisades Water Resource Index. We prefer
the higher-yielding (but less liquid) CGW instead (see box above).
Mining/Minerals SPDR S&P Metals & Mining (XME)

NAV: $41.76 P/E: 21.3x Turnover: 59%
Yield: 1.53% ADV: 4.1 million Inception: 19 Jun ’06
Tracks the total return of the S&P Metals & Mining Select Industry Index
(SPSIMM.X, SPSIMMTR), which contains about two dozen stocks.
76
Financials
In the financial-services sector, we expect all eyes once again to be on the repay-
ment of funds raised through the Troubled-Asset Relief Program (TARP), which
passed in October as part of House Resolution 1424 (which created the Office of
Financial Stability). TARP was designed to allow the Treasury Department to pur-
chase toxic assets directly from banks, or to insure banks against the default of
such assets. That was the stated intent of the program—it was announced and
marketed as a taxpayer-funded rescue package. Instead, the Treasury Department
used the $700 billion allocated to the TARP to dilute bank shareholders through the
purchase of senior debt and equity warrants.
The Treasury never actually purchased any toxic assets through TARP, but merely
wrote loans to banks in larger amounts than were needed or to banks that needed
no such loans at all. Then, for a time, the Treasury refused to be paid back, using
funds (a) that it did not have (b) to dilute the ownership stakes of bank investors,
by (c) putting capital to banks that (d) in many cases did not need it, in order (e) to
purchase “troubled assets” that it did not purchase.
The TARP was and remains a taxpayer-funded earnings-dilution program that never
had anything to do with toxic assets except in name only. Those banks that have
not yet repaid TARP have until November to raise more capital. This is why the re-
payment of TARP funds matters: It is not so much the increased regulatory burden
that comes with greater government ownership and oversight, though that is a
factor. More important, in our view, is the earnings accretion that comes from re-
versing participation in TARP.
Charts 37 and 38:

S&P Select Financial SPDR (XLF)—Weekly (Left) and Daily (Right)
77
An Economic Play
As long as rates of foreclosure, mortgage delinquency and unemployment remain
high, there will be pressure to keep interest rates low. Consumer-loan delinquen-
cies continue to increase on the still-high unemployment level, though the spread
between the long and short ends of the yield curve now generously supports
banks’ net interest margins.
For these reasons, we view banks as very much a play on the larger economic re-
covery, though hampered by the need to raise additional capital through dilutive
equity sales. Growth in deposits has been strong and may be sustainable, in our
view—even on an uptick in consumer confidence and spending, given the “new
frugality” trends cited earlier (pages 41–46, see also page 87). Year-to-date, small
banks have underperformed large, more diversified financial-services companies,
though we expect this gap to narrow on the continued work-down of delinquent
loans.
Defensive Posture
We advise maintaining a defensive posture going into the second half of 2010—
when the next tidal wave of adjustable rate mortgages (ARMs) is expected to reset
(see discussion beginning on page 45). To play financials more aggressively, we
would need to see greater evidence of the secular economic rebound supporting
new-loan growth.
Outside the U.S., we would look to put on slightly more exposure to the sector in
the emerging-market and BRIC countries. Financial institutions in these countries
generally have less exposure to subprime assets than do the developed nations,
and to exotic financial products in general.
U.S. Community Banks

We do prefer U.S. community banks over other sectors in the U.S., especially those
that have begun to show signs of stabilizing their delinquent-loan balances, or even
reversing the delinquencies trend of the last eighteen months. But we do not think
the commercial real-estate market is set to recover this quarter, and regional banks
do remain at risk for greater equity dilution, in our view.
Some of the metrics that we would use to time entry into the community-bank
segment include:
• an uptick in asset quality: declining bad loans and write-downs, and greater
clarity and stability into these trends vis-à-vis the suitability of a changing
regulatory framework;
• earnings quality and growth;
• banks’ capital bases: need to expand sufficiently that the need for new-
equity raises (recapitalizations) is reduced, relative to the impact on stock
prices;
• credit: declining mortgage defaults and leveraged-loan spreads;
• U.S. dollar: a strong dollar benefits financials by boosting consumer buying
power, and signal a lower market assessment of economic risk.
At some point, we expect stronger fundamentals (strengthening asset quality driv-

ing higher reserve coverage and profitability) to overtake the risk of dilution, and
would look to increase allocations to U.S. community banks aggressively, relative to
both their larger U.S. and international counterparts. We also think this segment,
78
while volatile, is ripe for M&A activity, driven by larger institutions that will look to
boost their market share at discount prices.
Insurance
Life insurers and reinsurers have suffered losses in their securities holdings, both
their market and real-estate-backed holdings. We expect continued pressure on
earnings growth for this segment and for the property & casualty (P&C) group,
which are still recovering from losses suffered during last year’s storm season.
Reinsurers have also felt this pain, though generally remain better capitalized. The
government opened the TARP to a number of P&C companies, due to their need to
boost capital levels following these events. The industry remains under pressure.
Reduced financial flexibility and weak underwriting and reserves have further add-
ed to the woes. The only positive trend visible as of now is slight improvement in
some insurance pricing after continued deterioration during the last couple of
years.
Insurance SPDR KBW Insurance (KIE)

Yield: 2.36% ADV: 619,000 Inception: 8 Nov ’05
Tracks the performance of the KBW Insurance index, offering ample liquidity for its
relatively diminutive size.
Regional Banking KBW Regional Banking ETF (KRE)

NAV: $21.81 P/E: 18.7x Turnover: 35%
Another well-placed financials ETF from KBW, this regional-banking vehicle pro-
vides high-volume and attractive yield to investors seeking exposure to small U.S.
banks (as well as mortgage banks and loan processors). Tracks the KBW Regional
Banking index using a modified, float-adjusted weighting based on market.
Global Financials iShares S&P Global Financials (IXG)

Yield: 2.97% ADV: 102,000 Inception: 12 Nov ’01
The IXG has recently traded just over 100,000 shares per day, including light-
volume summer sessions. We like the global exposure and view this fund as just
large enough for mainstream institutional investors. We currently recommend a
9% allocation to financials overall, but prefer a more liquid, global ETF like the S&P
Select Financials SPDR (XLF).
79
Short Financials UltraShort Financials ProShares (SKF)

NAV: $28.18 P/E: n/a Turnover: n/a
Yield: 0.44% ADV: 32.1 million Inception: 30 Jan ’07
For intraday trading, this fund seeks to turn in twice the inverse daily performance
of the Dow Jones U.S. Financials index. We discuss its use in the context of our
“dollar-doomsday scenario” (see page 44).
Table 13:
Financials ETFs
Index Ticker
Global and International
• iShares S&P Global Financials ....................................................... IXG
• WisdomTree International Financial ............................................. DRF
Broad U.S.
• iShares Dow Jones U.S. Financial .................................................. IYF
• iShares Dow Jones U.S. Financial Services ..................................... IYG
• Financial Select Sector SPDR......................................................... XLF
• Vanguard Financials ETF ............................................................... VFH
Fundamental and Equal-Weighted
• PowerShares FTSE RAFI Financials ................................................ PRFF
• Rydex S&P Equal Weight Financials ETF ........................................ RYF
Quant
• First Trust Financials AlphaDEX ..................................................... FXO
• PowerShares Dynamic Financials .................................................. PFI
• PowerShares Dynamic Banking..................................................... PJB
• PowerShares Dynamic Insurance .................................................. PIC
• PowerShares Financial Preferred .................................................. PGF
• ProShares Ultra Financials ............................................................ UYG
• ProShares UltraShort Financials.................................................... SKF
Banks
• iShares Dow Jones U.S. Regional Banks† ....................................... IAT
• KBW Bank ETF.............................................................................. KBE
†
• KBW Regional Banking ETF .......................................................... KRE
• Merrill Lynch Regional Bank HOLDRs† ........................................... RKH
• PowerShares Dynamic Banking Portfolio ...................................... PJB
Brokers and Asset Managers
• Claymore/Clear Global Exchanges, Brokers & Asset Managers ...... EXB
• iShares Dow Jones U.S. Broker-Dealers ......................................... IAI
• KBW Capital Markets ETF ............................................................. KCE
Insurance Companies
• iShares Dow Jones U.S. Insurance ................................................. IAK
• PowerShares Dynamic Insurance Portfolio.................................... PIC
• KBW Insurance ETF ...................................................................... KIE
†
Regional and/or community banks.
80
Energy
Contrarian in the Short-Term
Oil and gas prices are highly correlated with expectations for economic growth in
the major developed (energy-consuming) countries and uncertainty over the relia-
bility of energy supplies. When strong demand-versus-supply factors reinforce ex-
pectations for strong macro growth, we get peak performance in commodity and
the share prices of oil and gas firms. But in the short-term, the performance of
energy equities is most closely associated with changes in commodity prices them-
selves. These trends in turn are very much demand-driven, and this explains the
relative underperformance in the energy sector year-to-date—especially among
smaller production companies. (Though still strongly up, the sector has lagged the
broad market by approximately 17 percentage points over this period.)
That said, short-term gains may be realized even in a declining global-growth envi-
ronment, especially during periods of heightened uncertainty over energy produc-
tion trends, inventory levels, disruptive geopolitical events in key oil-producing re-
gions, etc. The current situation is therefore a mixed bag. To understand why
energy is a contrarian call right now, let us examine the historical relationship be-
tween commodity prices and economic growth.
Global Growth Barometer

Chart 40 below depicts the relationship between growth in GDP and energy con-
sumption on a global basis, from 1980 to 2008. (Annual change in GDP is calculated
using the purchasing-power-parity value of individual countries’ GDP, in order to
account for new dollar creation.) The average correlation between global GDP and
the consumption of oil, gas and coal was +95% annually over this time period, with
a coefficient of determination of 90%. The individual correlation of GDP growth
with the consumption of both oil and natural gas are as high as any seen in finance:
over 98% for oil and 99% for natural gas, with coal at 89%.26 Globally, growth is
energy, and fossil-fuel consumption is analogous to growth.
Charts 39 and 40: U.S. Real GDP (left) and Global GDP & Energy Consumption (right)
12 10% 14% 8%
Annual change in energy

Annual change in GDP
8% 12% 6%
10
consumption
6% 10% 4%
$ trillions
4% 8%
8 2%
2% 6%
0% 0%
6 4%
-2% 2% -2%
4 -4% 0% -4%
1Q80
3Q82
1Q85
3Q87
1Q90
3Q92
1Q95
3Q97
1Q00
3Q02
1Q05
3Q07
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
Real GDP (chained 2000 dollars, SAAR) Annual growth in global GDP (PP basis)
Annual change Energy consumption, 2-year MA
26
Global GDP is expressed in constant prices for the national currencies of 176 countries. Data from the IMF. The coefficient of deter-
mination, or r 2, measures “goodness of fit.”
81
Top-down Framework
Given the relationship between economic activity and energy requirements, the
construction of a sector thesis may begin with a top-down analysis of secular
growth trends. In our view, the long-term nature of demand and consumption
cycles may tend to lull investors (as opposed to traders) into the expectation that
energy vehicles will benefit from a pending return to normal economic growth. The
fact that many energy-producing firms pay healthy dividends, and the nature of the
analytical framework described, combine to reinforce this notion. Through this
lens, the safety of energy ETFs hinges largely on the macroeconomic outlook. Yet
the performance of oil and natural gas are not currently indicating that a return to
normalized growth assumptions is warranted.
So we think the framework can be used to inform tactical allocation decisions by

requiring the sector to confirm any broader strength that the equity market may
signal. The growth of many developed economies has slowed appreciably over the
last six quarters, and the IMF forecasts 2009 GDP growth in the advanced econo-
mies of –3.8%. The second half of this year will provide critical information about
the strength of the current turnaround—whether it is purely a function of stimula-
tive efforts (see Chart 16 on page 46) or a true, secular recovery.
If Markets Are Strong, Why More Stimulus?

But with the broad stock market up nearly 50% from its March lows and expecta-
tions for global GDP picking up, the question du jour is whether or not more stimu-
lus may be needed. Needless to say, we question whether recent market strength
can be based on economic fundamentals if both easy credit and a market rebound
contribute to the need to consider more stimulus.
Exhibit 7:
The Countries of OPEC
82
Such concerns are relevant to the energy sector because recent challenges have
caused companies to drastically reduce investment in new exploration and produc-
tion. With oil inventories at eighteen year highs, there is plenty of excess capacity
about. But we think this capacity can also be wound down more quickly than ever
on broader global demand, fomenting price spikes on any new supply concerns.
EIA Data
The EIA provides short- and long-term price forecasts for WTI crude oil, gasoline,
and Henry Hub natural gas. (These forecasts are available in its monthly and annual
“Energy Outlook” reports, though short-term price forecasts are sometimes merely
directional.) In traditional equities analysis, the futures markets’ expectations for
commodity prices and current equity valuations then inform peer-group selection
within the energy sector, followed by actual stock selection.
Bias Is for Early Entry

Short-term speculation or hedging in the energy markets may be better conducted
through futures contracts than equity shares. Within the context of our business-
cycle analysis, we are therefore biased toward early entry in the energy sector—as
dividend yields will be highest ahead of clear signs that the economy is in a re-
bound. The risk of being wrong (or holding these stocks too soon) is therefore less
than for non-dividend-yielding sectors.
Stay Focused on the Trading Picture

While long-term portfolio strategy can and should take into account the high corre-
lation between energy consumption and economic growth this basic relationship, it
risks ignoring business-cycle dynamics, oil & gas valuations, changing sentiment
and expectations, and relative sector performance.
During periods of economic distress leading to below-average growth expectations,

factors causing uncertainty about reliable supply can add even more (upside) vola-
tility to equity prices in the oil & gas sector than during periods of prosperity, in our
view.
Near-Term Expectations
Oil is up sharply year-to-date on a rebound in global growth expectations (from the
trough in expectations late last year), a weak dollar, OPEC’s ongoing production
cuts, and civil unrest in Nigeria, where guerrillas have successfully attacked oil wells
and other infrastructure. These disruptions follow a downturn in drilling activity
last year, when oil prices remained at unexpectedly low levels.
It is expensive for petroleum producers to finance new drilling products with lend-
ing rates in the industry up sharply since 2008 (to the low teens, for some drilling
projects). That said, inventories in the developed countries are high and there is a
large amount of crude currently “stored” at sea in tankers. The return of market
liquidity has supported equity and commodity prices, encouraging investors to take
larger amounts of risk than in 2H08.
Yet for all this, the commodity and sector stocks have underperformed. That said,
the production cuts initiated by OPEC late last year are starting to have their in-
tended effect, and inventories have begun to fall sharply.
We like oil long-term but think it may be due for a breather at current levels, and
any failure of 2H GDP numbers to support the growth expectations reflected in the
price of crude could represent an additional near-term risk, in our view.
83
We recommend (a) a 4% allocation to crude oil overall and (b) 10% as part of a
commodities-only portfolio, (c) no long positions in natural gas, and a 10% alloca-
tion to coal (overall; 20% for pure commodities investors). We do not currently
recommend any allocation to the energy sector through equity ETFs, but to funds
that grant exposure to energy commodities themselves.
Our analysis of the risk-adjusted performance of energy stocks relative to other

equity sectors yielded such a low recommended allocation that we rounded it to
zero, allowing us to focus all of our attention to the sector on commodity price and
volatility trends.
Energy Energy Select Sector SPDR (XLE)

Yield: 1.95% ADV: 21.6 million Inception: 16 Dec ’98
An ETF that tracks the crude, natural gas and supporting industries (e.g., energy
equipment and services). Components include Hess (HES) and Chesapeake Energy
(CHK), but the ETF is heavily skewed toward Exxon Mobil (XOM) and Chevron
(CVX), which together represent about 34% of index weight. The fund’s compo-
nents represent about 13.1% of the S&P 500 (though the XLE is not limited to
large-cap names).
Charts 41 and 42:

S&P Select Energy SPDR (XLE)—Weekly (Left) and Daily (Right)
84
Energy iShares S&P Global Energy (IXC)

Yield: 2.32% ADV: 221,000 Inception: 12 Nov ’01†
Tracks the S&P Global Energy Sector index, which includes oil equipment and ser-
vices, exploration & production, refineries, etc. Trading is sufficiently active for
institutional investors. Major holdings include Exxon Mobil (XOM), BP (BP), and
Total SA (FP). †First traded on 16 Nov ’01.
Table 8: Energy ETFs

Index Ticker
Global, Foreign and Commodity
• iShares S&P Global Energy Sector ................................................. IXC
• iPath Goldman Sachs Crude ETN................................................... OIL
• Claymore/SWM Canadian Energy Income ..................................... ENY
• WisdomTree International Energy Sector ...................................... DKA
Broad U.S.
• iShares Dow Jones U.S. Energy Sector ........................................... IYE
• iShares Goldman Sachs Natural Resources .................................... IGE
• Energy Select Sector SPDR............................................................ XLE
• Vanguard Energy .......................................................................... VDE
Sub-Industries
• BearLinx Alerian MLP Select Index ETN ......................................... BSR
• iShares Dow Jones U.S. Oil Equipment & Services ......................... IEZ
• iShares Dow Jones U.S. Oil & Gas Exploration & Production ......... IEO
• Market Vectors Nuclear Energy .................................................... NLR
• Merrill Lynch HOLDRS Oil Services Trust him as............................. OIH
• SPDR S&P Oil & Gas Equipment & Services ................................... XES
• SPDR S&P Oil & Gas Exploration & Production .............................. XOP
Cleantech
• Claymore Global Solar Energy....................................................... TAN
• Claymore/LGA Green.................................................................... GRN
• First Trust NASDAQ Clean Edge ..................................................... QCLN
• Market Vectors Environmental Services ........................................ EVX
• PowerShares Cleantech ................................................................ PZD
• PowerShares Global Clean Energy ................................................ PBD
• PowerShares WilderHill Clean Energy ........................................... PBW
• PowerShares WilderHill Progressive Energy .................................. PUW
• Van Eck Global Alternative Energy ................................................ GEX
Equal-Weight and Fundamentally Indexed
• Rydex S&P Equal Weight .............................................................. RYE
• PowerShares FTSE RAFI ................................................................ PRFE
Quantitative Strategy
• First Trust Energy AlphaDEX.......................................................... FXN
• PowerShares Dynamic Exploration & Production .......................... PXE
• PowerShares Dynamic .................................................................. PXI
• ProShares Ultra Oil & Gas ............................................................. DIG
• ProShares UltraShort Oil & Gas..................................................... DUG
Sources: SeekingAlpha; Stracia, LLC
85
n Infrastructure
In its broadest sense, infrastructure may be defined not as a sector but as a sepa-
ETFs are ideal an ideal way
rate investment category—the physical and technological assets and systems that
to gain exposure to global
“make society go,” including:
infrastructure assets in
deals, in our view. • long-lived transportation and telecommunications networks (toll roads and
bridges; air-travel systems; Internet infrastructure; etc.);
• energy and utilities systems (pipelines, water supply, sewers); and
• public/social assets such as:
– schools,
– hospitals,
– courthouses and prisons,
– stadiums and convention centers, and
– defense equipment.
The sector therefore overlaps a number of groups that must also be analyzed inde-
pendently, including utilities, telecommunications, and healthcare. Understanding
that most index providers have designed their tracking vehicles based on this over-
lapping definition allows us to manage our beta exposures with greater sensitivity.
We currently recommend a slightly larger exposure to infrastructure (7% overall,
11.9% of a global-sector portfolio) than our allocation model recommends (5%),
based on the economic fundamentals discussed below.
Charts 43 and 44:

iShares S&P Global Infrastructure (IGF)—Weekly (Left) and Daily (Right)
86
We Expect Correlations to Decline

