The New Dow Jones Industrial Average

ETF Specialist

The New Dow Jones Industrial Average

By Alex Bryan | 09-13-13 | 06:00 AM

Since its inception in 1896, the Dow Jones Industrial Average has served as a barometer of the U.S. stock market by tracking a select group of the country's industrial leaders. Earlier this week, S&P Dow Jones Indices announced that  Visa (V),  Nike (NKE,) and  Goldman Sachs (GS) will replace  Hewlett-Packard (HPQ),  Alcoa (AA), and  Bank of America (BAC) in this iconic index, effective Monday, Sept. 23. Because the index weights its constituents by their share price, rather than by market capitalization, these changes will have a significant impact. Both Visa and Goldman Sachs currently trade above $150, which will make them two of the index's top three holdings. They will also help take some of the weight out of  IBM (IBM), which currently represents more than 9% of the index. In contrast, the three departing stocks account for less than 2.5% of the index combined.

Price weighting is a relic from the 19th century that was adopted primarily because limited computing power made alternatives impractical. This simple price averaging approach that gives higher-priced stocks larger portfolio weights does not have a sound economic basis. Price weighting also limits the index committee's selection options. Although  Apple (AAPL) and  Google (GOOG) are leaders in their fields, if either company were included in the index it would account for more than 15% of the portfolio, which would distort the Dow's representation of the U.S. market. The index construction methodology does not follow mechanical rules, so there are no firm guidelines dictating how or when the committee overseeing the index will pick new constituents. Despite these idiosyncrasies, the Dow was 0.97 correlated with the market-cap-weighted S&P 500 Index over the past 10 years.

Although price weighting leaves something to be desired, the Dow tracks a fairly diverse set of top-quality companies that approximates the industry composition of the U.S. stock market.  SPDR Dow Jones Industrial Average (DIA) offers investors a convenient way to replicate its performance and may be a suitable core holding. The fund only invests in mega-cap stocks and, therefore, does not represent a large segment of the U.S. market. However, most of these companies have sustainable competitive advantages that may help protect their profitability in bad times. In fact, more than two thirds of DIA's assets are invested in companies with wide moats, Morningstar's assessment of a firm's competitive advantage. The corresponding figure for the S&P 500 is around 43%. As a result, DIA exhibited less volatility than the S&P 500 over the past 10 years, despite its more concentrated portfolio.

Fundamental View

In light of the Dow Jones Industrial Average's mandate to track U.S. industrial leaders that are representative of the broad U.S. stock market, the decision to replace Alcoa and Hewlett-Packard with Nike and Visa was prudent. Hewlett-Packard is clearly no longer a leader in the computing industry. While Alcoa is still the largest aluminum producer, the metals and mining sector is a very small part of the U.S. stock market. In contrast, Nike and Visa both carry wide moats and are leaders in their respective industries, which represent a meaningful part of the U.S. stock market.

Bank of America was a less obvious candidate for replacement. It is still one of the largest and most competitive banks around. If anything, it is getting stronger, not weaker. But the decision to replace it with Goldman Sachs may have less to do with the fundamentals of either company than their share prices. Goldman will receive nearly 10 times the weight of Bank of America. The index has been light on the financial-services industry over the past few years. It may seem like overkill to add both Goldman and Visa to address this issue, but not everyone classifies Visa as a financial-services company. S&P groups it with the information-technology sector because it makes its money from payment processing rather than from lending. In contrast, Morningstar classifies it as a financial-services company. Based on S&P's GICS classification system, the new constituents will bring the Dow's financial-services stake closer to the sector's weight in the S&P 500 Index. If Visa is grouped in with the financials, the index's exposure to the financial-services sector will more than double from its current weight.

The index's quality tilt gives it a defensive posture that can help it outperform the broader market in bad times. Over the trailing 20 years through August 2013, the Dow Jones Industrial Average outpaced the S&P 500 Index by nearly 1.2% annualized, with slightly less volatility. It also generally held up a little better during market downturns. There is some evidence that the market does not fully appreciate the long-term sustainability and predictability of high-quality firms' earnings more than a few years into the future. This inefficiency may arise because many investors have relatively short investment horizons. There may be an opportunity for long-term investors to profit from the market's myopic focus by buying the type of quality stocks this fund holds at reasonable prices.

Although the Dow Jones Industrial Average has had a good run over the past few years, valuations are still reasonable. At the end of August, the index's constituents were trading at a slightly lower average price/forward earnings multiple (14.2) than the S&P 500 Index (15.4). Morningstar equity analysts cover all 30 stocks in the Dow Jones Industrial Average. Based on their fair value estimates of the fund's underlying holdings, DIA is fairly valued. Only five holdings in the new portfolio, including new additions Visa and Nike, currently carry a Morningstar Rating of less than 3 stars. Adding to its appeal, DIA currently offers a slightly higher dividend yield than the S&P 500.