The global infrastructure sector has underperformed the broad market for the past
year as funding for new projects has dried up. (See price charts above.) Infrastruc-
ture deals tend to come with longer-term breakeven points and require access to
large pools of upfront capital, often involving multiple financial sponsors working
together. Even in a normal environment, these deals can be tricky to complete—
difficult to price, illiquid, and with a finite set of sponsors working in “coömpeti-
tion” (by turns coöperating and competing). Of course, all of the ingredients of
bringing together complicated, long-term deals have been adversely affected by
the global economic slowdown.
Projects worldwide have suffered as the appetite for extending long-term financing
has declined, and as the relationships among traditional sponsors grew more fra-
gile throughout last year. For example, the planned sale (privatization) of the U.S.’s
thirtieth largest airport, Chicago Midway, was canceled in April because the devel-
opment corporation could not secure the required $2.52 billion to finance it (back-
ers, including Citi Infrastructure Investors and John Hancock, incurred a 5% cancel-
lation fee). Such high-profile failures make it more difficult for other large-scale
privatization projects to get funding.
We think that deals viewed as speculative or those which are exposed to consumer
spending trends will remain at risk, as:
• leverage ratios come in;
• investors continue to place a premium on liquidity; and
• a greater consumer frugality takes hold—one that may represent a compo-
nent of the “new normal.”
But the long-term, fixed nature of infrastructure assets and the monopoly income
streams often attached to them should make for lower correlations with the more
cyclical sectors in the years ahead, in our view. So while infrastructure remains ex-
posed to credit-market risks, we do think it offers a unique opportunity to gain ex-
posure to a future buyer’s market for long-lived projects, especially in the develop-
ing world.
Developing Markets: Growth Is Infrastructure

From an investment perspective, “developing market” implies infrastructure devel-
opment. Other trends that characterize developing economies, such as growing
per-capita income and literacy rates, greater urbanization, and workforce educa-
tion and specialization, themselves require and assume new infrastructure invest-
ment. Some of the fastest sector growth rates in the world are expected to be
achieved in Asian economies (China, Vietnam, Korea), in areas like electricity and
air travel.
China is the world’s biggest consumer of new infrastructure, representing at least

half of the market for new expenditures globally over the next several years. It is
followed by India. Both countries are spending on widespread urbanization and the
development of infrastructure to support it, fueled by rapid growth in average in-
comes.
The numbers are almost bailout-sized: China and India alone could account for well
over $3 trillion in total investment over the next decade—probably more. We also
expect commodities and natural resources to benefit from these expenditure
trends.
87
Developed Markets: Privatization Trend

The economic crisis will actually tend to increase the number of privatizations in
the U.S. and abroad over the next several years, in our opinion. Budget deficits at
the municipal and state levels of government are severe—at crisis levels in many
areas.
A recent analysis by the CBPP forecasts budget shortfalls in “at least 47 states… this
year and/or the next year or two.”27 Cumulatively, states face a shortfall of $230
billion through 2011 against federal pledges of $246 billion in bailout funds so far.
Forty-two states have already begun cutting budgets, and about half have also
raised taxes.28 While the recent American Recovery and Reinvestment Act (and a
smaller program aimed at state and local governments, called Recovery Zone
Bonds) is expected to provide some fiscal relief, the need for longer-term deficit
funding at the state level is clear.
California, effectively the world’s eighth largest economy, appealed to the federal
government to fix its $24 billion budgetary shortfall and was denied. California ran
out of cash, yet still retained a credit rating of A until the last—the lowest of all 50
states, after recently being downgraded from A+ (it’s now junk-rated by Fitch).
Many of the other states will face shortfalls next year, as the state-aimed stimulus
packages announced to date dry up.
Tax hikes on top-tier earners, enacted last year, have already begun to backfire in
some states. Maryland, for example, created an ill-advised “millionaire tax bracket”
in 2008, which saw some residents’ combined state and local tax rates climb as
high as 9.45%. Not surprisingly, aggregate collections from this bracket were down
year-over-year, both on recessionary pressures and due to tax competition from
other states; as a result, the state’s net budgetary shortfall was larger than ex-
pected.
These deficits have to be filled and no amount of progressive taxation

Table 14: U.S. Infrastructure Report Card will do the trick. States and municipalities are desperate for financing,
which in our opinion makes for interesting opportunities in the infra-
Category Grade
structure sector.
Aviation D+
Bridges C U.S. infrastructure is in a sorry state, and not just because flying through
Dams D Manhattan, say, now provides a notably inferior experience compared
Drinking water D– to that of many second- and even third-world countries. Preventable
Energy D disasters across the country provide horrific reminders of the failure of
Hazardous-waste D state and local transportation boards and other departments to ade-
Navigable waterways D– quately maintain existing infrastructure at minimally safe levels.
Public parks and recreation C–
Rail C– In 2005, the American Society of Civil Engineers (ASCE) released its “Re-
Roads D port Card for America’s Infrastructure,” assessing the condition and ca-
Schools D pacity of the country’s public works. The overall grade was a D (see Ta-
Solid waste C+ ble 14 at left). The ASCE estimated that $1.6 trillion would be needed
Transit D+ “over a five-year period to bring the nation’s infrastructure to good con-
Wastewater D– dition.” Our bridges are representative, with the ASCE finding over 27%
Source: “2005 Report Card for of them “structurally deficient or functionally obsolete.” That’s over
America's Infrastructure,” ASCE 75,000 bridges.
27
Center on Budget and Policy Priorities. Only North Dakota, Montana and Wyoming are ex-
pected not to face shortfalls.
28
Weisman, Jonathan. “States’ Budget Gaps Are Another Test for Washington.” The Wall
Street Journal, 15 June 2009, eastern ed.: A2.
88
Third-World Disasters in the U.S.

We all recall the August 2007 collapse of the Mississippi River bridge in Minneapo-
lis. It fell into the river, traffic and all, killing thirteen, the weight of rush-hour traffic
having contributed to structural deficiencies first identified seventeen years earlier.
Milwaukee’s Hoan Bridge partially collapsed in December 2000 due to heavy traffic
and snow.
These and similar accidents across the country were not caused by earthquakes or
barge collisions, but by failures of infrastructure and oversight, aggravated in most
cases by a lack of funds for maintaining public projects. June’s Metro disaster in
D.C. occurred despite three warnings by the National Transportation Safety Board
(NTSB) that one of the types of car involved provided insufficient passenger protec-
tion, and that the city should update or repair such cars.
Those warnings followed a 1996 disaster involving the same series of train car and
a similar crash in 2004—two years after the D.C. Metro declined to update the
equipment because to do so would be “expensive and complicated.” (Here, again,
we see the unintended consequences of fancy financial engineering. The Washing-
ton Metro Authority had entered sale-leaseback-type tax shelters prohibiting it
from taking those cars out of service until 2015.29, 30)
At the same time, the current administration is seeking to increase dramatically the
amount of electricity produced by clean, renewable sources, such as solar and
wind power. Parts of our existing electric infrastructure are antique at nearly a cen-
tury old, and desperately in need of upgrades before continued safe operation and
to ready them for cleaner energy conduction, and more of it.
Infrastructure ETFs
If we were looking to invest in specific infrastructure projects, our inclination would
be to avoid the megadeals—not enough visibility, too much potential counterparty
risk, uncertain timing, too much can go wrong even when capital markets are not
facing structural concerns of their own. But even smaller infrastructure projects
with nearer-term ROI carry relatively high upfront costs and limited liquidity. This is
where ETFs can add real value: minimizing exposure to deal-specific risk while al-
lowing investors to balance their final sector exposure.
The SPDR FTSE/Macquarie Global Infrastructure 100 (GII) tracks 100 companies
engaged in various infrastructure sectors, with a heavy concentration on utilities.
The iShares S&P Global Infrastructure Index (IGF) offers exposure to infrastructure
equities in both developed and emerging markets, with a focus on utilities and in-
dustrials. About a quarter of its assets are U.S.-based and 20% are in the energy
sector.
Note that in addition to the ETFs listed in the table below, the Macquarie Global
Infrastructure Index carries almost 90% exposure to utilities assets, which we con-
sider too high for an infrastructure index.
29
Ferran, Lee, Sarah Netter and Jay Shaylor. “Metro Crash:, [sic] D.C. Mayor Adrian Fenty Blames Local Officials for Deaths,” AB-
CNews.com; 24 June 2009. Accessed 24 June 2009 at <http://abcnews.go.com/News/story?id=7914933&page=1>.
30
Drucker, Jesse and Christopher Conkey. “Tax Shelters Slowed D.C. Metro Upgrade.” The Wall Street Journal, 26 June 2009, eastern
ed.: A6.
89
Table 15:
Tracking Infrastructure
Index Ticker
†
• Dow Jones Brookfield Global Infrastructure Index ....................... $DJGBI
• Internet Infrastructure HOLDRS .................................................... IIH
• iShares S&P Global Infrastructure Index ....................................... IGF
• Macquarie Global Infrastructure† ................................................. MGU
• Macquarie International Infrastructure† ....................................... MQIIF
• Macquarie Korea Infrastructure† .................................................. MQKIF
• SPDR FTSE/Macquarie Global Infrastructure 100 .......................... GII
†
Not an ETF
Infrastructure SPDR FTSE/Macquarie Global Infrast’r 100 (GII)

Yield: 4.2% ADV: 9,500 Inception: 25 Jan ’07
An ETF designed to track the gross performance of global infrastructure and utility
companies of the similarly named MGII100 (Bloomberg; Reuters .FTMGII100),
such as Kinder Morgan (KMP), Spain’s Iberdola (IBDSF), and Tokyo Gas (TKGSY).
Largely holds depository receipts (ADRs and GDRs). We currently recommend a 7%
allocation to this fund as part of our anchor portfolio.
Infrastructure iShares S&P Global Infrastructure Index (IGF)

Tracks the S&P Global Infrastructure index, but may invest in securities not in-
cluded in the index, including related futures contracts, options, and swaps. We
currently recommend no exposure to this fund, which has shown moderate trad-
ing activity during the light-volume summer months, and prefer the global GII
(above) instead).
Infrastructure/
Market Vectors Steel (SLX)
Materials
NAV: $47.59 P/E: 40.1x Turnover: 21%
Tracks the AMEX Steel index and sees high trading volume relative to its asset size.
While the yield is moderately attractive and we like the prospects for the global
infrastructure sector, we seek to limit the number of holdings in our anchor port-
folio. This means forgoing allocations to many corners of the global equity, com-
modity, and currency markets that may be of interest—while seeking to gain some
exposure to those areas through more general-purpose vehicles. That said, we can
design customized portfolios targeting any asset class or sector. See page 141 for a
discussion of our custom services.
90
Utilities
Utilities companies are highly leveraged to the broad economy, the price of inputs,
such as oil and natural gas, and weather trends. Warmer-than-expected winters
hurt the sales of gas utilities in most geographies, but can help electric utilities—
especially in the Southern states, which increase electricity consumption to stay
cool.
As a general rule, the utilities group is expected to move inversely with long-term
interest rates (that is, to move in correlation with long-term bond prices). So all
else being equal, investors generally buy utilities at the early stages, or in expecta-
tion, of a decrease in long rates. Moreover, this relationship generally holds strong-
er for very long-term bonds—i.e., 30-year Treasurys or corporates—than for short-
er maturities (like 10-years). Utilities stocks are therefore similar to the broader
equities market in their relationship with interest rates: rising rates are bad for
stocks and the utilities sector is no exception.
Buy Utilities when Rates Decline

The reason is that utilities typically carry healthy dividend yields, so when interest
rates are declining, investors migrate from fixed-income securities to the utilities
sector. And since periods of declining interest rates are typically associated with
economic weakness—the Fed doesn’t lower rates due to “too much” economic
strength or consequent fears of high inflation—utilities stocks, which are some-
what defensive, offer a safer haven from declining equity valuations and prices
than most other stock categories. This is not to suggest that utilities stocks yield
positive returns during periods of falling interest rates (or economic decline)—
because historically and as expected, they have not. But utilities stocks do
represent a cushion (however imperfect) against declining equity prices during
such periods.
Conversely, in an environment of rising interest rates, bonds offer increasing cou-

pon payments without the equity risk premium associated with utility stocks. Thus,
the incremental increases in coupon rates offered by bonds during periods of rising
rates (and the bonds’ falling prices) typically cause investors to shun utilities stocks
in favor of safer, fixed-income securities during such periods.
Utilities and the Yield Curve

The foregoing analysis is straightforward and its conclusions conform to the general
rule-of-thumb regarding the relationship between stocks, including utilities stocks,
and interest rates. A more interesting analysis involves the behavior of the utilities
sector in various yield-curve environments.
Let’s define the yield curve as the spread between 30- and 10-year Treasurys. The
general relationship between (a) the utilities sector, like the broad equities market,
and (b) bond yields holds in a yield-curve analysis as well. That is, a flattening yield
curve—in which long rates move lower relative to short rates (and not just in abso-
lute terms)—is also associated with outperformance in the utilities sector. Likewise,
a steepening yield curve has historically been associated with the underperfor-
mance of utilities stocks.
Thus, the rule would be to buy utilities’ stocks when (a) interest rates—especially
long-term rates—are falling, and/or (b) the yield curve is getting flatter. So if long
rates are falling faster than short rates or rising slower than short rates, buy utili-
ties. Sell utilities when long rates are rising or the yield curve is getting steeper. If
91
long rates are rising faster than short rates or falling slower than short rates, sell
utilities.
Current Outlook
Regulated utilities may offer less than stellar returns as a slower-growing economy
consumes less energy. Electricity demand has been hit especially hard, for example,
and is growing about as slow as at any time in the last half century or more. Low
demand has severely pinched utilities firms’ gross margins.
One question is the extent to which the market’s significant sell-off last year will
impact authorized returns on equity (ROE) and by extension, energy consumption.
(Regulators set the maximum rates that monopoly utility companies can charge,
based in part on the long-run return expectations of companies in related indus-
tries. Last year’s sell-off may impact authorized ROE in unprecedented ways.)
Of course, the answer will vary for different utilities industries in different states.
The risk from an investment standpoint is that regulators will cap rates aggressively
to aid the struggling consumer. The bull case for utilities would be a regulatory
money-grab to raise funds for pursuing cleantech investment.
Utilities firms are big borrowers, and so the threat of inflation is also a concern to
this sector. These companies have a lot of fixed infrastructure in place, which is
costly to maintain, repair and upgrade. Inflation or the fear of it raises those costs,
and regulated rate schema can fail to keep up during periods of rapid inflation.
These factors squeezed utilities’ bottom lines. New environmental legislation may
also raise industry risk, as investors expectations around the capping of carbon
emissions and other new programs and objectives fluctuate rapidly.
We currently do not recommend any allocation to the utilities sector, but view the
iShares Dow Jones U.S. Utilities ETF (IDU) as an appropriate vehicle for investors
seeking exposure.
Utilities iShares S&P Global Utilities (JXI)

NAV: $44.09 P/E: 11.2x Turnover: 10%
This small, relatively inactive ETF offers attractive yield, but it is unsuitable for
large institutional investors, in our view. Retail investors may choose it on the basis
of its higher yield, but for large positions, we prefer the VPU (see below).
Utilities Vanguard Utilities ETF (VPU)

NAV: $61.22 P/E: 10.6x Turnover: 23%
Tracks the MSCI U.S. Investable Market Utilities Index, which includes companies
of all sizes. Has a lower yield than the JXI, above, but the fund’s greater size and
volume makes it more suitable for large investors, in our opinion.
92
Utilities SPDR FTSE/Macquarie Global Infra 100 (GII)

Track the Macquarie Global Infrastructure 100 index, investing in constituent ADRs
and GDRs. Also includes utility assets. Good yield and volume, and we like its
global exposure. Unfortunately, there is not enough activity in the shares to justify
either institutional or retail ownership, in our view.
Utilities iShares Dow Jones US Utilities (IDU)

Tracks the Dow Jones U.S. Utilities Index, but may also invest in securities not in-
cluded in the index (e.g., futures, options, swaps, and money-market funds).
Table 16:
Utilities ETFs
Index Ticker
Global
• iShares S&P Global Utilities Sector................................................ JXI
• SPDR FTSE/Macquarie Global Infrastructure 100 .......................... GII
Broad U.S.
• iShares Dow Jones U.S. Utilities .................................................... IDU
• Utilities Select Sector SPDR .......................................................... XLU
• Merrill Lynch Utilities HOLDRs ...................................................... UTH
• Vanguard Utilities......................................................................... VPU
Foreign
• WisdomTree International Utilities ............................................... DBU
Equal Weight
• Rydex S&P Equal Weight Utilities .................................................. RYU
Fundamental Index
• PowerShares FTSE RAFI Utilities.................................................... PRFU
Quant Strategy
• First Trust Utilities AlphaDEX ........................................................ FXU
• PowerShares Dynamic Utilities ..................................................... PUI
• ProShares Ultra Utilities ............................................................... UPW
• ProShares UltraShort Utilities ....................................................... SDP
Sub-Sectors
• PowerShares Water Resources ..................................................... PHO
93
n Geographic Diversification
Investment research often treats international assets as a separate category, as if
We favor Australasia and
one should hold a certain portion of equity, fixed-income, and—oh yes, don’t for-
developing/emerging mar-
get the foreign stuff.
kets over the U.S. and Eu-
ropean countries. By contrast, we very much view international currencies, commodities, and com-
panies—their stocks and bonds—as core holdings rather than part of a discrete
asset category.
Given the inclusion of foreign-securities exposure can limit portfolio volatility and
help investors achieve above-market returns, the availability of a broad range of
international, multi-category ETFs means that for managers of portfolios of any
size, there is simply no reason to limit the investment purview to assets domiciled
in a certain country, and none other.
Global and Multi-Category

Below, we discuss some of the dynamics impacting our recommended allocations
to global markets. These recommendations typically imply allocations to countries
equity and currency markets, but we are happy to work with clients to specify tar-
get allocations for international fixed-income or alternative-investment exposures,
as well.
These discussions relate not just to our recommended equity exposures, but to the
currency allocations outlined on page 10, as well.
Chart 45:
Geographic Allocation
India Mexico
7% 13% Emerging
57%
Hong Kong
12%
Singapore
14%
China
8% Developed
43%
South Korea
8%
Chile
7% Americas
40%
U.S.
6%
Brazil Australasia
14% Australia
60%
12%
© 2009 Stracia, LLC
94
Europe
The European economy continued to shrink, albeit modestly, in Q2. We are gener-
ally guiding investors away from the area as we do not think that Europe offers
adequate diversification to U.S. investors at this time. Some EU countries have had
a more difficult time pulling back from the economic abyss, with banks in Spain, for
example, seeing the ratio of nonperforming loans rise dramatically in the past year
and a half, and unemployment at a record high 17.4% and expected to rise.
Europe Vanguard European Stock ETF (VGK)

Yield: 7.2% ADV: 377,000 Inception: 4 Mar ’05
Uses statistical sampling to track the MSCI Europe index, which is market-cap-
weighted and contains over 500 stocks in 16 countries.
Britain
The financial crisis has also been quite hard on Britain, which in recent years had
seen its capital replaced New York is the center of global market capitalism. Unem-
ployment is at its highest level in thirteen years and rising, though at a slower pace
than in previous quarters. For 18-to-24 year-olds, the unemployment rate well is
16%—much higher than would normally be expected at this stage of a recession.31
Support for the Labour Party has waned, adding to uncertainty ahead of next May’s
general elections.
As in the U.S., public-sector debt is high on the heels of the downturn in revenue
and taxes, compounded by Britain’s own bank bailouts. Standard & Poor’s revised
its outlook for the U.K.’s credit rating to negative in May, which implies the country
could lose its triple-A credit rating in coming years. Britain faces a wave of retiring
baby-boomer demographics similar to our own, putting pressure on the country’s
balance sheet. The Bank of England is pursuing quantitative-easing measures to
manage the current crisis, risking inflation down the road, in our view. We expect
GDP to decline this year and into next, and only modest longer-term growth.
ETF Securities recently began offering leveraged funds targeting the FTSE 100: a 2x
long and 2x short fund, though they trade on the London Stock Exchange. As with
similar vehicles, the emphasis is on leveraged daily returns, and the vehicles are
inappropriate for managing longer-term exposure (even directionally, in cases of
extreme volatility).
United Kingdom iShares MSCI United Kingdom ETF (EWU)