Rising interest rates could create a headwind for the fund's holdings as the Fed unwinds its bond-buying program. However, they should continue to benefit from the strengthening U.S. economy. According to Morningstar director of economic analysis Robert Johnson, consumer debt as a percentage of income has declined from 140% to 112% between 2008 and 2013. Bank balance sheets have also significantly improved over the past few years. Manufacturing productivity and oil production have picked up, inflation remains low, and the unemployment rate has continued its gradual decline.

Portfolio Construction

DIA tracks the Dow Jones Industrial Average by owning all 30 stocks in the index. This index reflects the performance of U.S. industrial leaders, excluding stocks in the utilities and transportation industries. A committee, which includes the managing editor of The Wall Street Journal, selects stocks for the index on the basis of subjective factors, including the strength of each firm's reputation, industry leadership, investor interest, and a history of successful growth. In constructing the index, the committee also takes steps to ensure that the index is representative of the U.S. economy. While the committee seldom changes the index's composition, it reviews the entire index when it replaces any component. Therefore, multiple changes often occur at once.

The index dates back to 1896, when Charles Dow would simply average the stock prices of the index's constituents to calculate the index value. Unlike most indexes, each component in the Dow is weighted by its share price. For example, with a stock price near $200, IBM receives a greater weight in the portfolio than  Wal-Mart (WMT), which trades around $75. Stock splits reduce the weight of a constituent in the index, even though they have no effect on a company's relative value. This odd weighting scheme and low number of holdings result in a highly concentrated portfolio. DIA's top 10 holdings soak up nearly 55% of its assets. The fund is structured as a unit investment trust.

Fees

The fund charges a 0.17% expense ratio, which is comparable to its peers. However, there are cheaper and better diversified alternatives. The fund offers good liquidity, which keeps the cost of trading it low. State Street engages in share lending, the practice of lending out the fund's underlying holdings in exchange for a fee. It passes through 85% of the proceeds to investors, which partially offsets the fund's expenses.

Alternatives

 Vanguard Dividend Appreciation ETF (VIG) offers a similar quality-oriented portfolio with greater diversification and a lower expense ratio (0.10%). VIG screens for companies that have increased their dividends in each of the past 10 years and have the capacity to sustain that growth. Despite that high hurdle, VIG offers broader market representation than DIA and extends its reach further down the market-cap ladder. In fact, VIG's average market capitalization is less than half of DIA's. VIG applies market-cap weighting, which more accurately reflects each constituent's market footprint. Over the past five years, these two funds were 0.98 correlated.

Investors can also get direct exposure to quality stocks through iShares MSCI USA Quality Factor (QUAL) (0.15% expense ratio). It targets stocks with high return on equity, low debt, and stable earnings. Because it was just launched a couple of months ago, QUAL still only offers limited liquidity, which can make it more expensive to trade.

Investors looking for similar market-cap exposure as DIA might consider  iShares S&P 100 Index (OEF) (0.20% expense ratio), which invests in a subset of the largest stocks from the S&P 500.  iShares Core S&P 500 ETF (IVV) (0.07% expense ratio) is a good option for broad large-cap exposure, while  Vanguard Total Stock Market ETF (VTI) is a suitable alternative for investors who also want exposure to mid- and small-cap stocks. VTI represents close to 99% of the total U.S. stock market for a rock-bottom 0.05% expense ratio.

 

 Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index. 

Alex Bryan is a fund analyst with Morningstar.

Indexing and the Average Active Manager

Indexing and the Average Active Manager

By Dan Culloton | 02-04-12 | 06:00 AM | E-mail Article

Statistical portraits of the average American are often unflattering. The numbers usually describe the typical Yank as someone who eats too many Quarter Pounders, drinks too many sugary and alcoholic drinks, watches too much TV, and plays too many video games. "Basically," my eldest daughter quipped a few years ago after reading such a description, "the average American is gross."

I thought of her comment and the average actively managed mutual fund after listening to one of the panel discussions at a recent event held in honor of Vanguard founder Jack Bogle by the Institute for The Fiduciary Standard in New York. Because it was the John C. Bogle Legacy Forum, one of the first panels was naturally about indexing. It was stacked with passive-investing sympathizers such as Yale professor and founder of Morningstar unit Ibbotson Associates Roger Ibbotson; Princeton professor and Random Walk Down Wall Street author Burton Malkiel; and Vanguard CIO and former index fund manager Gus Sauter. The Yale endowment's very active manager, David Swensen, also participated, but he has a well-documented soft spot for indexing as well. Indeed, all of them reiterated and agreed on most of the well-worn arguments for indexing.