NAV: $14.61 P/E: 11.2x Turnover: 14%
Yield: 4.36% ADV: 1.1 million Inception: 12 Mar ’96
Uses a representative sampling strategy to track the MSCI United Kingdom index.
U.S. investors to gain exposure to shares listed on the London Stock Exchange.
31
“Out Of Work and Out Of Luck.” The Economist, 4 June 2009.
95
China
The U.S. and China have become locked in an economic symbiosis that has taken
on worrying ramifications for both parties, in our view, but especially for America.
While China often takes the lion’s share of blame for America’s growing depen-
dence on foreign borrowing, we think the problem lies more with our underlying
trade deficit than with China or any other country’s willingness to fund that deficit.
The relationship began in the late 1970s, when China first opened its economy to
foreigners. Trade between the two countries accelerated rapidly following China’s
entry into the World Trade Organization (WTO) in late 2001. Growth in the rate of
U.S. imports would double over the next three years, reaching $243.5 billion by
2005 and growing almost 40% since then.32
Economic Symbiosis
Both countries want to enjoy an increasing standard of living. For China, that
means building basic infrastructure and industry; attracting a generation of workers
from the farms to the factories of growing cities and mega-cities; and swelling the
ranks of the middle-class. For America, a higher standard of living means enjoying
greater convenience and perceived lower prices—more cost-efficient consumption
and more of it. (One of Wal-Mart’s slogans: “Save More. Live Better.”) Underlying
these dynamics is the drive toward economic specialization at the national level
(especially among developing countries), increasing global interdependencies: Chi-
na manufactures non-durable goods, India outsources work execution, Taiwan
manufactures semiconductors, etc.
As measured by the balance-of-trade figures, neither coun-

try is currently pursuing healthy, sustainable strategies for
achieving their mutual trade goals, in our view. And we think
Chart 46: U.S. Trade Balance with China that for the first time, China has perhaps gained the upper
hand in the economic relationship. At the very least, its
trade strategy seems the wiser.
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Despite being the United States’ largest creditor, China has

0 less riding on the strength of the dollar than does the U.S. It
-50 is leveraging our appetite for consumption into a massive
infrastructure build, creating productive hard assets and
-100 globally competitive human capital at the fastest rate in the
world, perhaps the fastest rate the world has ever seen.
$ billions
-150
-200 Yet China’s total U.S. bond holdings—built up over a period
of years—is $800 billion, roughly the size of our first bailout
-250 program, and only a sliver of the total expenditures and
commitments we have already dedicated to managing the
-300
recent crisis.
-350
Of course, the bailout packages and other programs will no
U.S. balance Trendline more increase productivity or grow this country’s base of
Sources: US–China Business Council; U.S. International competitive assets than the crisis they are meant to address.
Trade Commission, Department of Commerce, Nor does a bailout make America’s labor force more com-
and Census Bureau; Stracia, LLC petitive.
32
Frisbie, John and Michael Overmyer. “US–China Economic Relations: The Next Stage.” US–
China Business Council, September 2006. Data from the Council’s Web site
(www.uschina.org) has been used for more recent calculations.
96
Developing Nation Hoards Greenbacks

While most commentary addresses the two-way trade relationship from the U.S.
perspective, less attention is paid to why China—a developing nation with tens of
millions of people still living in poverty and illiterate—hoards more dollars than
Japan, say. For a country like China, with vast untapped deposits of natural re-
sources, burgeoning industrial and manufacturing interests, and its extensive need
for infrastructural development and improvements, the strategy of sitting on so
many greenbacks is driven as much by geopolitical gain as by the desire to sustain
its strong export market, in our view. China has less to lose in a dollar collapse than
the U.S., but precious little to gain, and it gains mightily from the ongoing relation-
ship and in ways that prepare its economy and workforce for long-term future
growth.
But a build-up in foreign reserves is not without its own risks, as recent history in
the region demonstrates. The Asian financial crisis of 1997 followed a decade-long
increase in reserves from Indonesia to Malaysia and Thailand. Then, as now, (a) a
foreign country (Japan) was tapping cheap Asian labor for its manufacturing needs,
and (b) experiencing rapid credit creation as a result. Today, the China case is po-
tentially riskier, due to:
• the size of the trade imbalance with America,
• the precipitousness of our current economic situation, and
• equity speculation by Chinese retail investors.
So there are risks on both sides of the current U.S.–China economic relationship, in
our view. China knows it, and is taking steps to protect its interests in the case of a
dollar crisis or synchronized global currency-regime transition, in our view. China is
reducing its capital controls for international trade and investment and, in a scena-
rio that sees the U.S. erect new capital controls to protect its currency, could re-
duce them further. As discussed on page 39, we expect to see the growth of a re-
gional currency market in Asia that comes to rely more on the yuan.
Current Allocation
But as the then-comedian Richard Belzer once asked, “What if the world doesn’t
end tomorrow?” What if the status quo is either not endangered, or the reckoning
(as we examined it in this section, “Whither the Dollar,” beginning on page 37) re-
mains years out? With China clearly defined as one of the major engines of global
economic growth, we recommend investors ride this rickshaw to the end of the
line, and currently recommend a 5.3% allocation to Chinese equities (no allocation
overall) and a 20% allocation to the renminbi (6% overall).
China PowerShares Golden Dragon Halter USX China (PGJ)

NAV: $23.01 P/E: 14.4x Turnover: 15%
An ETF designed to track the gross performance of tech industries including Inter-
net and telecom, software, computer hardware and peripherals, semiconductor
equipment, etc.
97
Japan
Japan recently saw its worst recession in the post-war era. As elsewhere, the feder-
al response is to slash interest rates and print money: ¥25 trillion ($265 billion) in
bailout funds at a benchmark interest rate at 0.1%.
The efforts appear to be paying off. After an 11.7% contraction in Q1 GDP on a

weak export market and broadly lower spending, second-quarter GDP showed
marked improvement, up 3.7% annually—just shy of forecasts but the first time the
country has seen economic expansion in over a year. Consumer confidence recent-
ly hit a 10-month high and the Nikkei 225 average has advanced by nearly 20%
since tumbling to a 26-year low in March.
That said, we think that economic stimulus supporting consumer spending propped
up growth in Q2 to a degree that is probably not sustainable. Exports showed
strength as well, but unemployment is on track to reach record highs next year and
production-capacity levels remain high. There remains a lot of slack in the Japanese
economy, in our view. We currently recommend no long positions in either Japa-
nese equities or the yen.
Japan iShares MSCI Japan Index (EWJ)

Tracks the gross performance of the MSCI Japan Index, which consists mainly of
stocks traded on the Tokyo Stock Exchange (TSE). The fund’s largest holdings in-
clude the Japanese automakers followed by Canon (Tokyo: 7751) and Tokyo Elec-
tric Power (Tokyo: 9501). We currently recommended no allocation to the country.
Hong Kong
Hong Kong’s second-quarter GDP expanded at a 3.3% sequentially, well exceeding
expectations and ending a year of economic contraction. Strength was driven by
exports to mainland China. We currently recommend an 11.8% allocation to the
city as a portion of our international-equities allocation.
(Incidentally, note that in May, the stock exchanges of China, Hong Kong and Tai-
wan announced a joint plan to introduce a Greater China ETF benchmark, though
no specific launch date has been announced.)
Hong Kong iShares MSCI Hong Kong Index (EWH)

NAV: $15.23 P/E: 14.1x Turnover: 17%
This relatively high-yielding, high-turnover ETF tracks the MSCI Hong Kong Index.
Most of its holdings, the largest of which are Sun Hung Kai Properties (Hong Kong:
0086) and Cheung Kon Holdings (Hong Kong: 0001) trade on the Hong Kong Stock
Exchange. The fund brings heavy exposure to financials—approximately 57% of its
holdings represent banks, real-estate holding companies, etc.
98
Singapore
Singapore is the beacon of Southeast Asia, as is Hong Kong in the east. Singapore is
a free and open market without significant corruption (its legal system is based on
English common law), and friendly to capital (low tax rates in all categories) with a
high standard of living. It is organized as a parliamentary republic and holds direct
elections. And it is tiny, about four times the area of Washington, D.C., with a most-
ly Chinese population about equal in size to Colorado’s (4.8 million people). The
country is heavily reliant on electronics exports.
For these reasons, Singapore may be viewed as a canary in the coal mine for global
economic recovery. Its economy is both stable and nimble, deeply integrated with
western and (especially) Asian economies, and without abiding structural flaws
that might cloud the difference between a short-lived, stimulus-fueled global “re-
covery” and true economic growth.
Against the backdrop of continuing global malaise, the story of Singapore’s sharp
second-quarter rebound leads us to believe that the artificial sweetener of loose
monetary policy is playing a more significant role in recent GDP numbers than is
widely recognized.
Singapore’s economy rebounded sharply in the second quarter on strength in the

manufacturing and financial sectors, with GDP up 20.7% sequentially (seasonally
adjusted). A combination of electronics-inventory restocking and production in the
pharmaceuticals industry drove strength in manufacturing output. Still, the econ-
omy shrank by 6.5% in 1H and is expected to contract for the year.
We currently recommend a signficant, 14.3% allocation to Singapore as a portion of

total international-equities exposure.
Singapore iShares MSCI Singapore Index (EWS)

NAV: $10.33 P/E: 15.3x Turnover: 16%
Uses a representative sampling strategy to track the MSCI Singapore index. Suffi-
cient size and volume for even the largest institutional investors—which is good,
because after the delisting of the SGT (below), this ETF remains a primary means
for foreign investors to gain exposure to Singapore.
Singapore NETS FTSE Singapore Straits Times Index ETF (SGT)
This FTSE-pegged ETF no longer trades, Northern Trust having decided to exit the
ETF business less than a year after launching a family of 16 international funds
(and one sector fund) that tracked local indexes. ETF closures have been increa-
singly common lately, as managers find it difficult to attract assets against the
backdrop of contracting global markets. This is one of the reasons we pay so much
attention to asset size and trading volume in our recommendations. Small funds
not only carry liquidity risk, but will commonly be delisted if it is clear to the man-
ager that the funds cannot gain competitive traction. Investors holding the shares
of a delisted ETF typically receive cash equal to the shares’ net asset value on the
liquidation date.
99
Emerging Markets
Emerging markets tend to outperform following major, global economic troughs,
and that is certainly what we have seen year-to-date. But counterbalancing this
tendency on a fundamental level, in our view, is the falloff in foreign direct invest-
ment being felt in emerging markets around the globe. The combination of these
dynamics—a run-up in emerging-markets equity prices without widespread expec-
tations that a true, secular recovery has taken hold in these economies (or else-
where)—could spell a potential bubble forming in EM, in our view. For example,
Central European countries are seeing industrial production decline at alarming
rates, in some cases forcing appeals to the IMF. Infrastructure projects are espe-
cially suffering (see page 86). Russia, overly dependent on oil, is struggling follow-
ing last year’s price bubble. And as previously discussed with regard to inflationary
risks (page 39), the BRIC countries are marshaling their strength in their own best
interests, with possible negative ramifications for the dollar.
BRICs
The BRIC countries together account for about 15% of global GDP, or $9.1 billion—
far exceeding earlier estimates for their aggregate output. Some economists expect
that these four countries (Brazil, Russia, India and China) will outgrow the major
industrialized nations—in terms of absolute size—over the next couple decades.
Their rates of growth are certainly much more competitive than the major devel-
oped economies, and the BRICs have recently begun to recognize their economic
and strategic importance as a group, seeking ways to pool combined might for their
own (often anti-dollar) interests. Of course, these are very different countries—
even more different from one another than are the members of the G7; their in-
terests are often far from mutual; and they are politically corrupt (in the case of
Russia, to the point of structural instability).
But together, the BRIC countries exercise enough economic power and political
influence (at the IMF, for example) that their calls for the creation of a new reserve
currency for international trade carry weight. Historically, this has been the dollar’s
role—a role that may be at least partially usurped by a new supranational foreign-
reserve paper in the years ahead. The BRICs represent enough buying power to
“launch” a new reserve currency in relatively short order, to the tune of hundreds
of billions of dollars and to the detriment of U.S.
economic interests.
Chart 47: Fund Flows: Emerging-Markets ETFs ($m) Brazil

Indeed, the BRIC countries as a whole have wea-
700,000 90,000
thered the current crisis better than the major
600,000 80,000
70,000
developed economies to date—in some cases,
500,000
60,000 with help from the commodities boom that
400,000 50,000 stretched from summer 2007 to summer 2008.
300,000 40,000
30,000 Brazil’s recession saw GDP contract 1.8% annually
200,000 in Q1 (the last period for which data is available),
20,000
100,000 10,000 versus –2.4% for the U.S., and exceeding expecta-
0 0 tions of –2.3%. Brazil has been relatively resilient
in the face of the global crisis, but mainly for rea-
Jun '08
Jan '08
Aug '08
Oct '08
Jan '09
Feb '08
Apr '08
Jul '08
Sep '08
Feb '09
Apr '09
Mar '08
May '08
Nov '08
Dec '08
Mar '09
sons having to do with its loose monetary policy,

in our opinion. Nevertheless, relative strength in
All ETFs (left axis) Emerging-Markets ETFs (right axis) many of the emerging markets reinforces our the-
Source: ICI sis for diversifying away from the U.S.
100
Brazil iShares MSCI Brazil Index (EWZ)

NAV: $59.76 P/E: 12.8x Turnover: 30%
Yield: 3.66% ADV: 20.1 million Inception: 10 Jul ’00
An ETF designed to track the performance of the MSCI Brazil Index, which consists
of equities traded primarily on the São Paulo Stock Exchange (the Bolsa de Valores
de São Paulo, or BOVESPA).
India
India’s GDP grew at a rate of about 5.5% in the 1990s and even faster (between 7%
and 8%) through 2007. The recent victory of the United Progressive Alliance (UPA)
reinforces the expectation that India is on a strong growth footing. Unlike China,
India is a democracy, if a hugely inefficient one in terms of its court system, support
for new businesses, widespread, petty corruption, and inefficient, misguided pub-
lic-spending priorities.
These failings are all the more troubling because India boasts a strong corporate-
entrepreneurial class that can tap a deep bench of highly trained IT workers. Yet
the country has historically attracted less foreign direct investment than China by
failing to pursue available strategies of privatization and deregulation. These areas
represent some of India’s greatest “latent competitiveness,” in our view, and while
the newly elected UPA is widely expected to promote a gross initiative, the coun-
try’s real challenges are deeply structural.
India WisdomTree India Earnings Fund (EPI)

NAV: $18.97 P/E: 13.3x Turnover: 42%
Yield: 0.58% ADV: 864,000 Inception: 22 Feb ’08
Invests in companies that trade on major stock exchanges in India, tracking the
Wisdom Tree India Earnings index. All holdings must have a minimum market cap
of $200 million. Good volume relative to its size, this is our preferred vehicle for
managing exposure to India.
China and India First Trust ISE Chindia (FNI)

NAV: $18.33 P/E: 14.6x Turnover: 39%
Yield: 0.86% ADV: 82,000 Inception: 8 May ’07
Performance is designed to correspond to the ISE ChIndia index, a non-market
cap-weighted portfolio of 50 stocks, ADRs, and similar securities, selected from
the universe of Chinese and Indian companies that trade in the U.S. Holdings in-
clude ICICI Bank (IBN), Infosys (INFY), and Baidu (BIDU).
Taiwan
Taiwanese GDP fell by a record 10.2% in Q1 from the year-ago period, mainly on
lower exports. Private consumption and government spending are picking up some
of the slack created by weak demand from abroad—especially in the electronics
market, to which Taiwan is heavily exposed.
101
Taiwan iShares MSCI Taiwan Index (EWT)

NAV: $11.23 P/E: 18.6x Turnover: 33%
Designed to track the performance of the MSCI Taiwan Index, which consists of
equities traded primarily on the Taiwan Stock exchange. Holdings include contract
chip-maker TSMC (2330.TW) and Hon Hai (2317.TW).
The N-11
The fastest growing of the N-11 countries is Vietnam, and its growth is especially
concentrated in the infrastructure sector.33 Looking out ten years, Vietnam is ex-
pected to be the first or second fastest growing economy worldwide in terms of:
• new roadway construction,
• new electrical capacity,
• passenger air volume,
• telecommunications infrastructure (Internet, mobile phones), and other in-
frastructural areas.
The only country matching it in terms of expected growth rates will be the domi-
nant BRIC play, China. Among the N-11 set, Nigeria is the next fastest growing, fol-
lowed by Indonesia and Bangladesh, in our view. Electrical capacity and roadways
are the dominant themes, but it is difficult to target these sectors geographically
using ETFs. Just as we view present ETF coverage as too narrow when it comes to
industry definitions in major developed as markets (see page 133), we would like to
see expanded coverage of foreign sectors, size/style categories and themes. ETF
providers have gotten this message and are beginning to respond.
“Total” versus Regional Exposure

So while investors may prefer to concentrate their EM exposure in the fastest grow-
ing countries/sectors, “total” emerging-market ETFs are larger and more liquid.
These vehicles provide exposure to a wider selection of the fastest-growth econo-
mies, but require sacrificing targeted exposure to single-country equity markets or
the sector dynamics supporting them (Vietnamese infrastructure, for example).
Frontier Markets Claymore/BNY Mellon Frontier Markets (FRN)