They called Bogle's introduction of the first index fund 36 years ago a bold stroke of entrepreneurial genius that ultimately changed investing for the better. They said low-cost indexing beats most active managers in most asset classes and peer groups over most time periods and that even the managers who do beat their bogies in one time period find it darn near impossible do so in subsequent time spans. They cited the recent torrent of asset flows from active to passive mutual funds and exchange-traded funds as validation and vindication of an approach that was once dismissed as "Bogle's Folly." And they concurred that most investors would be best served by setting a balanced portfolio of stocks, bonds, and cash and tinkering with it as little as possible.

All of this had been said many, many times before.

All or Nothing?
The only issue on which they differed was whether indexing, which now accounts for about a fourth of mutual fund and ETF assets, would or should completely dominate investors' portfolios. That's when an interesting difference emerged and I thought about the average American and my child's revulsion of him.

Sauter, the veteran index fund manager from the firm that did for passive investing what McDonald's did for the hamburger, actually conceded that active management was not a hopeless case. It's possible for some active managers to beat the market, Sauter said, though it's so hard to pick them beforehand that even investors who consider themselves sophisticated should still index a big portion of their assets just in case. Swensen, the highly active endowment manager whose success and writings have inspired a generation of institutional investors to add alternative strategies and asset classes to their portfolios, said it was either all or nothing when it came to active versus passive investing. If you can't bring the same kind of time, expertise, and resources Yale does to bear on the task of selecting managers, don't bother, he said. Just index everything. "There's almost no chance that you're going to pick an active fund that's going to beat the market over a 20-year period," he said.

Swensen makes a point. Morningstar research of asset-weighted investor returns, which he cited, show professional and do-it-yourself investors alike often do a lousy job buying and selling funds. They get in just as hot streaks are about to cool and get out of cold funds right before they heat up again.

Bad Funds vs. Bad Behavior
That isn't so much an argument against active fund managers, though, as it is an indictment of overactive fund investors, regardless of whether they're using active or passive vehicles. Asset-weighted returns of index funds often show that index investors show the same tendency to chase returns to their detriment. You can lead investors to low-cost index funds, but you can't make them buy and hold.

If you followed Swensen's advice and bought and held an appropriate mix of index funds, you'd help your odds of avoiding self-destructive behavior and reaching your investment goals. You need not be doomed, however, if you did the same thing with a set of low-cost, competently managed actively managed funds, which despite Swensen's blanket dismissal, do exist. The average actively managed mutual fund, like the average American, can look pretty gross. It charges higher fees than passive funds for subpar returns with more volatility and tax headaches. But just as not every American is an obese, soft-drink swilling, chain-smoking couch potato; not every actively managed fund is a bloated, risky, shareholder-gouging mediocrity.

You can increase your odds of success, though by no means guarantee it, by setting very high standards for selecting actively managed funds and sticking with them. Morningstar analysts have long done so, first with our Fund Analyst Picks and now with our new qualitative Analyst Rating, which both focus on funds with experienced managers, proven strategies, responsible parent companies, reasonable fees, and long track records of success. We call the criteria the five Ps: People, Process, Parent, Price, and Performance. Our own studies have shown that our picks have done well over time and we're confident it will also hold true for the Analyst Ratings, which have supplanted the Analyst Picks.

Bogle's Ps
Don't take our word for it, though. Indexing's greatest evangelist, Bogle himself, delineated eerily similar standards for selecting successful active managers in the inaugural 1985 annual report of Vanguard Primecap (VPMCX). In it Bogle said Vanguard hired Primecap because of its people, philosophy, portfolio, and performance. Those criteria have been the basis for Vanguard's approach to selecting subadvisors for actively managed funds for years. Bogle and Vanguard will be the first to tell you they've made mistakes in this area, which is a big reason why the family uses multiple managers on most of its active funds now. But many of Vanguard's actively managed subadvised funds have done well relative to their peers and index fund siblings over time and some, like those managed by Primecap, have been superior.

It's tough to beat low-cost index funds. But just as it was wrong to deride passive investing as settling for average results, it's a mistake to equate all active funds with the average active fund.
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Morningstar認為投資主動型基金需要理解五個P (People, Process, Parent, Price, and Performance)。
Bogle則認為投資主動型基金需要了解People, Philosophy, portfolio, and performance。
如果無法掌握上述那些P的話，指數化投資似乎比較妥當。

Is an 'Annualized' Return the Same as an Average?

Is an 'Annualized' Return the Same as an Average?

The Short Answer

Is an 'Annualized' Return the Same as an Average?

By Karen Wallace | 09-20-11 | 06:00 AM | E-mail Article

Question: Morningstar's longer-term return data are all "annualized" returns. Is annualized return the same as average return?

Answer: Well, the short answer is yes. But it's a certain type of average, and that distinction matters.

To use a simple example, let's pretend you invested exactly $1,000 in an S&P 500 Index fund on Jan. 1, 2008. The fund promptly lost 37% that year (ouch!). But then it reversed course and shot up 26.5% in 2009, and then it gained nearly 15% in 2010. What is the annualized three-year return of your investment? And more important, have you made money?

You might be tempted to add these three numbers and divide by three to produce an average yearly return (negative 37% + 26.5% + 15%) ÷ 3, which would mean an average three-year return of 1.5%. At the end of three years, your initial $1,000 investment is worth about $1,046. Not great, but not bad, right? But your statement says you have around $920--$80 less than you started with three years ago! How did that happen?!

The reason is that a simple arithmetic average is not appropriate for calculating investment returns. It works perfectly to determine the central tendency of a series of numbers that are independent of one another, however. For instance, perhaps an investment team comprises three members: The portfolio manager, who has been running the fund for 30 years, and two analysts, who have been there for eight and seven years, respectively. This team could perhaps claim an average of 15 years' investment experience on the fund, which is the arithmetic average (or mean) of their three tenures. (At Morningstar, we'd still be more comfortable knowing the old hand had final say on buys and sells here, but I digress.)

Investment returns, however, need to be calculated using a geometric mean, or average. Don't be put off by the term: It simply means that because investment returns are compounded, they are dependent on one another.

Let's take a look at our example investment. In the first year you held your investment, it lost 37%, so the $1,000 you invested at the beginning of 2008 was worth only $630 by year-end. Your fund had a good year in 2009, gaining 26.5%; remember, however, that because you started the year with only $630, the 26.5% gain only brought you to $796.95 by Dec. 31, 2009. Then you gained 15% in 2010, but because you only had around $800 at the beginning of the year, you finished the year with around $920. Your three-year annualized return is a less cheerful but more accurate negative 2.86%.

To calculate a geometric mean for an investment over a period of years, you add 1 to the percentage returns for each calendar year (to get them all to be positive), then multiply them all together, and take the Nth root of the product of n numbers. ("N" depends on the number of years you want to annualize.) So, for the example above, the formula for calculating geometric average would look like this: (0.63 x 1.265 x 1.15)^1/3 - 1. The factors in the equation are found by adding 1 to the yearly return percentage expressed as a decimal (so, 1 + (negative 0.37) = 0.63, and so on).

Essentially, the example illustrates that if you lose half of your money, you have to double it just to get back to where you started. Those losses really sting! That's why our proprietary Morningstar Risk rating, which is a component of our Morningstar Rating for funds, emphasizes downside variations; it is based on the expected utility theory, which recognizes that investors are concerned enough about potential losses that they are willing to trade a portion of their potential upside in exchange for a greater certainty of return. For more on how to use Morningstar ratings (and how not to), check out What's Behind the Morningstar Ratings?

Karen Wallace is an editor with Morningstar.

Three Sources of Alpha

Three Sources of Alpha

By Jason Stipp| 5-23-2011 11:08 AM

Jason Stipp: I'm Jason Stipp for Morningstar.
The market for the informational advantage, the alpha, the step ahead of the competition out there in the marketplace has become so competitive that some folks have bent or even broken the law to try to get a leg up on everyone else.
But how can you actually get some alpha and stay within the confines of the law?
Here with me to discuss that is Pat Dorsey. Pat is Morningstar's former director of equity analysis. He is now with Sanibel Captiva Trust, but a friend of Morningstar. I'm happy to be sitting down with him today. Thanks for joining me, Pat.
Pat Dorsey: I'm always happy to talk about how to make money legally.
Stipp: It's good to stay within the confines of the law when you can.
Dorsey: I'm down with that.
Stipp: You're going to be outlining three sources of alpha. The first one is related to the information that you have, and there's ways to that legally and there's ways to that not legally. Tell us a little bit about that number one source of alpha.
Dorsey: This comes from a wonderful paper by Russell Fuller, of Fuller & Thaler, the well-known asset management shop and one of the founders of behavioral economics, called theThree Sources of Alpha. The first one is having an informational advantage, as you had mentioned--knowing more than the other guy.
I would say that in small caps you can do this. Even as a small investor, if you're diligent and you work hard on a smaller business, they are not very well followed by Wall Street; they are not very well owned by money managers. So, you can get to know them a little bit better than everybody else, but for the kinds of stocks that Raj Rajaratnam was trading, the informational advantages only come in less than legal ways.
But critically, I would say that generally informational advantages don't exist outside of very small companies.
Stipp: OK, so the information that you get, that could be one advantage that you have. What you do with that information obviously could be the source of another advantage.
Dorsey: So the second kind of alpha that Fuller posits is have an analytical advantage. Basically, you see this with quant people a lot: "I have a model that processes data better than everybody else, and it comes to more accurate conclusions about where security prices will go." That's typically the way you think about an analytical model.
The problem is, these analytical models get copied. Everyone is trying to do something ... is operating with similar information. So if you've got a really smart quant model, the odds are good that it's probably going to get copied in time, and so again, I would say, like an informational advantage, analytical advantages are also pretty hard to come by.
Stipp: The third one has a lot to do with your temperament as an investor. It is something that we like to listen to Warren Buffett to remind ourselves of this. But sometimes it's hard to put into practice. What's another way, then, that you can get that leg up?
Dorsey: So, the third one that Fuller talks about--and I think this is really where the money is made, to be frank--is having a behavioral advantage. So it's not what information you have, it's not how you process that information, it's what you do with it once you have it and process it. And that is just about basically behaving a little bit more rationally than everybody else. In the famous Warren Buffett words, being fearful when others are greedy, greedy when others are fearful. Being aware of recency bias, being aware of anchoring. All the various things that we talk about in the behavioral finance literature.
But the reality is that, simply acting a little bit more rationally than everybody else, having that behavioral advantage, I think is a far more achievable source of alpha than actually out-thinking everybody else, because there's a lot of money, a lot of computing power, even a lot of shady tipsters being thrown at trying to get more information than the other guy. But if you just kind of sit back and say, can I just behave a little bit more rationally? I would say that's pretty achievable given how irrational the market can be.
Stipp: A lot of good advice, especially for the individual investor. Pat, thanks so much for joining me today.
Dorsey: Anytime, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