Price: $16.14 Net assets: n/a Expense ratio: n/a
NAV: $n/a P/E: n/a Turnover: n/a
Yield: n/a ADV: 12,000 Inception: 12 Jun ’08
Tracks the Bank of New York Mellon New Frontier DR Index. Provides interesting
exposure and has a trading history of just over a year, but is insufficiently liquid for
all but the smallest retail portfolios, in our view.
33
The countries of the so-called “next eleven” (or N-11) are Bangladesh, Egypt, Indonesia,
Iran, Mexico, Nigeria, Pakistan, The Philippines, South Korea, Turkey, and Vietnam. (See
map on page 104.) Of these, only South Korea may be considered a developed economy,
with three newly industrialized countries—Mexico, The Philippines, and Turkey— generally
more highly developed than the remainder.
102
Emerging
Vanguard Emerging Markets Stock ETF (VWO)
Markets
NAV: $35.86 P/E: 10.7x Turnover: 20%
Tracks the MSCI Emerging Markets Index, which includes approximately 780 stocks
traded on the emerging-markets exchanges. It therefore offers broad-based EM
exposure that complements our allocations to the Asian and South American
funds.
Emerging
iShares MSCI Emerging Markets Index (EEM)
Markets
NAV: $36.02 P/E: 12.8x Turnover: 11%
Yield: 1.82% ADV: 70.5 million Inception: 7 Apr ’03
Only six years old, this is the leading emerging-markets vehicle. It tracks the
benchmark MSCI Emerging Markets index. One of the largest, most actively traded
ETFs available, with net assets approximating the GDP of Costa Rica.
Table 17:
Emerging Markets ETFs
Index Ticker
• iShares MSCI Emerging Markets Index Fund ................................. EEM
• BLDRS Emerging MKTS 50 ADR Index Fund† .................................. ADRE
• Market Vectors Indonesia............................................................. IDX
• PowerShares FTSE RAFI Emerging Markets Portfolio ..................... PXH
• SPDR S&P Emerging Europe† ........................................................ GUR
• SPDR S&P Emerging Markets ........................................................ GMM
• Vanguard Emerging Markets......................................................... VWO
• WisdomTree Emerging Markets High-Yielding Fund ...................... DEM
†
Note: Multi-region ETFs; the others provide “total”
emerging-markets exposure, except where specified.
Table 18:
BRICs ETFs
Index Ticker
• Claymore/BNY BRIC ETF ............................................................... EEB
• iShares MSCI BRIC Index Fund ...................................................... BKF
• Market Vectors Russia .................................................................. RSX
• streetTRACKS SPDR S&P BRIC 40 ETF ............................................ BIK
103
Frontier Markets
The term “frontier market” has come into wide usage in the last couple years, de-
scribing countries that are even riskier and less well-developed than emerging
markets, and which tend to be among the smallest and least liquid markets open to
foreign investment. As such, the correlations among developed and frontier mar-
kets are normally quite low, with the latter often viewed as a proxy for risk itself—
moving in and out of favor with global investors’ risk appetites. Definitions of the
frontier-market set differ, but generally include most of the countries listed in Table
19 (see map on next page). ETFs that offer exposure to the frontier markets typical-
ly do so through a combination of local-market purchases and ADRs (or GDRs, H
shares, etc.).
Recent events have disproved the decoupling thesis with respect to frontier mar-
kets, in our opinion. Correlations simply do not remain low enough during broad
selloffs (a) to justify the extra volatility at a time when expectations for a sustained
global recovery are in question, or (b) to discount with respect to timing. (I.e., V-
shaped or W-shaped? Or maybe L-shaped?) In such an environment, portfolio risk
is difficult enough to manage using assets that had less volatility under any likely
scenario.
For these reasons, and because of the limited trading volume and liquidity availa-
ble in frontier-market funds (as discussed in various of the ETF “profile boxes” ap-
pearing throughout this section), we do not recommend an allocation to the fron-
tier markets at this time.
Vietnam
Vietnam demonstrates some of these points. At the end of May, its trade deficit
was approximately $1.5 billion (all figures USD), up $300 million from the month
before and 9.8% year-over-year. The deficit figure, almost incomprehensibly low
from the standpoint of major developed markets, demonstrates a divergence be-
tween developed and emerging-market economies following monetary inflation in
the global financial capitals.
If it cannot grow its way back toward surplus with support from its export partners,
an Asian tiger like Vietnam flirts with economic instability even at relatively low
deficit levels, in our view.
Table 19:
Frontier-Market Countries
Europe Africa: Middle East Asia
• Bulgaria • Botswana • Bahrain • Bangladesh
• Croatia • Cote d’Ivoire • Kuwait • Cambodia
• Estonia • Ghana • Lebanon • Sri Lanka
• Georgia • Kenya • Oman • Vietnam
• Kazakhstan • Mauritius • Qatar
• Latvia • Namibia • UAE Latin America
• Lithuania • Nigeria • Ecuador
• Romania • Tunisia • Jamaica
• Slovak Republic • Panama
• Slovenia • Trinidad and Tobago
• Ukraine
104
Inflation, for example, peaked at 28.3% in August 2008—when food prices in-
creased a whopping 45.6% year-over-year—and has since declined to a relatively
modest 5.6% (with food up 6.5% through May). The deficit trend may seem sus-
tainable but is not only historically quite high, but fed by more worrisome and
more tangible trends at the household level.
The point is not that Vietnam’s economy is unstable—just the opposite. Vietnam is
one of the most stable and highly developed frontier markets. GDP grew 3.1% in
the first quarter and 4.5% in the second. Exports have held up well and the country
is participating in the global commodities rebound, especially in its oil and steel
markets (demand from China is helping on the latter front).
Structurally, the country’s biggest challenge is the level of education and training of
its workforce, in our opinion, though the population demographics are otherwise
very positive. In a country of 90 million people, over half are under 30 years of age.
GDP is on track to grow approximately 5% this year.
Not about Decoupling

For all of the supposed decoupling that we still hear about in connection with fron-
tier markets, Vietnam saw rental rates in Grade A office space decline 30% to 40%
with the global real-estate bust. Yet the Ho Chi Minh City Stock Exchange (which
averages about $80 million in trading volume per day) has rebounded sharply since
March—like many, more stable global equities markets.
Through such a lens, the “flight-to-safety” trade that dominated late last and early
this year comes into sharper relief, in our view. If the U.S. or U.K. economies ma-
neuver like tankers, the frontier markets are more like bottle rockets, with volatility
in macroeconomic fundamentals sometimes matching market volatility in the de-
veloped world. Due to their commodities exposures and reliance on exports, these
Exhibit 9:
The Frontier Markets
105
small economies often have significant exposure to changes in the U.S. dollar. (As
does Vietnam, for example, with its heavy reliance on dollar-denominated oil ex-
ports.)
Until such time as global fundamentals strengthen, we view the frontier markets as
growth stocks trading at value levels: inexpensive, but for a reason—even if a fron-
tier-market country’s own fundamentals appear stable in isolation.
New Vietnam ETF

Despite these positives, there was no easy way for U.S. investors to gain exposure
to Vietnam until August 13, when Van Eck introduced a Market Vectors Vietnam
ETF (VNM). We anticipate huge demand for the new vehicle, which tracks firms
that generate at least half of their revenues in the country. The index has nearly
doubled since March, and is heavily weighted toward financials, energy and mate-
rials shares.
This follows Standard & Poor’s creation, last year, of an index tracking the largest,
most liquid Vietnamese firms, the S&P Vietnam 10 Index; and there is a db x-
trackers FTSE Vietnam ETF, but it is listed only in London and on certain European
exchanges, including the Xetra in Frankfurt. We think interest among U.S. investors
in gaining exposure to Vietnam will help support the Market Vectors fund, which
has first-mover advantage here.
For investors seeking broadly diversified exposure to safe investment arenas with
the best long-term prospects, the frontier markets offer promise. But selecting an
individual market carries too much risk and offers insufficient diversification. The
Claymore/BNY Mellon Frontier Markets ETF (FRN) invests in frontier markets
around the world, from Chile to Poland, Asia to MENA. It tracks the Bank of New
York Mellon New Frontier DR Index (BKNFR). Introduced about a year ago (12 June
2008), the ETF currently caps expenses at 0.65%.
Exhibit 10:
The N-11
106
Table 20:
Tracking Frontier Markets
Index Ticker
†
• Bank of New York Mellon New Frontier DR Index ......................... BKNFR
• Claymore/BNY Mellon Frontier Markets ....................................... FRN
• Market Vectors Africa................................................................... AFK
• Market Vectors Gulf States ........................................................... MES
• Market Vectors Vietnam ............................................................... VNM
• PowerShares MENA ..................................................................... PMNA
†
Not an ETF
Africa Market Vectors Africa ETF (AFK)

Price: $27.01 Net assets: $18.7 mil. Expense ratio: 0.88%
Yield: n/a ADV: 27,000 Inception: 10 Jul ’08
Tracks the Dow Jones Africa Titans 50 Index, which includes companies that are
based and trade in Africa, and generate over half their revenues there. Also uses
swaps, options, warrants, futures and forwards, etc., to track index performance.
May be appropriate for retail portfolios.
Gulf Countries Market Vectors Gulf States ETF (MES)

Price: $21.29 Net assets: $8.1 million Expense ratio: 1.0%
Replicates the performance of the Dow Jones GCC Titans 40 Index, which includes
Gulf Corporation Counsel companies that trade on GCC exchanges. Too illiquid for
high-net-worth portfolios, in our view.
Frontier
PowerShares MENA Frontier Countries (PMNA)
Countries
NAV: n/a P/E: n/a Turnover: n/a
Tracks the Nasdaq OMX Middle East North Africa index, which includes companies
based or trade in a Middle East or North African frontier country. We like this type
of exposure but think of fun too illiquid for all but the smallest retail portfolios.
Frontier
WisdomTree Middle East Dividend ETF (GULF)
Countries
Tracks the similarly named index. Another regional ETF that does not scale to sup-
port large portfolios.
107
MENA
Long among the world’s most undeveloped regions and the smallest in terms of
attracting foreign capital, the Middle East and North Africa (MENA) area includes:
• Morocco • Israel • Qatar
• Algeria • Iraq • UAE
• Tunisia • Iran • Saudi Arabia
• Libya • Jordan • Bahrain
• Egypt • Kuwait • Oman
• Syria • Lebanon • Yemen
The last several decades have seen the region chart a new course toward economic
development. The region has undertaken structural reforms and is seeking to de-
velop in part through better regional integration, supporting labor and capital flows
and investment—including infrastructure development.
The region’s macroeconomic picture remains healthy, even as oil prices are off
from their highs of the year ago. GDP growth continues to exceed the worldwide
average every year-in and year-out, with rapid economic development across ma-
jor infrastructure and industrial sectors driving healthy growth and corporate earn-
ings. Low labor costs help support this development.
Furthermore, this decade has seen average tariffs decline steeply across the region,
in some cases by as much as half. By international standards, MENA’s banking cul-
ture is conservative, and its more traditional practices have provided a cushion
against the over-extension of credit and leverage so widespread elsewhere.
Portfolio Strategy
Frontier markets offer diversification and low expected correla-
Exhibit 11: tions with developed states. However, it remains difficult for
Middle East and North Africa (MENA) large investors to put on significant exposure to the region using
ETFs. Most of the funds targeting the area were introduced re-
cently, and simply have not attracted sufficient investor interest
during a period of widespread withdrawals and redemptions to
support scalable portfolio strategies.
For this reason, MENA is not yet among the areas that we rec-
ommend for ETF investors. We hope to be able to advise alloca-
tions to this region on an uptick in volume in some of the funds
discussed below.
That said, small retail investors may consider managing expo-

sure to this lowly correlated, high-growth set of countries.
Small ETFs
The PowerShares MENA Frontier Countries Portfolio (PMNA)
covers many of the countries listed on page 104 page plus Nige-
ria, with a concentration on Kuwait and the UAE.
Other ETFs that provide exposure to MENA include the Market

Vectors Gulf States Index ETF (MES); the SPDR S&P Emerging
Middle East & Africa ETF (GAF); and the WisdomTree Middle
East Dividend Fund (GULF). See the previous page for more in-
Source: Stracia, LLC formation on most of these ETFs.
108
n Fixed-Income ETFs
With the financial crisis in full pitch last year, investors flocked to the safety of Trea- Barclays’s iShares domi-
surys. Yields in some fixed-income categories reached long-term lows but have nates the fixed-income ETF
since rebounded, as expectations for a worst-case scenario have calmed (see charts category with low-cost
on page 31). From such low levels, we see little room for price appreciation failing
Treasury, corporate and
the increasingly widespread expectation for a second-half rebound.
TIPS offerings.
That said, the inclusion of fixed-income assets in a globally diversified portfolio can
smooth volatility substantially, and coincides with our somewhat defensive posture
on the heels of the recent rally in global economic expectations. Were investors’
appetite for risk to continue increasing through the end of the year, we would see
opportunities to add exposure to the long-term corporate, high-yield, and TIPS
categories. (Our recommended fixed-income allocations appear on the next page.)
Treasury International Capital Report

We use fixed-income capital flows to challenge or confirm our macroeconomic ex-
pectations. The monthly Treasury International Capital (TIC) report provides detail
regarding foreign investors’ purchases of U.S. Treasurys. When foreign purchases of
U.S. debt are strong, it allows the U.S. government and domestic consumers to
continue to borrow new funds at a lower rate than if overseas demand were weak.
Strong inflows of new foreign purchases therefore help keep U.S. interest rates low.
(The report also details purchases by U.S. investors of foreign securities.) Given the
centrality of changes in monetary policy from the current stance of quantitative
easing, we think the TIC report may prove even more useful than usual.
Year-to-date, net foreign purchases of long-term U.S. bonds has been positive,
though with some deterioration in May (the last month for which data is available).
While not yet constituting a strong trend, the concern would be that investors have
started to discount more robust prospects for the international economy, removing
some support for U.S. government and U.S.-based corporate bonds—but with oth-
erwise generally positive implications all around.
The data support a slightly higher allocation to foreign bonds and emerging-market
equities, in our view—as might be expected if global risk appetite is increasing
from trough levels.
These trends would also have implications for the dollar. Specifically, were we to
see evidence of a pullback in foreign demand for U.S. debt, we would look to in-
crease our recommended allocation to dollar-based assets, on the expectation of a
rise in U.S. interest rates.
The next TIC report, containing data for net foreign purchases in June, is scheduled
for release on August 17.
Fixed-Income ETF Universe

Dozens of ETFs are available across a range of fixed-income strategies, including:
• government and corporate bond funds of various duration,34
• high-yield corporates,
• national and state municipal bonds,
34
Fixed-income maturities may generally be categorized as follows:
• long-term: 20-plus years,
• medium-term: 3–7 years,
• short-term: 1–3 years.
109
• inflation-protected,
• laddered Treasurys, etc.
iShares versus Vanguard

In terms of investment liquidity and assets gathered, Barclays Global (shortly,
BlackRock) dominates the fixed-income category with its 20-plus and 1–3 year
Treasury iShares (TLT and SHY, respectively); its investment-grade corporate iShares
(LQD); and its inflation-protected offering (TIP). These ETFs are low-cost, with ex-
pense ratios ranging from 0.15% on the low side to 0.50% for the LQD.
The iShares are vastly more popular than Vanguard Group’s government-bond
ETFs, both because Barclays was first to market and because Vanguard’s ETFs are a
share class of its mutual funds—giving rise to potential tax liabilities that may con-
ditionally apply to mutual, but not exchange-traded, funds.
This is one reason why Vanguard’s expense ratios are so low—it wants to counter
the effect of any unwanted liabilities on its tax-adjusted performance statistics. By
our analysis, it manages to do this fairly effectively, and for small investors the Van-
guard ETFs may often be as attractive as the iShares. But in the fixed-income cate-
gory, the iShares have recently been about 30 times more liquid (in terms of aver-
age daily volume) than the Vanguard funds,35 making the Barclays product vastly
more attractive for large/institutional investors.
Growth in Category
Chart 48: The mutual-fund giant Pimco ($756 billion in assets under
iShares iBoxx $ Investment Grade Corporates (LQD) management) offered its first ETF in early June (ticker
TUZ), and plans to introduce a family of additional ETFs
that we expect could shift the landscape in the fixed-
income category—especially if Pimco were to offer an
active ETF along the lines of its Total Return Fund
(PTTAX), which is this managed by Bill Gross. No such
plans have been announced, though the company has
applied to the SEC to launch actively managed ETFs—and
not just in the fixed-income market, but in currencies and
commodities, as well.36
Recommended Fixed-Income Allocations

Our recommended fixed-income allocation models focus
on offerings from iShares, PowerShares and State Street
in the fixed-income category.
Treasury bills (BIL)................................................... 17.2%

1–3-year Treasury bonds (SHY)................................ 10.5%
Treasury Inflation-Protected Securities (TIP) .............. 6.2%
Municipal bonds (TFI) ............................................. 12.2%
Investment-grade corporates (LQD) ........................ 33.3%
High yield (JNK) ...................................................... 20.6%
Chart produced with TradeStation Total ..................................................................... 100.0%
35
For example, the Vanguard Long-Term (BLV), Intermediate Term (BIV), and Short Term
(BSV) ETFs recently traded less than 53,000 shares per day, on average, versus over 1.4
million shares for the comparable iShares.
36
Anand, Shefali. “As Some Contract, PIMCO Is Expanding.” The Wall Street Journal, 3 June
2009, eastern ed.: C15.
110
Table 21:
Selected Fixed-Income ETFs (our recommendations are highlighted )
Sponsor expense distribution
ETF name ............................................... ticker ratio rate ADV
Barclays Global Investors:

iShares Lehman Aggregate Bond Fund .... AGG 0.20% 4.36% 610,000
iBoxx Investment Grade Corporates ........ LQD 0.15% 5.59% 1,010,000
iShares TIPS Bond Fund........................... TIP 0.15% 4.68% 1,120,000
iShares 1–3 Year Treasurys ...................... SHY 0.15% 3.16% 900,000
iShares 7–10 Year Treasurys .................... IEF 0.15% 3.91% 640,000
iShares 20+ Year Treasurys ...................... TLT 0.15% 4.12% 4,710,000
SPDR Municipal Bond ............................. TFI 0.30% 3.88% 190,000
PowerShares Capital Management:

Insured National Municipals ................... PZA 0.28% 4.88% 110,000
State Street Global Advisors:

SPDR Barclays High Yield ......................... JNK 0.40% 13.25% 1,100,000
SPDR Barclays Capital TIPS ...................... IPE 0.19% 3.38% 70,000
Vanguard Group:
Vanguard Total Bond Market................... BND 0.11% 4.44% 460,000
Sources: ETFConnect and Stracia, LLC
Fixed Income iShares Barclays Aggregate Bond (AGG)

NAV: $102.67 P/E: n/a Turnover: 520%
Tracks the Barclays Capital U.S. Aggregate index, which itself seeks to replicate the
performance of the aggregate U.S. investment-grade bond market. Holds thirty-
year Fannie Mae notes, Treasury notes and bonds, U.S. corporates, and other
fixed-income securities.
Fixed Income Vanguard Total Bond Market ETF (BND)

Yield: 4.44% ADV: 465,000 Inception: 3 Apr ’07
Seeks to track (by sampling) the performance of a broad, market-weighted bond
index. Maintains a dollar-weighted average maturity of 5 to 10 years. The underly-
ing index, the Barclays U.S. Aggregate Bond Index, is rules-based and tracks in-
vestment-grade, taxable U.S. fixed-income securities. It includes government, cor-
porate, and international (but dollar-denominated) bonds, as well as mortgage-
and asset-backed securities. All of its constituents mature in a year or more, with
the average maturity between 5 and 10 years.
111
Investment-Grade Corporate Bonds

Investment-grade (IG) corporate bonds are viewed as carrying less credit risk than
speculative bonds, with ratings that range from triple-B (or Baa) to triple-A.37 At the
low end, the perception is that the issuer maintains an adequate ability to pay in-
terest and repay principal, though with the recognition that adverse conditions
would be expected to impair that ability. At the high end, debt service is considered
very secure, even in the presence of increased risk.
Because large banks tend to be big issuers of senior debt, IG indexes typically carry
hefty exposure to the banking sector. The collapse of Lehman Brothers, the ensuing
credit panic, the seizure of Washington Mutual (September 25), and the Treasury’s
aborted attempt to engineer a Citigroup (C) takeover of Wachovia had a dramatic
impact on this segment of fixed-income. Mid-September saw IG bond yields spike
to levels not seen since the Depression—in many cases, over 600 basis points
above Treasurys (which is more in line with the average spread on high-yield over
the last 20 years).
Following a Q4 rebound, the cumbersomely named “iShares iBoxx $ Investment