China's Unsustainable Investment Boom

Stock Strategist

China's Unsustainable Investment Boom

By Daniel Rohr, CFA | 11-11-11 | 06:00 AM | E-mail Article

The Chinese fixed-asset investment boom of the past decade has been unprecedented. While all low-income countries have required outsize capital stock additions to make the leap to middle-income status, China's current boom is unmatched by anything on the record books. In fact, by some measures of physical capital, China already looks more like one of the world's leading developed economies, rather than the middle-income economy it is. We don't believe China can continue to rely on building more skyscrapers, highways, and manufacturing plants to sustain the kind of GDP numbers its citizens and global investors have grown accustomed to. In the next 10 years, the onus for growth will rest on Chinese households: their willingness and ability to consume. If consumption fails to grow at a rate well above historical norms, the economy may be able to muster only 5% growth at best, a far cry from the 10% average from 2001 to 2010.

In 2000, before the boom really kicked off, gross capital formation (or GCF, the GDP accounting term for investments in physical capital) accounted for 35% of Chinese economic output. While large by developed economy standards (the U.S. 10-year average is 19%, Japan 23%), it wasn't atypical for a high-growth emerging economy. Nor was it unusual for China: A decade prior, GCF also had a 35% share. The consistent share reflected the balanced growth China enjoyed in the 1990s. By 2000, the Chinese economy was 170% larger than it was in 1990, driven by a 173% increase in investment and a 156% increase in consumption.

Chinese GDP expanded at a similarly impressive rate in the 2000s. By 2010, the Chinese economy was 171% larger in 2010 than it was in 2000. But the sources of growth were anything but balanced. A massive share came from a surge in fixed-asset investment. By 2010, China was spending 273% more on physical capital than it was in 2000, with GCF accounting for a 49% share of output by decade's end. Yet Chinese households were "only" consuming 97% more than they were in 2000, depressing the share of household consumption of total GDP to 34% by 2010, a paltry share by any standard and the lowest level seen in China since the founding of the People's Republic.

The extreme imbalance between investment and consumption appears even more exceptional in the context of the three biggest investment-led success stories of the past 50 years: Japan, Korea, and Taiwan. By any measure of fixed-asset investment intensity--growth rates, share of cumulative GDP growth, or share of GDP--China has far surpassed the precedents set by Japan, Korea, and Taiwan. We estimate that, relative to the starting size of the economy, cumulative additions to Chinese capital stock in its boom decade have been 43% greater than Japan's, 33% greater than Korea's, and 49% greater than Taiwan's.

Just as striking is the relatively feeble contribution of consumption to Chinese growth rates. While GCF grew faster than consumption in the boom decades of Japan, Korea, and Taiwan, consumption still accounted for at least half of total economic expansion in each case, versus the paltry 26% share we see for China. While the investment share of Chinese GDP has exceeded the consumption share in every year since 2003, this was not achieved in any year by Japan, Korea, or Taiwan.

Various hard measures of GCF confirm the outsize role of fixed-asset investment in the Chinese growth story. The Chinese economy is roughly 170% larger than it was a decade ago, but it now consumes 383% more aluminum and 393% more steel. Total expressway mileage is up 354% over the past decade, the number of tunnels is up 338%, and floor space under construction, a concrete measure of real estate activity, is up 337%.

One might argue that this rapid buildout of Chinese real estate and infrastructure makes sense to the extent it correctly anticipates a commensurately rapid increase in consumption. Even if a good deal of the new floor space goes unoccupied at the moment, continued urbanization and rising incomes will eventually fill it. And while some of the new expressways, bridges, and tunnels may see only a trickle of traffic today, rising automobile ownership rates will ultimately generate a steady stream of vehicles. From this perspective, today's investment is nothing more than a down payment on tomorrow's consumption.

Consumption Has a Lot of Catching Up to Do
But given the immense investments made in the past decade, consumption has a lot of catching up to do. Even if the massive capital additions have correctly anticipated the consumption growth we'll see in the decades to come, the economic rationale for further outsize capital outlays grows increasingly weak with each passing year. Any nation, even a rapidly growing one, needs only so many airports, highways, high-speed rail lines, and luxury apartments.

By some measures, China's physical capital base already looks like that of a major developed economy. Consider the installed capacity of China's steel industry. Now roughly 5 times the size of what it was a decade ago, capacity is nearly twice that of the United States, Japan, and the European Union combined. Notably, the latter collection of economies has nearly 1 billion people of its own and collective GDP of about $36.6 trillion, making it more than 6 times the size of China's economy.

China's expressway system, the national trunk highway system, also looks rather overbuilt. By year-end, the NTHS will have quintupled its 2000 length. Heading into the year, the total length of the NTHS (45,554 miles) was already on par with that of the interstate highway system (46,876 miles) in the U.S., a country of similar size but with 3 times as many cars on the road. While growing Chinese vehicle ownership rates are likely to trim some of the bloat in the next couple of decades, the rationale for additions comparable to what we've seen in the past 10 years is very limited.

The biggest contributor to China's fixed-asset investment boom, particularly in the past few years, has been residential real estate. Throughout the 2000s, China built housing at a blistering pace, adding a cumulative 120 square feet in residential floor space per person. This is understandable, given the significant additions China made to its urban population over the period. What is less understandable is the roughly 80% surge in the rate of floor space additions we've seen in the past few years, which has not been accompanied by a comparable surge in urbanization. On a per capita basis, China now has nearly 5 times the amount of residential floor space under construction as the U.S. in its peak housing boom. This is particularly remarkable since, despite enormous gains in wealth and income, Chinese remain on average much poorer than their American counterparts and tend to occupy residences that are much smaller.

Perhaps the biggest counterargument to the overbuilding thesis goes as follows: Despite its massive urbanization of the past couple of decades, China remains relatively rural by global standards and will continue to require large additions to its capital stock as it accommodates new urbanites. According to Chinese government figures, even after an influx of 207 million new urban residents in the past decade, only 50% of the population resides in urban areas. An increase to 70% urban--a level typical of the high-middle-income status to which China aspires--would add 272 million to China's urban total. That's equivalent to adding 33 cities the size of New York.

While that notion is intuitively powerful, we'd strongly caution investors against taking the data underpinning the "stronger for longer" urbanization story at face value. Countries use very different definitions of what constitutes urban. As a result, relying on headline data alone can lead to ill-informed conclusions. China's self-reported urban share of 50% is equivalent to reported figures from Ghana (50.7%) and apparently well below that of North Korea (60.1%), which remains largely a subsistence agriculture economy.

As it turns out, China's definition of urban is stricter than most, effectively portraying the country as more rural than it might otherwise appear and potentially overstating the remaining runway for further urbanization. China's statistics bureau generally requires a density of 1,500 persons per square kilometer for a population to be deemed urban. By this hurdle rate, 4 of the top 10 largest U.S. cities would fail to meet China's definition of urban, not to mention hundreds of suburbs. While the data necessary to reformulate China's urban/rural breakdown on a more apples-to-apples basis with that of the U.S. aren't made available, it seems fair to assume that such an undertaking might add at least 10 percentage points to China's stated urbanization level, significantly curtailing the urbanization upside promoted by China bulls.

All told, we expect to see significantly lower GCF growth in the coming decade than we did in the decade just past. As a result, for China to sustain robust economic growth in the coming decade, household consumption will need to grow at above-trend rates, rebalancing its economy toward a more normal composition of consumption and investment. Chinese policymakers are not blind to the need to increase consumption, as evidenced by the recently articulated objective of boosting consumption's share of GDP to 50% by the end of the decade.