Grade Corporate Bond Fund” (LQD) is still flirting with its pre-Lehman levels. The
fund closed out February with a 44% allocation to financials— 60% of that allo-
cated to diversify its (American Express and its credit arm, Goldman Sachs, NYSE
Euronext in the CME) 14.5% allocation to banks, mostly U.S. money centers and
nationals. The LQD has been uptrending for five months, indicating that the worst
secular economic fears are being replaced by expectations for a late 2009/early
2010 rebound, in our opinion.
Table 22:
Investment-Grade Corporate ETFs
Index Ticker
• iShares iBoxx InvesTop High Yield Corporate Bond ETF .................. HYG
• iShares iBoxx InvesTop Investment Grade Corporate Bond ETF ...... LQD
• iShares Lehman Credit Bond ETF .................................................. CFT
• iShares Lehman Intermediate Credit Bond ETF ............................. CIU
• iShares Lehman 1-3 Year Credit Bond ETF ..................................... CSJ
Investment-
iShares Barclays Intermediate Credit Bond (CIU)
Grade Corporates
Seeks to replicate the performance of the Barclays Capital Intermediate U.S. Credit
index, which itself tracks short- and-intermediate-term bonds. The CFT offers a
slightly higher yield, but we like the liquidity characteristics of the CIU better.
37
Ratings agencies have different definitions of “investment grade:”
• Moody’s: Baa3 or higher
• Standard & Poor’s and Fitch IBCA: BBB– or higher
• Duff & Phelps: BBB– or higher
• DBRS: BBB(low)
112
Municipal Bonds
As discussed earlier, (a) last year was characterized by widespread counterparty
risk, which prevented large financial sponsors from making liquidity available to the
market; and (b) there are real differences between not wanting to extend credit
and having no credit to extend. We view the over-extension of credit as the genesis
of the markets’ turmoil.
Municipals and the Crisis of Confidence

The municipals market is a case in point. Like other fixed-income categories, muni’s
struggled throughout 2008, most dramatically in the wake of the widespread lack
of confidence that gripped investors with the collapse of Lehman. The market for
municipal issuances is dominated by banks and brokerage firms; when those nor-
mal providers of liquidity pulled back from taking on additional counterparty risk in
general, state and local issuers were not just out of trading partners, they were out
of customers.
At the same time, the most highly leveraged customers were desperate to raise
capital against margin calls. Municipalities saw supply in their secondary markets
increase even as short rates were spiking and primary demand dried up.
This perfect storm gave rise to some deeply discounted and relatively secure op-
portunities to lock-in yield. Muni’s have still not returned to levels last seen prior to
Lehman’s collapse, despite the likelihood of tax increases, which will increase the
competitiveness of municipal yields.
Available ETFs
Nationally, the yield curve for bonds in this category is normal, with short rates
hovering below 3% and three-year muni’s yielding approximately 6%, on average.
The PowerShares Insured National (PZA) muni fund has been delivering yield just
above the national midpoint, though its mandate is to hold securities of long-term
duration.
Though it currently yields 4.9%—a full percentage point higher than the SPDR Bar-
clays Municipal ETF (TFI)—the latter is more liquid and offers just as long a trading
history (slightly longer).
TFI for Institutions, PZA for Retail

We use the TFI to model our recommended allocations, but think that retail inves-
tors could do just as well using the PZA. Our rationale here is simple: institutional
clients are better equipped to build out their muni allocations through specific
state and/or national issuances, while smaller investors may more easily scale to a
6% position (our recommended overall allocation to this category) with normal
trading volume of about 100,000 shares or better per day, in our view.
The PZA satisfies this criteria for retail investors, and its higher yield makes it worth
consideration for those clients. What’s more, we view muni’s as one of the least
actively traded segments of the recommended portfolio, making the low average
daily volume less of a concern for long-term holders.
As noted, we currently recommend a 6% allocation to municipals by way of the TFI
(though retail investors may substitute the PZA); and a 12.2% allocation as part of a
fixed-income (only) strategy.
113
Municipal Bonds SPDR Barclays Municipal Fund (TFI)

Tracks the long-term U.S. municipal-bond market, with the Lehman Brothers Mu-
nicipal Managed Money Index as its proxy, providing income that is exempt from
federal income taxes. Includes state and local general-obligation, revenue, pre-
refunded, and insured bonds. We recommend that institutional investors favor
this ETF over the PowerShares Insured National Municipal Bond Portfolio (PZA),
despite this fund’s lower yield, due to its higher daily trading volume.
PowerShares Insured Nat’l Muni Bond Portfolio

Municipal Bonds
(PZA)
An ETF designed to track (deep breath) the Merrill Lynch National Insured Long-
Term Core Municipal Securities Index, an index of AAA long-term debt that is tax-
exempt and insured. The debt is issued by U.S. states and political subdivisions.
We recommend that retail investors consider using this ETF in place of the SPDR
Barclays Municipal Fund (TFI), as the PZA boasts a higher yield.
Municipal Bonds SPDR Barclays Capital Short Term Muni Bond (SHM)
A liquid, short-term muni fund that tracks the Lehman Brothers Managed Money
Municipal Short Term Index.
Table 23:
Municipals ETFs
Index Ticker
• iShares S&P California Municipal Bond Fund................................. CMF
• iShares S&P National Municipal Bond Fund .................................. MUB
• iShares S&P New York Municipal Bond Fund................................. NYF
• Market Vectors AMT-Free Short Municipal ETF ............................. SMB
• Market Vectors AMT-Free Intermediate Continuous Municipal ..... ITM
• Market Vectors AMT-Free Long Continuous Municipal.................. MLN
• PowerShares Insured National Municipal Bond Portfolio .............. PZA
• Market Vectors High-Yield Muni ETF ............................................. HYD
• SPDR Lehman Municipal Bond ETF ............................................... TFI
• SPDR Lehman New York Municipal Bond ETF ................................ INY
• SPDR Lehman Short-Term Municipal Bond ETF ............................. SHM
114
TIPS
TIPS were introduced in 1997. Issued by the U.S. Treasury, they pay a promised
interest rate, which rises in dollar value with increases in the Consumer Price Index.
Moreover, the principal value of the TIPS is also indexed to the CPI, and adjusted
for inflation twice per year.
For example, a TIPS investment of $100,000 with a 3% annual coupon yields $3,000
in annual interest payments. The coupon rate never changes over the life of the
security; but every six months, the principal amount is adjusted upward or down-
ward for inflation or deflation (so that the coupon rate is multiplied by a biannually
adjusted principal amount, yielding a different payoff twice each year). TIPS are
issued in 5-, 10-, and 20-year maturities.
Investment Strategy Using TIPS

TIPS should be purchased ahead of an expectation for rising inflation, which typi-
cally begins late mid-way through a normal business cycle (i.e., during the expan-
sionary stage), as the economy stages a growth rally and bond yields have begun to
rise. Though we are not at that point in the cycle, we do see the risk of inflation on
the horizon, and note that that TIPS have failed to participate in the Q2/Q3 rally.
The risk to owning TIPS is that market interest rates rise without an associated rise
in the general price level. In such a case, demand for (and the price of) TIPS would
be expected to decline, as bond investors turn to ordinary fixed-income invest-
ments, such as straight Treasury bonds, for higher yield, without paying a premium
for inflation protection.
We think the risk of inflation is real enough to recommend a 5% aggregate alloca-
tion to TIPS. (For discussion of the reasons behind our inflationary expectations,
see section beginning on page 37.)
TIPS iShares Barclays TIPS Bond (TIP)

Yield: 4.68% ADV: 1.1 million Inception: 4 Dec ’03
Tracks the inflation-protected U.S. Treasury market, as defined by the Barclays
Capital U.S. TIPS Index. May invest up to 10% of assets in U.S. government bonds
not included in the underlying index. Our current recommended allocation is 5%
overall (and 6.2% as part of a fixed-income portfolio).
Table 24:
TIPS ETFs
Index Ticker
• iShares Lehman TIPS Bond Fund ................................................... TIP
• SPDR Barclays Capital TIPS............................................................ IPE
• SPDR DB International Government Inflation-Protected Bond ....... WIP
115
High Yield
High-yield bonds have been among the strongest categories in fixed-income year-
to-date, with the prices of U.S. and European corporates up about 20%—an order
of magnitude stronger than investment-grade bonds. In our view, this recent per-
formance is one of the most meaningful indicators of secular investor sentiment, as
it shows that risk appetites are returning to more historically normal levels. At the
margin, such sentiment spells the difference between widespread depressionary
expectations and the latter stages of a U.S. and European recession, in our view.
What’s more, this performance is backed by an increase in new high-yield is-

suances—at least in the U.S. We would look for strength in new issuances in the
European market as confirmation of the trend and, and to increase our recom-
mended allocation accordingly.
Current recommendation
Of the three high-yield bond ETFs listed in the table below, the SPDR Barclays Capi-
tal High Yield Bond (JNK) is the highest yielding, currently at 13.3% versus 10.5% for
the HYG and 11.03% for the PHB. The former is also slightly more liquid, despite
the HYG having been introduced in April 2007, some eight months before the JNK.
The higher yield and greater liquidity tip us in the direction of the Barclays ETF.
We currently recommend a 20.6% allocation to the high-yield category as part of a

fixed-income strategy using JNK; and no allocation overall (preferring exposure to
yield through global equities in the anchor portfolio).
Table 25:
High-Yield Bond ETFs
Index Ticker
• iShares iBoxx High Yield Corporate Fund ....................................... HYG
• PowerShares High Yield Corporate Bond....................................... PHB
• SPDR Barclays Capital High Yield Bond .......................................... JNK
High Yield SPDR Barclays Capital High Yield Bond (JNK)

Yield: 13.25% ADV: 1.0 million Inception: 28 Nov ’07
Tracks the Lehman Brothers High Yield Very Liquid index. Normally invests at least
80% of total assets in securities contained in the benchmark. Our current recom-
mended allocation is 20.6% as a portion of total fixed-income exposure.
High Yield iShares iBoxx $ High Yield Corporate Bond (HYG)

Yield: 10.52% ADV: 741,000 Inception: 4 Apr ’07
Tracks the iBoxx $ Liquid High-Yield index, using constituent securities and deriva-
tives. The underlying index targets the most liquid, tradable high-yield corporate
bonds available in the U.S. (and which are denominated in U.S. dollars).
116
n Commodity ETFs
Non-financial assets—physical goods that have innate value—tend to be more sta- Commodities not only pro-
ble than derivative assets (including securities) during periods of geopolitical, poli- vide an inflation and dollar
tico-social, or financial volatility. These assets include gold, silver, and agricultural hedge but represent upside
and industrial commodities, as well as non-liquid assets that exceed the scope of
exposure to continued eco-
this discussion (art and antiques, numismatic and philatelic assets, etc.).
nomic strength, in our view.
Inflation and Structural Hedges
Physical assets or “physicals” are therefore appropriate as long-term hedges during
extended periods of uncertainty—such as during war, hyperinflation, or deep and
lasting (structural) financial crises. In the short-term, however, these assets are
generally less appropriate than simply holding cash or related futures contracts,
which can carry storage and insurance costs.
That said, a certain allocation to physicals should be maintained at all times, as we

will discuss. These assets react positively to fear: be it fear of inflation, of terrorism,
or of natural disasters, of acts of God, which can drive supply shortages or simply
cause confusion or panic.
Equities and Bond Plays

Equity markets that are particularly tied to trends in commodities markets include
the Toronto Stock Exchange Index (TSE) and Australia’s All Ordinaries Index
(XAO.AU), as well Brazil’s Bovespa exchange. Each of these markets can be ma-
naged through an ETF (EWC, EWA, and EWZ, respectively).
Because commodity-futures contracts and bonds tend to react in opposite ways to

inflation—as the former represent claims on real assets, while bonds are mere
claims to a fixed amount of (inflating or deflating) fiat currency—we discuss ways
to manage exposures using commodity ETFs in the following pages.
Commodity Weightings
First, a note of caution: It is important to understand the extent to which various
commodities are weighted within each ETF. Especially during periods when a single
commodity (typically, oil or gold) seems to be dominating others in terms of its
performance and expected contribution to future economic conditions, the per-
centage weight of that commodity in each of the various ETFs and underlying in-
dexes is especially important.
Such is the case now for oil and gold, which are seen as global-growth and inflatio-
nary plays, respectively. Institutional investors and traders will almost certainly
want to manage their exposure to gold more aggressively than the PowerShares DB
Precious Metals ETF (DBP) allows. We discuss that vehicle next.
Precious Metals
There are eight precious metals: gold, silver, and six closely related metals that
comprise the platinum group: ruthenium (Ru), rhodium (Rh), palladium (Pd), os-
mium (Os), iridium (Ir), and platinum (Pt). Other than osmium, which is bluish
white, the other platinum-group metals are all silvery white.
Our research focuses on those precious metals that are best represented in the ETF
universe: gold and silver. These are the only two holdings of the PowerShares DB
Precious Metals (DBP), and we use that vehicle to gain exposure to both metals
while reducing our total number of portfolio holdings. In the next two sections, we
break down our analytical framework for and trends in each metal.
117
Gold
How rare is gold? If you could gather all the gold ever mined, melt it down, and
pour it into one giant cube, that cube would measure about eighteen yards across.
That’s all the gold owned by every government on earth, plus all the gold in private
hands, all the gold in rings, necklaces, chains, and art. That’s all the gold used in
tooth fillings, electronics, and coins and bars. It’s all the gold that exists above
ground since man learned to extract the metal from the earth. All of it can fit into a
house-sized cube that would weigh about 91,000 tons—or less than the amount of
steel produced worldwide each hour.
Given that about three-quarters of all gold sold each year is used in jewelry, it is not
surprising to see the metal rally in the gift-giving months—Christmas in the west
and Diwali, the Indian Festival of Lights, in late October/November, followed by the
(first) Indian wedding season in December. (Inventories in India are typically res-
tocked in January and September, ahead of these gift-giving seasons.)
The second Indian wedding season, which begins in late March and runs through
early May, is also led by strength in gold demand on restocking. Gold is typically
strongest from August to January, and weaker for the rest of the year through April
(with a pause in May). The seasonal slowdown may be exacerbated by the summer
doldrums generally, and the fact that most exploration takes place in the summer,
which removes principal “news brokers” to remote areas of the Northern Hemis-
phere that are less accessible during the winter months.
Year-to-date, gold has underperformed both silver and the broad U.S.-equities
market. We think that investors’ expectations for inflation will increase in the years
ahead and would look to gold for confirmation of this thesis—but clearly that trade
is not on yet. Since we manage exposure to precious metals through a combined
gold/silver ETF (the DBP, discussed above), the relative underperformance of gold
has been moderated by the explosive rally in silver.
Silver
Silver is up 22.8% year to date, versus 8.5% for the S&P 1500, due both to its status
as an industrial metal and its speculative appeal as a (hyper) inflationary hedge, in
our view. That is, while the metal’s status as a monetary equivalent is mostly theo-
retical in recent times, certain investors fearful of the hyperinflationary scenario
view silver as a hedge that may once again come into its own, should that scenario
play out. Also, many investors for whom physical gold is simply too expensive to
own or store likewise flock to silver for the same reason, when inflationary expec-
tations run high.
Discovery and Uses

Silver is a rare, white metal (rare, not least, in that has no rhyming English word). It
is both a precious and an industrial metal, used in:
• bleach: because it interferes with bacteriological processes
• industrial-quality mirrors; and
• photography applications (especially radiography): silver is extremely sensi-
tive to light and highly conductive.
Most silver—between 60% and 70%—is produced as a by-product of mining other

industrial metals, such as lead, copper, and zinc. Some silver is also found as a by-
product of gold mining; only the remainder, about 30%, is found as a direct result
of silver mining.
118
Because the base metals of which silver is a by-product are mined in greater quan-
tities during times of economic boom than bust, widespread macroeconomic
downturns can actually support the price of silver, by decreasing its production
(increasing its scarcity). This is one of the factors we have seen at work over the
past year. All things being equal, one expects the dollar to decline simultaneous
with a broad economic downturn, which could further support demand for silver as
a financial asset or “safe haven,” like gold.
Silver Prices and Terminology

Silver is quoted in U.S. dollars per troy ounce or, where no monetary denomination
is indicated, U.S. cents per troy ounce. For example, a quote of $12.95 or 129.5
refers to the price per troy ounce.
Note that “fine” silver is required to be 99.9% pure to be so named, while “ster-
ling” silver need only be 92.5% pure. (The other 7.5% is usually copper.) In pre-
cious-metals jargon, silver of these grades might alternatively be described as hav-
ing a millesimal fineness of 999 (or “three nines fine”) and 925, respectively. One
hundred troy ounces of silver weigh 6.8 pounds.
Uses of Silver and Government Holdings

While silver may today be found in commemorative coins, or bullion coins issued
by sovereign governments so that investors may own physical silver, its use in coi-
nage is limited to what it was in the 19th century. What’s more, unlike gold, silver is
not considered a reserve asset, so national and international statistics bureaus do
not maintain official data on government holdings of the metal, nor do govern-
ments hold it in large amounts. While it is estimated that government holdings of
gold amount to approximately ten to twelve years’ worth of supply, world govern-
ments may hold only about ten weeks of silver supply, in total.
Risk: ETFs Are Not a Claim on Raw Silver

ETFs are not the safest way to own silver or gold—at least not for the purposes that
most long-term investors in these metals maintain an allocation. The safest way to
own them is by storing the physical commodities, but that too comes with costs,
risks, and maintenance requirements (storage costs, insurance costs, theft, etc.).
And it is vastly more difficult and expensive to store physical silver than gold.
That said, we will discuss various methods for allocating to these metals beyond
the use of ETFs. Silver bars are available in various sizes and stored on pallets (bun-
dles of bars) or, in smaller amounts, loose. An investor who owns (or think she
owns) silver of any value or in any quantity must make sure that she is in posses-
sion of each bar’s serial number and specific weight. Otherwise, she is prone to the
same financial risks as the intermediary that purports to pool or hold the silver for
her—e.g., Refco, which declared bankruptcy and imploded in a single week in Oc-
tober, 2005, just a few weeks after its IPO.
Silver is said to be unallocated when the custodian holds silver that may, in theory,
be redeemed for delivery by the owner of any claims on that silver; but no actual,
physical silver is allocated to the owner per se. If the asset is stored in a fund’s own
safety deposit box, for example, then of course the manager can rest assured that
the fund truly owns the physical commodity—1,000- or 5,000-ounce bars, as the
case may be.
But if the asset is held in pooled accounts or as unallocated or leveraged silver

(with Refco or another futures or commodities broker, for example), then one has
119
no true guarantee of a claim on it, and risks being deemed an “unsecured creditor”
in the case of the intermediary’s bankruptcy, theft, financial fraud, etc.
Storage costs for physical silver run about $3 per month per 1,000-ounce bar, and
withdrawal fees are not uncommon (and may run $13 per bar). Generally, storage
costs may run roughly 1% of total silver assets annually.
In short: one should not consider oneself a silver owner unless the commodity is
stored in physical form on the account holder’s behalf, with the account holder
being in possession of the serial numbers and specific weights corresponding to
bars stored on the fund’s behalf. Owning unallocated, leveraged, or pooled silver is
no guarantee that the fund owns anything at all, under certain circumstances.
Normal Manipulation of the Silver Market

It is considered difficult for an “outsider”—a trader without a direct connection to
either a major commodities trading house or the COMEX pit itself—to trade silver,
because it is a closed market. That is, the value of futures contracts traded far ex-
ceeds the value of the physical market, and floor traders and others with access to
information regarding major houses’ large positions know the size of those posi-
tions, their maximum upper limits, and when large funds begin to buy additional
silver contracts or sell existing contracts from inventory. Those without access to
this information are necessarily at a disadvantage in trading the silver market.38 ETF
investors fall into this category, which is a source of ongoing controversy facing
regulatory bodies such as the Commodity Futures Trading Commission (CFTC).
We recommend the following allocations among commodities:
Precious metals (DBP) ..................15.0%
Base metals (DBB) ........................10.0%
Oil (USO) ......................................10.0%
Natural gas (UNG) ......................... 0.0%
Coal (KOL) ....................................20.0%
Natural resources (IGE).................10.0%
Agribusiness (MOO) .....................13.8%
Livestock (COW) ............................ 4.5%
Water (CGW)................................11.7%
Total .......................................... 100.0%
Precious Metals PowerShares DB Precious Metals (DBP)