Two Ways to Rebalance China's Economy
There are two ways to achieve this rebalancing: stronger growth in consumer spending or weaker growth in fixed-asset investment. History suggests the latter outcome is more likely. Consider the average GCF growth turned in by Japan, Korea, and Taiwan in the decade following each country's investment boom: 1.2%, 2.4%, and 5.9%, respectively. If China were to achieve the average of those three (about 3%) in its own post-boom decade and household consumption continued to expand at the rate it has in the past decade (7.0%), total GDP would grow at 4.8%, well below the 10.5% average of the 2000s. Even if consumption were to expand at 12.0% annually, a level it achieved not once in the past decade, GDP would grow at 7.5%--stellar by developed market standards, but somewhat below what Chinese citizens and global investors have come to expect.

In the case of Japan, Korea, and Taiwan, GCF growth post-boom was inversely related to the size of the boom. Japan and Korea had larger booms (GCF averaged a 37% share of GDP in the boom decade), leading to weaker GCF growth post-boom. Taiwan had a relatively smaller boom (31% share of GDP) and saw fairly robust GCF growth post-boom. With this in mind, it seems reasonable to believe that, since China's investment boom has been both longer and stronger than its antecedents, its post-boom decade will require more modest additions to the capital stock than the cases of Japan, Korea, or Taiwan. This suggests even 3.0% GCF growth would be a fairly rosy outcome by historical standards. Assuming instead 1.0% GCF growth and 7.0% consumption growth would put GDP growth at 3.8%--a potentially troubling outcome not only for China, but for the global economy as a whole.

Daniel Rohr, CFA, is a senior securities analyst at Morningstar.

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簡言之，過去十幾年中國投資佔GDP的比重過高，未來投資難以維持這種高成長。
如果中國的消費成長未能及時遞補，則GDP成長率勢必下滑。
硬著陸的風險仍在！

Indexer? Valuation Still Matters

Indexer? Valuation Still Matters
http://news.morningstar.com/articlenet/article.aspx?id=397159

By Samuel Lee | 10-12-11 | 06:00 AM | E-mail Article

Indexing is based on a simple proposition: Net of fees the markets are hard, if not impossible, to beat. The proposition has been tested many times, with supportive results. No surprise then that passive funds' market share has surged to 24% from 11% of all open-end and exchange-traded fund assets over the past decade. But indexing's well-deserved success has coincided with a disturbing abrogation of responsibilities by some investors and advisors. Many believe that they can't or shouldn't estimate expected returns of their investments. They've consigned valuation to the dustbin.

This is wrongheaded, motivated by a view of markets rejected decades ago. The early efficient-market theorists assumed that the market's expected returns, risks, and correlations were constant through time. Almost no financial economist believes this today. The market's expected returns change. And there's heaps of evidence that the market's returns are somewhat predictable over long horizons.

Market PredictabilityOn an intuitive level, the market must be predictable to some extent. Otherwise, how could investors set prices for stocks versus bonds versus cash? We can also reasonably rule out certain scenarios, such as corporate earnings growing much faster than gross domestic product indefinitely, which would result in corporate earnings eventually taking over the entire economy. That returns are bounded by mean-reverting attributes of the economy points to predictability. Indeed, the evidence is compelling. In the August 2011 issue of The Journal of Finance, University of Chicago professor John Cochrane wrote: ". . . predictability is pervasive across markets. For stocks, bonds, credit spreads, foreign exchange, sovereign debt, and houses, a yield or valuation ratio translates one-for-one to expected excess returns, and does not forecast the cashflow or price change we may have expected." In other words, measures such as dividend/price predict future returns, especially over long horizons. Cochrane is a prominent efficient-markets theorist.

Adding return predictability to classical asset-pricing models, with changing risk, correlations, and expected returns, has surprising implications. In many cases, the hallowed market portfolio, containing all assets in the market weights, no longer guarantees the most return per unit of risk. There's no need to privilege total stock and bond market indexes, or static buy-and-hold strategies. The more realistic models suggest investors should time the market depending on how affected they are by recessions and their estimates of expected returns. An investor who can stomach a lot of volatility should increase his exposure to risky, high-expected-return assets during bad times. This sounds an awful lot like the dictum to "buy when there's blood in the streets." But everyone can't buy at the same time, nor should they. Investors with income or wealth sensitive to the business cycle should put less of their portfolios in value stocks, which are especially hurt by recessions, and possibly even hedge their exposures to their specific industries.

These new and improved models have their impracticalities. Until recently, sticking with a plain market-weighted index fund was perhaps the best course of action for the vast majority of investors. Trading was prohibitively expensive, and it was difficult to cheaply tailor one's exposures to various risk factors. No longer, as decimalization, financial innovation, and competition have slashed costs and expanded the menu of indexlike investments. Investors should take advantage of these circumstances to tailor more-efficient portfolios. However, demanding that advisors and individuals constantly update for every asset class estimate of expected returns, correlations, and standard deviations is impractical. A compromise is to adjust portfolio allocations based on expected returns, perhaps the most important of all three factors. As we'll see, estimating long-run (over a decade or more) expected returns isn't terribly hard.