Yield: n/a ADV: 61,000 Inception: 5 Jan ’07
Seeks to replicate the performance of the Deutsche Bank Liquid Commodity Index-
Optimum Yield Precious Metals Excess Return. The index manages exposure to
gold and silver using futures contracts. Slightly less volume than we normally like,
but allows investors to combine their targeted gold and silver exposure in a single
vehicle. We currently recommend a 3% overall allocation to this ETF.
38
An infamous example of manipulation of the silver market culminated in the 1988 trial of
the Dallas-based Hunt brothers—W.H. and N.B. Hunt—who were found guilty of charges re-
lating to market monopolization and price manipulation for their attempt to corner the mar-
ket in 1979 and 1980.
120
Crude Oil PowerShares DB Oil (DBO)

Yield: n/a ADV: 312,000 Inception: 5 Jan ’07
Tracks the Deutsche Bank Liquid Commodity Index-Optimum Yield Oil Excess Re-
turn, which tracks WTI light sweet crude using futures.
Table 26:
Commodities ETFs
Index Ticker
Broad
• E-TRACS UBS Bloomberg CMCI ETN .............................................. UCI
• GreenHaven Continuous Commodity Index .................................. GCC
• S&P GSCI Enhanced Commodity Total Return ............................... GSC
• iShares GSCI Commodity-Indexed Trust ........................................ GSG
• iPath Dow Jones-AIG Commodity Index Total Return ETN.............. DJP
• iPath S&P GSCI Total Return ETN .................................................. GSP
• PowerShares DB Commodity Index Tracking ................................. DBC
• Commodity Index Pure Beta Total Return ETN .............................. RAW
Agricultural
• E-TRACS UBS Bloomberg CMCI Agriculture Index ETN ................... UAG
• E-TRACS UBS Bloomberg CMCI Food Index ETN ............................ FUD
• E-TRACS UBS Bloomberg CMCI Livestock Index ETN ...................... UBC
• iPath Dow Jones AIG-Agriculture ETN ........................................... JJA
• iPath Dow Jones AIG-Grains ETN................................................... JJG
• iPath Dow Jones-AIG Livestock Total Return Sub-Index ETN........... COW
• MLCX Biofuels Index ELEMENTS ................................................... FUE
• MLCX Grains Index ELEMENTS ...................................................... GRU
• MLCX Livestock ELEMENTS ETN .................................................... LSO
• Rogers International Agriculture ELEMENTS ETN........................... RJA
• PowerShares DB Agriculture ETF................................................... DBA
• Commodity Index Pure Beta Agriculture Total Return ETN............. EOH
Precious Metals
• DB Gold Double Long ETN ............................................................ DGP
• DB Gold Double Short ETN ........................................................... DZZ
• DB Gold Short ETN ....................................................................... DGZ
• E-TRACS UBS Bloomberg CMCI Gold Total Return ETN................... UBG
(continued on next page)
121
(continued from previous page)

Commodities ETFs
Index Ticker
Precious Metals (con’t)
• E-TRACS UBS Bloomberg CMCI Silver Index ETN............................ USV
• E-TRACS UBS Long Platinum ETN .................................................. PTM
• E-TRACS UBS Short Platinum ETN ................................................. PTD
• iShares COMEX Gold Trust ETF ..................................................... IAU
• iShares Silver Trust ETF ................................................................. SLV
• MLCX Gold ELEMENTS ETN........................................................... GOE
• MLCX Precious Metals ELEMENTS ETN.......................................... PMY
• PowerShares DB Gold................................................................... DGL
• streetTRACKS Gold Shares ............................................................ GLD
• PowerShares DB Silver ................................................................. DBS
• PowerShares DB Precious Metals ................................................. DBP
Base Metals
• E-TRACS UBS Bloomberg CMCI Industrial Metals Index ETN .......... UBM
• iPath DJ-AIG Industrial Metals Total Return Sub-Index................... JJM
• iPath DJ-AIG Nickel Total Return Sub-Index ................................... JJN
• PowerShares DB Base Metals ....................................................... DBB
Oil and Gas
• Claymore MacroShares Oil Up Tradeable ETF................................ UCR
• E-TRACS UBS Bloomberg CMCI Energy Index ETN ......................... UBN
• iPath DJ-AIG Energy Total Return Sub-Index .................................. JJE
• iPath DJ-AIG Natural Gas Total Return Sub-Index........................... GAZ
• iPath S&P GSCI Crude Oil Total Return Index ETN .......................... OIL
• PowerShares DB Energy ............................................................... DBE
• PowerShares DB Oil...................................................................... DBO
• PowerShares DB Crude Oil Long ETN ............................................ OLO
• PowerShares DB Crude Oil Double Long ETN ................................ DXO
• PowerShares DB Crude Oil ETN .................................................... SZO
• PowerShares DB Crude Oil Double Short ETN ............................... DTO
• United States Gasoline ................................................................. UGA
• United States Heating Oil ............................................................. UHN
• United States Oil .......................................................................... USO
• United States 12 Month Oil .......................................................... USL
• United States Natural Gas ............................................................ UNG
• ProShares Ultra DJ-AIG Commodity .............................................. UCD
• ProShares UltraShort DJ-AIG Commodity ...................................... CMD
• ProShares Ultra DJ-AIG Crude Oil .................................................. UCO
• ProShares UltraShort DJ-AIG Crude Oil ......................................... SCO
• DB Commodity Double Long ETN.................................................. DYY
• DB Commodity Double Short ETN................................................. DEE
Commodities-Related
• Claymore Global Timber ............................................................... CUT
• iShares S&P North American Natural Resources............................ IGE
• Van Eck Market Vectors Agribusiness............................................ MOO
• Van Eck Market Vectors Coal ........................................................ KOL
• Van Eck Market Vectors Gold Miners ............................................ GDX
• Van Eck Market Vectors RVE Hard Assets Producers ...................... HAP
• iPath Global Carbon ETN .............................................................. GRN
122
n ETNs
There are significant differences between these two types of vehicles. The most ETFs make taxable income
obvious is that ETNs tend to focus more on commodity and currency markets, distributions; ETNs do not.
while ETFs focus more on equity vehicles. ETNs were created by Barclays in 2006, ETFs and ETNs both carry
and are now also issued by Goldman Sachs (GS), UBS (UBS), Credit Suisse (CS), and
market risk, but only the
Morgan Stanley (MS). The leading sponsors in the category are iPath, U.S. Com-
modity Funds, and Elements. latter carry credit (sponsor)
risk as well.
ETNs are sometimes referred to under the broad umbrella of “exchange-traded
products” (ETPs), which can also contain exchange-traded securities and commodi-
ties (ETSs and ETCs, respectively). There are currently about 90 ETNs on the mar-
ket, one of the most popular of which is OIL;39 others include the VIX Short- and
Mid-Term Futures (VXX and VXZ, respectively) and United States Oil (USO).
ETFs Are Equity, ETNs Are Debt

Broadly, if ETFs are more like equities, ETNs are more like bonds. In fact, they are
unsecured, senior debt notes. They are registered under the Securities Act of 1933,
while ETFs, like mutual funds, are registered under the Investment Company Act of
1940.
Like other debt instruments, ETNs expire; if held to maturity, investors receive a
cash payment for their notes. So while an ETF represents a stake in the underlying
investment product, an ETN is structured by the issuing bank.
ETNs Carry Sponsor Risk

Thus, ETNs carry credit risk associated with the financial institution that issues
them. Should a fund sponsor suffer a cut to its credit rating, its ETNs would be ex-
pected to feel the pinch. In the case of bankruptcy, ETF investors have a claim on
the fund’s underlying securities.
But since ETN sponsors may not hold a note’s underlying assets, holders of those
notes may have no recourse in the case of the sponsor’s bankruptcy. Recent global
financial turmoil has served to demonstrate the importance not just of fund selec-
tion, but of sponsor selection (more on this below). Both carry market risk, but only
ETNs carry credit risk (more on this below).
ETFs: More Tax Efficient

There are also differences between the two instruments in terms of tax treatment,
with ETFs being the more tax efficient. Gains from single-currency ETNs, for exam-
ple, are taxed as ordinary income, not as capital gains.
But because ETNs make no distributions, investors can defer the payment of taxes
until the ETN is liquidated (or matures). ETFs, on the other hand, distribute income
to investors, and these distributions are taxable.
ETNs: Less Tracking Error

On the plus side, ETNs typically generate less tracking error than ETFs. The former
are better able to track their targets because of their debt structure. The note issu-
er has promised to make a cash payment to ETN holders at maturity, so the value
of the ETN is purely a function of its underlying asset or index. That said, concerns
39
The iPath Crude Oil ETN (OIL), which trades on the NYSE, is a sub-index of the S&P GSCI Commodity Index (previously known
as the Goldman Sachs’s Commodity Index). OIL tracks the returns associated with West Texas Intermediate (WTI) crude-
futures contracts plus the rate on T-bills earned on WTI-committed funds. The OIL notes are senior, unsubordinated and unse-
cured, and like all ETNs carry “sponsor risk.”
123
about the viability of Barclays during the recent financial turmoil did cause some of
its ETNs (notably, OIL) to underperform their benchmarks. Tracking error thus re-
sulted from market perceptions of Barclays's creditability, as discussed above.
Commodity ETFs often suffer from tracking error due to “roll yield,” which results
because futures contracts expire. That means that ETF administrators must conti-
nuously exchange expiring futures for further-to-expire contracts. The rollover of-
ten generates a small degree of price infidelity, increasing tracking error.
Crude Oil iPath S&P GSCI Crude Oil Total Return ETN (OIL)
Yield: n/a ADV: 1.4 million Inception: 18 Aug ’06
One of the largest and most popular ETNs, OIL tracks the Goldman Sachs Crude Oil
Return Index, which is itself based on the West Texas Intermediate (WTI) crude-oil
contracts that trade on NYMEX. The ETN seeks to represent the returns available
through a long position in WTI oil futures. However, OIL underperformed over
certain periods at the height of the financial crisis, due to concerns about the safe-
ty of Barclays, its financial sponsor. As discussed above, this is one of the unique
risks of ETN (as opposed to ETF) investing—sponsor risk.
MLPs JPMorgan Alerian MLP Index ETNs (AMJ)

Yield: n/a ADV: 162,000 Inception: 2 Apr ’09
Tracks the Alerian MLP Index, providing exposure to midstream energy master
limited partnerships (MLPs). Pays a variable, quarterly coupon linked to the MLPs’
cash distributions, less fees. (Taxable on Form 1099, rather than K-1.) Represent
senior, unsecured obligations of JPMorgan Chase & Co.
124
n Assorted ETF Topics

Our intention in publishing this report is to aid institutional, high-net worth, and This report uses the royal
retail investors in allocating assets among multiple asset classes using the most tax- we throughout, but was
efficient and trading-efficient vehicles currently available for that purpose. Equities written by a single author.
have broadly disappointed over long time periods for reasons discussed at length
The imaginary “we” have
earlier; the availability of exchange-traded funds for extra-equity diversification
should not be overlooked by investors large or small. no business-interest in ETFs.
Our (my) interest is in
As with any investment vehicle, ETFs are not without risks or vehicle-specific con- pointing investors to the
siderations. We sought to outline some of the major risks in ETF investing begin- tax and trading efficiencies
ning on page 20, as well as our techniques for managing risk and our recommend- of ETFs.
ed portfolios beginning on page 24. As well, we guide all readers to our disclosures
section beginning on page 143.
In the following pages, we divert our attention to miscellaneous issues surrounding

ETFs. At this point, it may be useful to note that we have no business exposure to
the ETF (or ETN) category at this point. We are not in bed with Barclays or Van-
guard, for example, and are not trying to sell an investment style or a certain cate-
gory of funds.
Though the current situation may change, too many U.S. and international inves-
tors have been inculcated to equity-centric or equity-only strategies, and such
strategies are inappropriate for most such investors, in our opinion. We hope that
this report can help set clients of various asset sizes and degrees of sophistication
on a path toward greater portfolio efficiency.
n ETFs and Taxes

ETFs are generally more tax efficient than open-end mutual funds because:
With ETFs, redemptions and
• ETFs do not increase and decrease their holdings in response to new fund in- normal trading activities
flows and redemptions; are treated as “in-kind,”
• there are fewer cash transactions involved in offering and managing ex- rather than cash, transac-
change-traded funds; and tions, for greater tax effi-
• the tax liability can be more transparent than with mutual funds. ciency than mutual funds.
Taken together, these factors make for superior tax treatment for ETFs compared to
mutual funds not expressly designed for tax efficiency.
In-Kind versus Cash Transactions

With a mutual fund, a tax event occurs when the manager sells a portion of the
fund’s holdings (such as shares of stock) that has accumulated capital gains, and
the fund distributes those gains to investors. These events are taxable as cash
transactions; the resulting liability typically must be recognized by fund investors at
year-end.
This is not the case for ETFs, which do not add or subtract holdings at the whim of
their managers. ETFs do accumulate capital gains, of course, and from time to time
rebalance, exchanging cash for shares or vice-versa—for example, when one com-
pany replaces another in the index the fund tracks. Such cash transactions typically
do give rise to an ETF tax liability, but shareholder redemptions and normal portfo-
lio turnover are treated as “in-kind” transactions for ETFs, allowing investors to
avoid a large share of the tax liability that would be incurred by a mutual fund.
125
Table 27: Comparing the Tax Structures of ETFs and Mutual Funds
Open-end
Potential tax event mutual funds Exchange-traded funds
Shareholder redemptions .............. Taxable .............. Not taxable
Normal portfolio turnover ............. Taxable .............. Not taxable
Change in underlying index............ Taxable .............. Generally taxable
Corporate actions40 ....................... Taxable .............. Taxable if cash transaction
As such, ETFs’ capital-gains distributions are typically much lower, over the course
of a typical holding period and as a percentage of fund assets, than with a mutual
fund. The in-kind tax treatment for ETFs has been described as a “loophole,” but to
our thinking, treating a basket of securities as just that makes better intuitive sense
than paying even a passive mutual-fund manager to increase fund holdings in pro-
portion to net new allocations to that fund—especially when some of the other
curiosities associated with mutual-fund tax liabilities are considered (see discussion
under “Investment Timing,” below).
Whereas mutual funds are forever growing or shrinking in proportion to capital

collected or redeemed, a fixed portfolio of securities can change hands without
changing size. This is the mechanism by which retail investors trade ETFs and,
through in-kind tax treatment, the mechanism by which the “authorized partici-
pants” who make markets in ETFs redeem shares at the institutional level.41
So not only do ETF investors not pay a fund manager to decide what to buy or sell,
giving rise to far fewer taxable events than with actively managed mutual funds,
but ETFs do not have to sell shares on the market (a taxable event) in order to meet
investor redemptions. ETF holders are not exposed to negative sentiment and in-
vestor panic of the kind that gives rise to waves of shareholder redemptions. And
normal redemptions are accounted for with the lowest cost-basis stock typically
transferred out.
Transparency
ETFs are also more transparent with respect to tax liabilities. With mutual funds,
the amount of qualified dividends received during an investment period is some-
times unclear (to the investor) until Form 1099-DIV arrives by early February—as
this is how the accounting treatment that applies to liquidated shares is reported
to holders.
The long- or short-term status of any liability arising from a capital-gain distribution
(as separate from an investor’s own capital gain) is a function of how long the fund,
and not the mutual-fund investor, owned the underlying shares, adding to the pe-
culiar headaches associated with mutual-fund investment, in our view.
Investment Timing
There are also pitfalls arising from the timing of mutual-fund investment and dis-
tributions. Mutual-fund investors who buy in right before a year-end distribution
may be liable for taxes on gains they did not receive!
40
Table 27 shows those events and transactions that typically give rise to tax liabilities for an
open-end mutual fund. Corporate actions include stock splits, mergers and acquisitions,
etc.
41
These large institutional investors redeem ETF shares for “creation units,” or blocks of un-
derlying securities, making in-kind treatment possible. See page 131 for more detail.
126
This surprising outcome occurs because mutual funds typically make lump-sum
distributions of realized net capital gains annually, in December. Investors who
bought in just ahead of the distribution experience a drop in NAV and inherit a tax
liability on capital gains they may never have received—for example, on gains ac-
cumulated from the start of the year to the distribution date or even in past years.
Such issues raise the cost and complexity of researching mutual-fund ownership,
while doing nothing to drive alpha for the typical investor.
n Tax Savings ≈ Half the Equity Risk Premium?

But maybe the peculiar tax headaches associated with mutual-fund investing are ETFs’ tax efficiencies can
somehow good for you? Maybe the lack of transparency and the risk of paying tax-
represent significant out-
es on capital gains that were never actually earned is somehow “worth it”?
performance versus mutual
Just the opposite: we would argue that these headaches come at an additional cost funds.
to net performance. Mutual-fund investors, by and large, are paying for the privi-
lege of facing skewed liabilities and inconvenience at tax time. Long-term, we esti-
mate that the superior tax efficiency of equity ETFs may represent a cost savings to
investors in the neighborhood of 400 basis points per year, on average, compared
to open-end mutual funds not specifically designed for tax efficiency.
If accurate, then ETFs’ greater tax efficiencies represent roughly half the recent
consensus expectations for long-term, annual equity-market risk premiums going
forward. But whether it’s half, a quarter, or some other portion of portfolio returns
relative to market returns, many of the tax inefficiencies of mutual funds add no
value. Given their tax idiosyncrasies, it’s no surprise that more efficient vehicle
have come along.
n An Alternative to Wash Sales—Tax-Loss Harvesting

A “wash sale” occurs when an investor liquidates a loss-making position and, 30 The recent rally has made
days prior to or after the liquidation, takes on a substantially identical position. The
certain tax-loss harvesting
rationale is to lock-in a claim on the realized loss for tax reduction, without really
losing exposure to the position. The “wash-sale rule” prohibits such a strategy. strategies worth consider-
ing.
The rule applies equally to stocks and ETFs, of course. However, an investor selling
an existing stock (bond, commodity) position at a loss and replacing it with a sector
or other ETF that delivers similar exposure has not violated the wash-sale rule, be-
cause the original security and the ETF are not considered “substantially identical.”
ETFs may therefore be used for “tax-loss harvesting,” an effective and perfectly
legal strategy for maintaining market exposure while realizing capital losses and the
tax benefits they represent.
Say you purchased shares of MetLife (MET) 15 months ago, at $61.77. The shares
now trade at $34.89 and you are motivated to liquidate the position in order to
reduce company-specific risk across your portfolio; to increase the yield you collect
through dividends; to minimize your exposure to the financial-services sector; etc.
You sell your MET shares and redeploy that capital in the S&P 500 Spyder (SPY) or
the iShares DJ Select Dividend Fund (DVY). MET has yielded about 2.5% and over
the last 15 months and shown a 96.1% correlation with the SPY (which yields
2.7%). MET has an 89.8% correlation with DVY (yielding 5.5% currently).
127
While there is certainly no guarantee that such relationships will hold, this redep-
loyment of capital has allowed you to:
• offset capital gains in your portfolio with realized losses,
• locking in a tax benefit, while
• freeing capital
• to maintain exposure to the market (or sector, if desired), and
• increasing your dividend yield.
A Legitimate Strategy
For clarity, this is not some kind of tax loophole or fancy financial-engineering ma-
neuver to avoid a tax liability. It only works if you want to maintain some degree of
market exposure while realizing a capital loss. The spirit of the wash-sale rule is to
prohibit realizing a tax benefit from purely cosmetic transactions; the SPY holds
500 individual securities, of which MetLife is but one; the DVY holds about 100
securities, and MET is not among them.
MetLife and the ETF holding MetLife are not “substantially identical” vehicles—that
is the whole point of a legitimate transaction of this type: to eliminate the nonsys-
tematic risk that comes from holding stock, while maintaining exposure to the
market, sector, size/style category, etc.
Even if you had opted to redeploy capital to a financial-services ETF, the 2007–’08
crisis of confidence and, recently, a return of investment capital to the markets
have seen correlations across the board increase spectacularly. Rebalancing when
market conditions change can be an effective way to adjust portfolio exposures tax
efficiently under such conditions.42
n Dividends and Shorting