Expected ReturnsMost expected returns can be decomposed into three parts: the current cash flow yield, the cash flow's expected growth rate, and the expected change in valuation (for example, a contraction or expansion of the dividend/price multiple). However, of the three, change in valuation multiples is often the least predictable, most volatile, and the least important in the long run, so investors should focus on current yields and expected cash flow growth. Current yields are easy to find. The trick, then, is to find the most appropriate and predictive cash flow growth figure. Fortunately, long-run historical growth rates provide a decent guide. For most major stock markets, dividend growth has averaged 1% to 2% annualized over the past century. For bond indexes, expected cash flow growth is negative owing to defaults. For U.S. Treasuries and investment-grade bonds, the default rate has historically been zero or close to it, so current yield (or better yet, real option-adjusted yield) provides a good guide to expected returns. According to Antti Ilmanen, U.S. high-yield bonds have since 1920 lost about 4.3% of value annually to defaults (2.6% after a 40% recovery rate is included).

Estimates of Real Long-Run Expected Returns

Current Carry

Cash Flow Growth

Real Expected Return

U.S. Equities

2.92%

1.50%

4.4%

Europe Equities

5.65%

1.50%

7.2%

Emerging-Markets Equities

2.32%

3.00%

5.3%

10-Year U.S. Treasury

0.07%

0.00%

0.1%

High-Yield Bonds

6.33%

-2.60%

3.7%

Investment-Grade Bonds

2.30%

-0.10%

2.2%

Note: Data as of 10/10/11. Yields based on 12-month yields of various ETFs. 0.75% added to U.S. equity dividend yield to adjust for net share buybacks. Bond yields adjusted for inflation. Cash flow growth estimated by long-run growth figures for developed-country stock markets.

Adding a few bells and whistles seems to help forecasting power, but they're beyond the scope of this article. GMO, a respected asset manager, adds mean reversion in its models. An investor without the time, data, or inclination to estimate expected returns probably would do well to follow the regular valuation estimates GMO publishes for free at its website (registration required, unfortunately).

This doesn't mean you're guaranteed to earn those returns, even over several decades. All an expected return estimate does is offer you a decent idea of the average of the many possible return streams you can reasonably expect from your investments.

Portfolio ImplicationsHow could you integrate expected returns into a portfolio strategy? It could help determine your savings rate. Ask yourself whether you're satisfied with the reward you're expected to earn for deferring consumption. Would you save the same amount if you're only expected to be paid 2% annualized versus 30% annualized on your portfolio? Probably not, yet many investors don't even take a stab at estimating expected returns.

The notion that valuations matter and predict returns is closely related to the idea of recession risk. If high expected returns came with no qualifications, then beating the market would be a cinch. Many efficient-market theorists think of assets with high expected returns as riskier. This means that an exceptionally patient, risk-tolerant investor with a safe job could act as an insurer, buying distressed assets with high expected returns during recessions and liquidity crises. If he's unable or unwilling to monitor the markets for high expected return opportunities, he could maintain a static allocation to value strategies that buy high-yielding or low-price/book stocks. Or he could compromise between market-timing and buy-and-hold by overweighting beaten-down assets during annual or biennial rebalances, a technique advocated by William Bernstein.

The opposite would hold true for an investor sensitive to the business cycle. Perhaps he owns a small business or works in finance. He could overweight high-quality growth stocks and in some cases could justifiably engage in "reverse market-timing," selling stocks when volatility picks up (usually accompanied by market declines), as an insurance scheme.

Integrating expected returns into portfolio strategy just scratches the surface of efficient portfolio construction. In an ideal world, investment bankers would hold few equities and lots of long-duration Treasury Inflation-Protected Securities; landlords would short REITs; bankruptcy lawyers would sell volatility. All of this would be done with an eye toward maximizing the risk/reward characteristics of investors' true portfolios, which include human capital, pensions, and so forth, in addition to stock and bond holdings. In the real world, individuals and advisors are sorely lacking in the tools, data, and knowledge to properly implement such strategies. The very least we can do is assess whether our investments offer prospective rewards commensurate with the risks we bear. And that requires a valuation-based view of the world.

Samuel Lee is an ETF Analyst with Morningstar.

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原先以為，指數化操作就只有資產配置而已，想不到也是需要評價的。

本文的內容相當於之前在綠角部落格曾介紹的「定期定值」操作策略。

我想利用本文所提供的數據，配合目前Firstrade所提供的ETF交易免手續費的活動，在操作上應該會更加容易。