Many of the considerations ETFs allow investors to gain exposure to dividend yield without taking on as much
non-systematic risk as direct stock ownership. This is possible because ETFs pay
that apply to shorting
holders dividends on securities held in the fund (in proportion to those securities’
stocks apply to ETFs, as
weightings and dividend payments) while simultaneously providing diversification
well. across fund holdings.
Dividends are passed along to fund holders net of expenses. Distributions are typi-
cally made either quarterly or, especially in the case of bond ETFs, monthly. Unless
the ETF is held in a retirement account, these distributions are taxable as dividend
income.
Shorting ETFs
While this report focuses on the construction of a long-only portfolio, many ex-
change-traded funds can also be shorted, just like stocks, and many of the same
considerations apply.
Because short-sales involve borrowing, they are essentially margin trades and can
only take place in margin accounts. Short positions are thus subject to margin in-
terest rates, and the short-seller must maintain the minimum maintenance re-
quirement on any short-sale, to avoid a margin call or being forced to cover. The
42
The subject of wash sales, like any topic in taxation, can become intricate. We advise you
to confer with a tax specialist on all tax matters.
128
broker charges the short-seller margin rates on her borrowings, adding to the (al-
ready difficult) practice of profitable shorting.
Short Positions Are Short-Term

Capital gains on short positions are taxed as short-term gains regardless of how
long an investor held the short position. So even if the shares were held short for
over a year, the investor must still pay taxes at the rate that applies to short-term
capital gains.
This is because the only time a short-seller actually holds the shares is between the
time they were purchased to cover (close) the position, and the actual delivery of
the shares. This transaction may take minutes or up to several days, but in no case
would be considered long-term (unless the short-seller delivered stock held more
than one year to cover the short position, but this is unusual).
Shorting ETFs That Pay a Dividend

Finally, an investor who holds ETF shares short on the fund’s ex-dividend date must
actually pay the dividend to the account from which the shares were borrowed. In
such cases, the dividend yield becomes the short-seller’s cost of carry. (Covering a
short position the day before the ex-date absolves the short-seller of the responsi-
bility for meeting this expense.)
Technology
UltraShort QQQ ProShares (QID)
(Inverse Short)
Yield: 0.50% ADV: 21.9 million Inception: 11 Jul ’06
Seeks to return twice the inverse performance of the Nasdaq-100, on a daily basis.
n A Closer Look at Price and Yield

On this page and the next, we discuss some of the miscellany around the presenta- The standardized SEC yield
tion of price and yield data.
isolates a fund’s per-share
Net Asset Value (NAV) net income from capital
NAV, or book value, is calculated in the same manner for ETFs and mutual funds: it appreciation (e.g., daily
is the fund’s assets less liabilities divided by the fund shares outstanding. For ETFs, market-price fluctuations).
NAV changes throughout the day and is typically slightly different than intraday
value (and its variants, discussed below).
Intraday Value
This price, alternately referred to as the Intraday Indicative Value (IIV) or Intraday
Optimized Portfolio Value (IOPV) by different ETF sponsors and data providers, in-
dicates the last sale price of the securities used to create or redeem the ETF (plus
any associated cash amounts).
It is typically published every 15 seconds throughout the trading day, under a dif-
ferent ticker than the fund to which it refers.
It may be thought of as the ETF’s underlying trading value; as such, its purpose is to
help investors track and, if they are inclined, arbitrage away price discrepancies
129
between the ETF and its underlying assets. Arbitrage is a principal means by which
the price of an ETF tracks the changing value of its underlying index or other target.
While all investors benefit from accurate price discovery, a fund’s authorized partic-
ipants conduct much of the actual arbitrage as a function of their ability to ex-
change large share blocks for creation units. Margin eligibility helps investors large
and small maintain close correspondence between an ETF’s NAV and its trading
value.
Annual Yield
A fund’s annual yield is calculated by dividing its trailing 12-month distributions
(dividend payments, interest payments, and any distributions of capital gains) by
either the current or prior month’s ending NAV. Obviously, depending on which
methodology is used, comparisons across funds from different index families may
not be strictly compatible. The SEC calculation, discussed below, seeks to standard-
ize the presentation of fund yield.
Distribution Yield
The distribution yield may be calculated in various ways. Some sponsors (and ana-
lysts) simply (a) annualize the fund’s most recent distribution to investors, divided
by the NAV as of the distribution date. Others use the (b) current NAV or, for funds
with a track record of at least one year, (c) divide the total trailing-12 months’ dis-
tributions by current NAV. Note that this last method produces a result consistent
with the annual-yield calculation.
SEC Yield
This standardized measure is calculated by dividing a fund’s net investment income
(less expenses) over the previous 30 days from its maximum offering price on the
last day of the calculation period. It is often quoted as of the end of the previous
day (or sometimes, month). Note that the SEC yield excludes any capital apprecia-
tion generated during the period, in order to separate price fluctuations from the
yield on net investment income.
130
n The ETF Creation Process

ETFs are created when a prospective fund manager (sponsor), such as The Van- The financial crisis has
guard Group, targets a category it believes will be popular with investors. The
shown the stability of ETN
sponsor then selects the underlying index or other securities the ETF will track and
sponsors to be of critical
begins the fund-registration process. The sponsor must arrange seed capital, ar-
range for the fund to be listed on an exchange, and file a proposal with the SEC. importance to fund selec-
tion.
If the plan is approved, the sponsor then enters an agreement with an “authorized
participant” (AP), or special class of financial institution approved to bring ETFs to
the market. APs consist of market makers (e.g., Bank of America Merrill Lynch,
Goldman Sachs, Morgan Stanley), specialist firms (e.g., Speer Leeds & Kellogg, a
unit of Goldman Sachs; Susquehanna Specialists), and large institutional invest-
ment houses. Some sponsors also qualify as APs. These players are interested in
arbitraging away momentary price discrepancies between the ETF and its underly-
ing securities, and on narrowing the fund’s spread. Both of these activities provide
liquidity to ETF investors.
The authorized participant creates a trust and arranges to borrow large blocks of
whatever stocks, bonds or commodities underlie the proposed ETF from long-term
holders, such as pension funds or endowments. These blocks of upwards of 10,000
(and typically 50,000) shares are termed ETF “creation units.” Large black holders
are incentivized to make their shares available to the ETF in exchange for interest
fees. Note that to this point, the specialists are working if not on spec, then inde-
pendently of the manager’s own fund operations.
The creation units, in turn, are placed in the trust created by the AP; the trust
makes the ETF shares available for market-making on an in-kind basis—allowing for
the avoidance of tax events in the creation and redemption of ETF shares (as dis-
cussed on page 125). A single share of an ETF is therefore a legal claim on
1/50,000th (typically) of a trust-backed creation unit. The trust domiciles the un-
derlying shares, collecting and distributing dividends there from.
The manager’s fee is paid out of a portion of fund assets, and a portion of this fee
goes to the custodial bank. To the extent that an AP may bring inadequate liquidity
to the fund and incremental profit opportunities arise, other investors or broker-
dealers are free to trade the spread. The foregoing excludes mention of other rou-
tine considerations, such as arranging for the sales and marketing of the fund, cer-
tain back-office and the custodial/distribution functions, etc.
The process is transparent from the initial filing to the various parties’ ongoing par-
ticipations, market activities, and fees. Indeed, the market has advance notice of a
sponsor’s intentions even before a proposed ETF launches.
Such announcement of intention gave rise to a me-

dium-term play in the silver market when Barclays an-
nounced, in 2005, its intention to sponsor a silver-
backed ETF (which would become the iShares Silver Table28: How an ETF Is Created
Trust, ticker SLV).
1. fund manager ® detailed proposal ®
Clearly, there are significant differences between the 2. SEC ® participation agreement ®
ETF- and mutual fund-creation processes. Mutual 3. authorized participant ® trust ®
funds typically collect cash from investors (often 4. pension funds (block holders) ® creation units ®
through fund-reinvestment plans) and then create and 5. custodial bank ® Depository Trust Clearing Corp. ®
issue new shares. 6. open market ® trading and redemptions of creation units
131
n Specialty and Active ETFs
Specialty ETFs
Specialty ETFs select their holdings based on an investment theme or specific hold-
ings criteria. The securities selected may or may not fit into the same industry or
sector, size or style category, geography, etc.; what binds them is some unique cha-
racteristic of their business or market profile.
Examples of specialty ETFs include those that focus on stocks with patterns of
heavy insider buying or companies with strong patent portfolios. The criteria for
inclusion may be more or less subjective depending on what the manager is trying
to measure. (Other, hard to classify ETFs may also be considered specialty vehicles,
such as the PowerShares S&P 500 BuyWrite [PBP].)
Patent-Focused Claymore Ocean Tomo Patent ETF (OTP)

Price: $19.88 Net assets: $5.6 million Expense ratio: 0.75%
NAV: $20.47 P/E: 14.0x Turnover: 18%
Selects holdings based on the notion that intellectual property and patents are
unique value drivers. Tracks the Ocean Tomo 300 Patent index, which consists of
approximately 300 companies based on patent valuation and other criteria. Uses a
proprietary methodology to identify patent value. Rebalanced yearly. Not suffi-
ciently liquid for even retail investors, in our opinion.
Patent-Focused ProShares Credit Suisse 130/30 ETF (CSM)

This new fund tracks the performance of the Credit Suisse 130/30 Large-Cap In-
dex, which ranks the 500 largest U.S. stocks by market cap from best to worst. It
goes long the top-ranking stocks using margin gained from shorting the lower-
ranking ones.
Socially
Islamic Market International Index Fund (JVS)
Responsible
Price: $41.84 Net assets: n/a Expense ratio: 0.68%
Yield: n/a ADV: 670 Inception: 1 Jul ’09
A new ETF launched by Javelin Exchange Traded Funds (JETS) that seeks to repli-
cate the performance of the Dow Jones Islamic Market Titans 100 Index. The index
consists of 100 companies in 23 countries. Avoids investments in vice sectors (al-
cohol, gambling, pork products, highly leveraged companies, etc.).
132
Active ETFs
There are two types of active ETF:
• those that rebalance based on purely quantitative algorithms; and
• those that are actively managed in the traditional sense—by stock-pickers man-
aging publicly traded, discretionary portfolios.
There are over 60 actively-managed algorithmic ETFs on the market, the first of
them having been introduced in April, 2008. But as discussed on page 20, the first
actively managed ETFs have now also come to market. As the Table below indi-
cates, most of them are sponsored by PowerShares.
The regulatory hurdles to approval remain significant (the first approvals took a
decade) due to concerns that the degree of transparency required by the ETF struc-
ture would give rise to front running. Managers have addressed this in part by con-
centrating on only the largest and most liquid underlying issues, and by delegating
position-management to multiple firms. (The latter strategy is designed to con-
found front-running because, as the story goes, any trader considering taking the
opposite side of a known manager’s position is less certain of the identity of the
counterparty in a multiple-manager scenario.)
The market’s reaction to the first active/discretionary ETFs has been underwhelm-
ing, and understandably so. Not only were these vehicles launched during a period
that saw the worst performance by active managers on record (and the largest
wave of withdrawals from alternative-investment categories), but some of the
funds place restrictions on when managers can trade or otherwise limit trading
freedom—not exactly what small investors who were looking for allocations to
skilled managers want in an actively managed fund.
Table 29:
Active ETFs
Index Ticker
• Grail American Beacon Large Cap Value ........................................ GVT
• PowerShares Active Alpha Multi-Cap ............................................ PQZ
• PowerShares Active AlphaQ ......................................................... PQY
• PowerShares Active Low Duration† ............................................... PLK
• PowerShares Active Mega Cap ..................................................... PMA
‡
• PowerShares Active U.S. Real Estate ............................................ PSR
† ‡
Fixed-income; REITs
Active—
PowerShares Active U.S. Real Estate (PSR)
Real Estate
Price: $30.56 Net assets: $2.6 million Expense ratio: n/a
NAV: $31.62 P/E: 23.3x Turnover: n/a
Yield: n/a ADV: 2,200 Inception: 20 Nov ’08
This ETF invests at least 80% of its assets in U.S. real-estate securities included in
the FTSE NAREIT Equity REITs Index. We recommend that investors avoid small,
illiquid ETFs such as this one; and are not currently recommending any allocation
to either active or real-estate ETFs.
133
n ETF Families
BlackRock’s pending acqui- Growth in the ETF category has been supported by a dizzying array of managers,
sition of iShares is expected authorized participants, and product families entering the market. Below, we detail
to shake-up the ETF indus- offerings from some of the leading ETF players (alphabetized by firm). This list is
not intended to be comprehensive, but to provide an overview of the players that
try, especially in the active-
an ETF investor may come across on a most regular basis.
ly-managed category. Other
dominant players include Absa Capital, based in South Africa and in affiliation with Barclays, issues ETFs that
State Street, Vanguard, and track the Johannesburg Stock Exchange (JSE), gold, and offers a host of other
PowerShares. unique fundamental/enhanced fundamental international and sector funds.
AdvisorShares has proposed issuing actively managed ETFs in affiliation with BNY
Mellon.
Ameristock Funds previously offered a line of ETFs that tracked the Ryan Treasury
indexes, but closed the funds down in mid-2008 after failing to gather sufficient
assets. This relatively rare ETF closing is one of the reasons we analyze prospective
funds for sufficient asset size and liquidity, before recommending (see page 16,
“Our ETF Selection Preferences”).
Barclays Global Fund Advisors (BGFA) is a subsidiary of Barclays Global Investors

(BGI), which is a majority-owned subsidiary of Barclays Bank PLC. The bank is the
third-largest in the U.K., and BGI has been one of the biggest names in the ETF un-
iverse (another being State Street Global Advisors, see below) through its iShares
family of funds, for which it served as investment advisor. BlackRock, having ac-
quired a 40% stake in Merrill Lynch’s DSP mutual-fund business last year, an-
nounced in June its intention to acquire an 80.1% stake in BGI, including the
iShares unit, from Barclays for $13.5 billion in cash and stock. BlackRock is currently
viewed as the frontrunner to CVC Capital Partners, which made an earlier bid for
the iShares unit alone. Should BlackRock prevail, the combined entity is to be called
BlackRock Global Investors (again, BGI). The deal is subject to shareholder approval
and expected to go to a vote in December. The combination will put pressure on
competitors, especially in the category of active ETFs—where BlackRock could uni-
quely dominate. IShares are distributed by SEI Investments Distribution (SEI).
BLDRs are unit investment trusts (UITs) based on The Bank of New York Mellon’s
ADR Index, which tracks depositary receipts traded in the U.S. The UITs are spon-
sored by PowerShares Capital Management, with BNY Mellon serving as trustee.
BLDRs are distributed by ALPS Distributors.
Earlier this year, AXA Investment Managers announced its intention to transfer the
operational management of the EasyETF funds to BNP Paribas Asset Management.
Previously, the funds had been managed as a joint venture between the two firms
since their 2005 launch. BNP Paribas’s index-tracking, structured products and risk-
allocation department, called Sigma, will now manage all 57 funds in the EasyETF
family. EasyETFs have attracted about €3.4 billion in assets. They track equity,
commodities, money-market and credit indexes, in addition to sectors such as real
estate and infrastructure, and thematic indexes. Most of the funds are listed on
Euronext Paris, with some trading on the Deutsche Börse, the Borsa Italiana, and
the Swiss and Tokyo stock exchanges.
Claymore Securities issues a range of useful, often unique, ETFs. See page 132 or
www.claymoresecurities.com/etf for more information. Claymore Investments
issues targeted and enhanced ETFs on the Toronto Stock Exchange (TSX).
134
Deutsche Bank’s db x-trackers is an ETF platform launched in January 2007 track

foreign markets. The company also manages the PowerShares DB funds, which
track currencies and commodities.
DIAMONDs are unit investment trust that tracks the Dow Jones Industrial Average.
Toronto-based ETF Capital Management manages a global fund of ETFs using its
proprietary Probability Indicator Convergence (PIC) process.
ETF Securities offers funds that tend to focus on commodities, such as gold (GBS),
silver (SLV), and oil (OILB, OILW).
Fidelity manages the ONEQs.
First Trust Advisors issues a range of exchange-traded vehicles, including unit

trusts, ETNs, and First Trust ETFs. It also serves as the investment advisor on prod-
ucts such as variable annuities.
First Trust Value Line offers a line of closed-end funds that license Value Line’s
rankings for the purpose of managing portfolios based on its picks. It also offers the
IPOX-100 Index Fund (FPX), which tracks an index of recent IPOs (IPXO).
FocusShares is a New Jersey-based investment manager that is working to issue

specialty ETF products.
Grail Advisors’ actively-managed, discretionary ETF (ticker GVT) has three sub-
advisors: Brandywine, Hotchkis and Wiley, and Metropolitan West. This structure is
intended to reduce the risk of front-running, as it is unclear which portfolio man-
ager is responsible for which trades/positions.
Canadian BetaPro Management offers Horizons BetaPro ETFs, a range of single,

leveraged, and inverse-leveraged funds.
HOLDRs are holding-company depository receipts offered by BofA Merrill Lynch.

They are traded in 100-share increments (round lots). Upon liquidation (sale) of the
investment, investors exchange these lots for shares of the underlying stocks.
HOLDRs are available for a number of sectors, including biotech, internet infra-
structure, regional banks, software, and wireless.
IShares is the largest ETF provider in terms of number of funds. The “iShares”
brand grew out of a joint offering between sponsor Morgan Stanley and manager
Barclays Global Investors, which were originally called WEBS (World Equity
Benchmark Shares) and structured as mutual-fund overlays. Morgan Stanley later
replaced WEBS with the current “iShares MSCI Series” line, and BGI launched a
separate set of ETFs as iShares. IShares trade on the NYSE Euronext (formerly the
American Stock Exchange), the Toronto and Australian exchanges, and several ex-
changes in Asia and Europe. (See Barclays Global Investors, above.)
European Lyxor Asset Management offers more than 130 equity, bond, and com-
modity ETFs on nine global stock exchanges.
Northern Trust exited the ETF business earlier this year; the Northern Exchange
Traded Shares (NETS) were liquidated on 20 February 2009.
Pimco (Pacific Investment Management Co.) launched its first ETF in early June,
with plans to offer half a dozen more. These ETFs provide exposure to U.S. Trea-
135
surys and TIPS. The firm is also expanding its family of open-and mutual funds, and
earlier this year created its first proprietary index (it covers global bonds). See page
110 for more discussion.
PowerShares offers a line of eponymous ETFs as well as BLDRS, which are based on
American Depositary Receipts. Amvescap PLC purchased Wheaton, Illinois-based
Power-Shares Capital Management LLC for $60m in January, 2006.
ProShares Advisors specializes in short (inverse) and leveraged ETFs, offering 89

funds in global equity, fixed-income, and commodity categories.
Rafferty Asset Management serves as the investment adviser to the Direxion Bull
and Bear Funds.
RevenueShares’ Revenue-Weighted ETFs weight their holdings by revenue, rather

than market cap. It offers half a dozen ETFs.
Rydex|SGI (previously Rydex Investments) manages five style and sector ETFs.
Source is a Morgan Stanley and Goldman Sachs joint-venture. It recently received

approval from the Irish Financial Regulator to launch 50 (mostly European equity)
ETFs under the Source Markets plc rubric, with Bank of Ireland as custodian.
SPA withdrew its half-dozen fundamentally weighted ETFs in March, having “de-
termined current market conditions are unsuitable for a long-only equity invest-
ment strategy, such as the one employed by the SPA MarketGrader ETFs.” Trading
in the funds had been sparse, though the company did announce its intention to
introduce new ETFs later this year.
SPDRs, or Standard & Poors’ Depository Receipts, are managed by State Street
Global Advisors (as are the StreetTRACKS funds). These vehicles track various S&P
indices—for example, the “Spiders,” or SPDR Trust Series 1, tracks the S&P 500 in-
dex. Some SPDRs, such as the SPDR Trust Series 1, are unit investment trusts. Select
Sector SPDRs are open-end mutual funds.
State Street Global Advisors (SSgA) is one of the largest ETF players. It manages
the SPDR family of funds and unit investment trusts. (SPDR stands for Standard &
Poor’s Depositary Receipts; also known as Spyders or Spiders.)
StreetTRACKS offers open-end mutual funds (not unit investment trusts). Like the
SPDRs, they are managed by State Street Global Advisors. They trade on AMEX, and
track Dow Jones style-specific indices, Morgan Stanley Dean Witter technology
indices, the Wilshire REIT index, and certain global indices.
Van Eck Global specializes in physical commodities investing through the Market
Vectors line.
Vanguard Group’s ETFs track its index funds. Previously, its VIPERs (Vanguard Index
Participation Receipts) were structured as share classes of the company’s open-end
mutual funds.
WisdomTree develops indexes and ETFs, including fundamentally weighted funds,

which track its indexes.
Ziegler Capital Management LLC sponsors the ArcaEx Tech 100 Index ETF (AXT),
which trades on Archipelago.
136
n Asset Allocation: The Statistical Evidence

We regard asset allocation as among the most important determinants of portfolio There is controversy over
performance across time and among different managers. Our approach reflects the whether asset allocation
consensus understanding that asset allocation explains a greater portion of the explains 40% of the variabil-
shared variation in portfolio returns than other investment factors, such as tactical
ity of returns, or 90%, or
timing and individual security selection—though the question is by no means with-
out controversy. somewhere in between.
This is a wide range, but the
This conclusion is based on a vast set of academic literature and practitioner stu- consensus is clear: no factor
dies, spanning decades. These studies have been designed to understand the com- is more important.
ponents of superior investment strategy—to help answer the question, what sepa-
rates acceptable and manageable risks from random or uncontrollable ones?
It is an area pockmarked with controversy, as the occasional peer-reviewed journal

article or opinion piece supports, rebuffs or extends earlier findings. Understanding
the development of these arguments over time is important, as early work by Brin-
son et. al. (the seminal “BHB study,” cited below) attributed over a whopping 93.6%
of portfolio performance to allocation.43
Later research has alternatively confirmed these results, called them into question,
or chosen to answer the question in a different context—for example, by compar-
ing the variability of returns across time, or among managers, or by looking at mul-
tiple factors in conjunction. Some studies have arrived at similar estimates as the
BHB paper using different methodologies; or have otherwise attributed a super-
majority of long-term investment performance to the allocation decision; or ques-
tioned such lofty estimates of allocation’s roll in portfolio management. Some of
the studies that we have reviewed in the preparation of this report include:
• Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. “Determinants
of Portfolio Performance,” Financial Analysts Journal; July/August, 1986. This
so-called “BHB study” study attributed 93.6% of portfolio performance to
asset allocation.
• Brinson, Gary P., Brian D. Singer and Gilbert L. Beebower. “Determinants of
Portfolio Performance II: An Update,” Financial Analysts Journal; May/June,
1991. Attributed 91.5% of portfolio performance to asset allocation.
• Ibbotson, Roger G. and Paul D. Kaplan, “Does Asset Allocation Policy Explain
40%, 90%, or 100% of Performance?,” Financial Analysts Journal; Janu-
ary/February, 2000. Attributed 90% of the variability of returns over time to
asset allocation, 40% of the variability among different managers, and 100%
of a portfolio’s return level.
• The Vanguard Group. “Sources of Portfolio Performance.” July, 2003. Attri-
buted 76.6% of portfolio performance to asset allocation, and slightly less in
bear markets (69.4%).
• Liu, Debbie. “Determinants of Portfolio Performance: CIBC Canadian Ba-
lanced Funds.” Master’s thesis, Business Administration. Presented at Simon
Fraser University; Fall, 2005 (accepted). Attributed 71.1% of portfolio per-
formance to investment policy, ±6.72% (and 83.68% to policy and timing,
±6.37%).
43
Specifically, the study found that 93.6% of the variability of the quarterly returns of a sam-
ple of investment plans could be explained by asset allocation. (When speaking of similar
analyses hereafter, the descriptive verbiage will be shortened.)
137
• French, Craig. “Another Look at the Determinants of Portfolio Performance:

Return Attribution for the Individual Investor.” Corbin Capital Partners, L.P.;
29 July 2003. Attributed over 90% of portfolio performance to asset alloca-
tion.
We are therefore comfortable stating that allocation is the single most important
factor not only on the basis of this and more recent work, but because even re-
search questioning such high levels of explanatory power tend to conclude that
allocation explains at least 40% of the shared variation of returns.
That is, such studies likewise conclude that there is no more important single fac-
tor, even if the actual explanatory power of relative asset weightings does not
comprise the super-majority. See, for example:
• Hensel, 1991.
• Jahnke, 1997.
• Nuttall, 1997.
• Zurz, 1999.
• Ibbotson and Kaplan, 2000.
We include these citations to important articles questioning the dominance of as-

set allocation not to confuse the reader, but to indicate that we understand the
impossibility of a just-so theory of markets. We view markets as chaotic behavioral
machines that often seem to confound just-so theories. It is for this reason that we
have designed the kind of disciplined approach to investment policy, security selec-
tion and risk management described in this report.
Finally, we are aware of no common-sense argument or research suggesting that

allocation is not of grave consequence to portfolio performance. Such a claim
would not only fly in the face of several decades of statistical research, which has
generally increased practitioners’ understanding of the dynamics of portfolio man-
agement, but common sense, too.
138
n How to Use Our Research

It is important for investors to understand the intended purpose of our ETF rec- Green and red indicate bul-
ommendations. Have we put forth the anchor portfolio on page 10 as a set of rec- lish/bearish trend expecta-
ommendations relevant to all investors? No, the anchor portfolio is both the con- tions; gray indicates chop-
clusion of our global investment analysis, and the starting point of investors’ own
piness ahead. The black
allocation work. Given a portfolio of any size, we would not go out and construct
the anchor portfolio today, because our technical work informs us that some of the dots are trailing stops. Fi-
securities in the portfolio meet one or more of the following conditions: nally, the indicator beneath
each chart highlights turn-
• in a secular downtrend, ing points.
• in a cyclical downtrend,
• trades below its volatility-adjusted stop-loss price.
So we would begin to construct a portfolio with the anchor weightings in mind,

picking entry prices on the basis of the proprietary trading rules we have designed
into our custom charts. Indeed, this section was originally called “How to Use Our
Charts,” but we realized that the primacy of our technical analysis is such that it:
• informs the interpretation of our recommended portfolio weightings at any
point in time, and
• determines the entry and exit prices of any security we analyze or recom-
mend.
n How to Use Our Charts

Our charts may look a little different than run-of-the-mill stock charts. While it is
common to use colors to denote price direction (e.g., green for up, red for down),
we are not so much interested in whether a stock closed above or below its open-
ing price, or yesterday’s close, or last Tuesday’s. What we are interested in is:
• trend—isolating price movements that may portend future strength or
weakness; or
• choppiness—indications that no strong trend is currently underway.
With that in mind, our stock charts could not be easier to interpret. What we have
done is convert algorithmic trading rules into an easy-to-read color system. Indeed,
a child could understand:
• When the price is green, our expectation (based on the technicals) is for fu-
ture price strength.
• When the price is red, future price weakness may be expected.
• When gray, our technique indicates a choppy or non-trending market.
Obviously, we are not generally interested in building long positions when our algo-
rithm reveals that weak or choppy price trends are dominating—that is, that price
is deteriorating. If a red price trend is confirmed by red trend bars (the “trend” sec-
tion of a chart appears immediately below the price chart) and/or red cycle bars
(the “cycle” section appears below the trend), then we would very likely be looking
to reduce or even liquidate any long position in that security.
We are not technical analysts, but to the extent that simple color-coding can be
employed to add incremental insight to a chart, how much the better.
139
Our Trailing-Stop System

The black dots in each price chart represent trailing stops, which automatically ad-
just for price volatility. (When a security’s trailing stop is trending above its price, it
represents the level at which to cover a short position. The algorithm prevents re-
commending new or ongoing long positions below the stop price.)
The Trend Indicator

As mentioned, immediately below each price chart is a row of bars, red or green,
that attempt to signal the security’s dominant trend. This indicator, too, is based on
a proprietary algorithm that continuously determines the relevant length of the
current trend (in days, weeks, etc.).
That is, one can always say, “Let’s compare the price to its 50- or 200-day moving
average [or any other indicator of choice], and see if the security is trending up or
down on that basis.” But we have never been happy with such an approach: the
choice of a 50- or 200-day moving average strikes us as essentially arbitrary. The
input really has nothing to do with the security’s own performance—the true
length of its dominant trend—in most cases.
So we have designed a methodology that determines the length of a security’s do-

minant trend (as well as its cycle, discussed below) instantaneously and “on the
fly,” and applies that variable (not a constant!) to many of the indicators built into
our proprietary algorithm.
Sound confusing? If so, then that’s why have we reduced the whole system to three
simple colors—red, green, and gray. The only additional information that a user
needs to know is that “trend” refers to a security’s long-term market trend and
“cycle” refers to short-term turning points, which we discuss next.
The Cycle Indicator

As mentioned, beneath each chart’s trend area is a turning-point, or cycle, indica-
tor. As would be expected of a cycle, these bars tend to fluctuate above and below
the zero line.
• When first turning green from deep beneath the zero line, we are more in-
clined to expect future (short-term) price strength.
• When first turning red from well above the line, we expect selling pressure
to dominate.
The signals are especially interesting when confirmed by trend and the color of the
price bar.
Background on These Techniques

The algorithms used to assess a security’s trend and cycle were developed by the
author, Troy Peery, CFA, using techniques imported from other fields. For several
years, the author worked as an equity research analyst covering next-generation
wireless communications companies. While researching these firms’ core technol-
ogies, Mr. Peery developed an interest in the science underlying cellular transmis-
sion and wave propagation. That interest, in turn, led to a radical rethink of the
forecasting techniques that Mr. Peery had been trained to deploy in financial and
econometric analysis.
Rather than seeking advantage by means of another technical indicator or combi-

nation of indicators—or looking to physics for equations to describe market beha-
vior—he took mathematical techniques that have been tested and refined for dec-
140
ades in the fields of wireless communications and electrical engineering (especially

circuit design), and incorporated them into econometrics.
But again, the only thing a user needs to know is this: green signals strength, red
signals weakness, gray means choppiness ahead.
n Custom Services
While this report necessarily speaks in terms of model portfolios, we realize that We can work with you to
every investors’ objectives, risk tolerances and holding-period constraints can be as
construct an investment
unique as their tax considerations.
policy and matching portfo-
We can work with individual clients to design a comprehensive investment strategy lio that fits your specific
or support any part of an ongoing investment program. Our services include: needs.
• customized investment policy (allocation models);
• specific security research and recommendations supporting those models,
• including not just ETFs but stocks, bonds, high-net-worth holdings or 401(k)
exposures, etc.;
• fixed holdings, such as real-estate, mortgage liabilities, etc.;
• a rebalancing schedule that suits clients’ needs, limiting transaction costs to
a predetermined level;
• customized charts that use our proprietary technical algorithms; etc.
The author’s contact information appears on the cover of this report. Let’s get
started.
141
n Notes
142
Stracia, LLC
Important Disclosures
The information presented herein, while not guaranteed, is believed Analyst Certification: I, Troy Peery, CFA, hereby certi-
to be accurate as of the date of this report, but the author(s) makes fy that the views expressed in this research report ac-
no representations as to its accuracy or completeness. Conditions curately reflect my personal views about the subject
affecting the performance of securities mentioned herein may securities and issuers. I also certify that no part of my
change subsequent to the date of this report, increasing their riski- compensation was, is, or will be, directly or indirectly,
ness and/or nullifying some or all of the estimates, statistical rela- related to the specific recommendations or views ex-
tionships, conclusions or other information presented herein. Infor- pressed in this research report.
mation, opinions and estimates contained herein reflect a judgment
as of the date this report was prepared, and are subject to change
without notice.
Nothing herein is to be deemed an offer or solicitation on the part of the author(s) with respect to the purchase or sale of any securi-
ty(ies). The information, tools and material presented in this report are provided to you for information purposes only, and are not to be
used or considered as an offer to sell or to buy any financial instrument(s), nor to subscribe for any security(ies) or other financial
instrument(s).
The strategies, models, studies, and analyses (and parts thereof) in this document are examples only, and have been included solely
for educational purposes. The author(s) does not recommend that you use any such strategy, model, study, or analysis (or any part or
parts thereof), as the use of any such strategy, model, study, and analysis does not guarantee that you will make profits, increase
profits, or reduce or minimize losses. The purpose of this document is not to engage in rendering any investment or other professional
advice. If investment or other professional advice is required, the services of a licensed professional should be sought.
The author did not take any steps to ensure that the securities or investment strategies referred to in this report are suitable for any
particular investor. The investments or strategies contained or referred to in this report may not be suitable for you. Do not make any
financial decision on the basis of the information, estimates, analyses or conclusions presented in this document. It is recommended
that you always discuss any investment decision with qualified financial professionals, including independent investment and tax advi-
sors, before buying or selling any financial instrument. This report is in no way intended as a substitute for your own due diligence.
Nothing in this document constitutes investment, legal, accounting, or tax advice or a representation that any investment or strategy is
suitable or appropriate to your individual circumstances, or otherwise constitutes a personal recommendation to you. The author ac-
cepts no liability for loss arising from the use of the material presented in this report, which is not to be relied upon in substitution for
the exercise of independent judgment, nor in substitution for professional investment and tax advice.
This report is for private circulation only. The author(s) may have issued, and may in the future issue, reports or opinions that are in-
consistent with, and reach different conclusions from, the material presented herein. The author(s) is under no obligation to ensure
that such other reports are brought to the attention of any recipient of this report. The author(s) has no obligation to continue to pro-
vide this research, and no such obligation is implied or guaranteed.
The author(s) or members of his or her family(ies) may at times hold positions in any of the financial instruments mentioned in this
report (or future reports) and may purchase or sell these instruments while such reports are in circulation. Furthermore, the author(s)
or members of his or her family(ies) may act upon or use the information, conclusions or opinions presented in this or any future re-
ports before the material is available to any reader.
Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, ex-
pressed or implied, is made regarding future performance. The price, value of and income from any of the securities or financial in-
struments mentioned in this report can fall as well as rise. The market value of any security may be affected by changes in company-
specific, economic, financial, political and geopolitical factors, market conditions, and volatility, and the credit quality of any issuer or
reference issuer, in addition to other factors.
Simulated or hypothetical performance results and analyses have certain limitations. Simulations are designed with the benefit of
hindsight, and unlike a record of actual performance, simulated results do not represent actual investment or trading decisions. They
may under- or over-estimate the impact, if any, of certain market factors, such as liquidity (or the lack thereof). No representation is
made that any account will or is likely to achieve profits or losses similar to those discussed herein.
Some of the investments mentioned in this report have a high level of volatility, and may experience sudden and large declines in
value, causing losses when that investment is realized. Those losses may equal or exceed the amount of initial investment. In such
circumstances, the investor may be required to pay additional money to support those losses. Income yields from investments may
fluctuate and consequently, the initial capital paid to invest in an income-yielding financial instrument may be used as part of the in-
come yield. Some investments may not be readily resalable and it may be difficult to sell or realize those investments or obtain reliable
information about the value, or risks, to which such an investment is exposed. The value of financial instruments is subject to ex-
change rate fluctuations and other factors that may have a positive or adverse effect on the price or income of such instruments. In-
vestors in securities such as American Depositary Receipts (ADRs), the values of which are influenced by currency valuations, which
can be highly volatile, effectively assume this risk.
143
Stracia, LLC
Structured securities are complex instruments, typically involve a high degree of risk, and are intended for sale or purchase only to or
by sophisticated investors who are capable of understanding and assuming the risks involved. The market value of any structured
security may be affected by company-specific, economic, financial, political and geopolitical factors, market conditions, and volatility,
and the credit quality of any issuer or reference issuer, as well as changes in spot and forward interest and exchange rates, time-to-
maturity, and other factors. Any investor interested in buying or selling a structured product should conduct his or her own investigation
and analysis of the product and consult with a financial advisor regarding the risks involved in conducting such a transaction.
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the site does not in any way form part of this report. Accessing such Web sites shall be at your own risk.
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Asset Allocation Using ETFs

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Copyright © 2009 by Stracia, LLC. All rights reserved.

How Much Diversification? ............................................... 19

Risk Management ............................................................. 24

Hair of the Dog ................................................................. 31

The Housing Market.......................................................... 45

Size & Style Exposure .............................................................. 50

High Yield ........................................................................116

Assorted ETF Topics................................................................125

A Closer Look at Price and Yield .......................................129

Asset Allocation: The Statistical Evidence...............................137

Please contact the author to discuss how best to utilize

n The ABCs of ETFs

Comparisons to Mutual Funds

Our approach is simple. We begin by forming a

The next step is actual ETF selection. We use a

Our expectations for changes in performance and Risk

We have designed our strategy and recommendations for:

Investors are already looking to other markets, and to superior portfolio-

n Building Better Portfolios

The goal is to achieve superior performance through diversification, risk budgeting,

Even alternative-investment structures such as private equity are now exchange-

Table 2: Recommended Weightings per Category

Chart 1: “Anchor” Portfolio Source: Stracia, LLC

The table above depicts

n How Important Is Asset Allocation?

The Most Important Single Factor

It’s time for a wake-up call:

Stock Selection Is Not Enough

Connecting the Dots in a Complicated Matrix

If asset allocation is the most important component of an investment strategy, why

Traditional Sell-Side Focus: Out of Focus

Wake-Up Call for Investors

Exhibit 2: Portfolio Building Blocks Source: Stracia, LLC

n Equities: Still Believe the Hype?

The Long View

Charts 2 and 3: Equities Investing over the Long-Term

Unadjusted Adjusted Unadjusted Adjusted

Inflation Too Often Ignored

By themselves, stocks have demonstrated an impressive ability to add volatility and

An Opportunity for Wall Street, Too

Source: CIA World Factbook 2009; Stracia, LLC

n Our ETF Selection Preferences

First-Mover Case Study

So while first-mover advantage is important, we typically want a fund to be of suffi-

All of these considerations are important when recommending ETFs to institutional

We weigh the novelty of an offering against its recent risk-adjusted performance

n Core and Satellite

Finally, the investor chooses to diversify in real estate,

The value of non-discretionary asset holdings and the

The same technique can be used on a more dynamic

n How Much Diversification?

Unfortunately, the consensus thinking with respect to diversification in pure equity

n Risks and Drawbacks

Recently, the Financial Industry Regulatory Authority (FINRA) discouraged brokers

We recommend the use of leveraged ETFs by investors sophisticated enough to

Not Available through All 401(k)s

Classification Schema Sometimes Too General