Economic Disturbances and Equilibrium in an Integrated Global Economy: Investment Insights and Policy Analysis

By Victor A. Canto

Economic Disturbances and Equilibrium in an Integrated Global Economy: Investment Insights and Policy Analysis helps readers develop a framework for analyzing economic events and make better, more consistent decisions. Victor Canto presents the theoretical building blocks that make up the overall framework, then expands the framework to tackle more complex problems, applying additional considerations to actual policy or investment issues. Drawing upon the most recent trends in monetary policy and international economics, the book offers sustained direct engagement with the main research question and makes innovative use of the simple concepts of supply and demand to illuminate modern finance literature.

The book succeeds by highlighting the often-forgotten interconnectedness of different economic processes. How do we respond to a change in policy or an economic shock? Are all the expected changes to the general equilibrium consistent with each other?

• Helps readers build an intellectual framework that enables them to interpret articles in the financial press and policy decisions in a logical and consistent manner
• Differs from other books by eschewing partial equilibria analyses and instead providing a general equilibrium perspective useful for investors and policy makers
• Provides supporting data on a freely-accessible website so readers can test and replicate results

• Language: English
• Publisher: Academic Press
• Release date: Apr 19, 2018
• ISBN: 9780128139943

Victor A. Canto

Victor A. Canto is the Chief Economist and Managing Director of Global Strategies at Cadinha & Co. and founder and Chairman of La Jolla Economics. He was an advisor to the Lazard Capital Allocator Series, Advisor to the Nestegg Funds, Trustee of StockJungle.com in Culver City, California, Director, Chief Investment Officer, and Portfolio Manager of Calport Asset Management, and President and Director of Research of A.B. Laffer, V. A. Canto & Associates. He was a tenured Associate Professor of finance and business economics at the University of Southern California (USC) from 1983 to 1985. Dr. Canto was Assistant Professor of finance and business economics at the University of Southern California from 1977 to 1983 and Visiting Professor at the Universidad Central del Este in the Dominican Republic. He was also a Visiting Professor of economics at the University of California at Los Angeles (UCLA) during the winter of 1987. During 1980, Dr. Canto was a consultant to the Financial Council of Puerto Rico; during 1977, an advisor to the economic Studies Division of the Dominican Republic’s Central Bank. During 1975 he was technical advisor to the Finance Minister of the Dominican Republic. Dr. Canto received a B Sc. in civil engineering from the Massachusetts Institute of Technology in 1972, an M.A. and Ph. D. in economics from the University of Chicago (1974, 1977). Dr. Canto has authored, edited, or co-edited a number of books, including the landmark Foundations of Supply-Side Economics, as well as Monetary Policy, Taxation, and International Investment Strategy; Supply-Side Portfolio Strategies; and Currency Substitution: Theory and Evidence from Latin America , Understanding Asset Allocation as well as Cocktail Economics. Economic Disturbances and Equilibrium in an Integrated Global Economy ( Forthcoming). He is the recipient of the Supremo de Plata awarded by the Dominican Republic JC to the Outstanding Young Man of 1983, and the recipient of the University of Southern California University Scholar award. He is a member of Chi Epsilon (the civil engineering honorary society). Victor Canto’s articles have appeared in many of the leading economic journals, including Economic Inquiry, Journal of Macroeconomics, The International Trade Journal, Journal of Business and Economic Statistics, The Southern Economic Journal, Applied Economics, Weltwirstchaftliches Archiv, The CATO Journal, Public Finance, The Journal of International Money and Finance and The Journal of Wealth Management. In addition to his principal fields of interest--International Economics, Public Finance, and Macroeconomics, Dr. Canto has been published in the Wall Street Journal and the Investor’s Business Daily. He authored articles on energy markets for the Public Utilities Fortnightly, and the Oil and Gas Journal, as well as a series of articles on portfolio strategy for the Financial Analysts Journal. He contributed “Exotic Currencies,” to The New Palgrave Dictionary of Money and Finance, published by MacMillan Press Limited in 1992. He also was a contributing editor for National Review Online Financial.

Book preview

Economic Disturbances and Equilibrium in an Integrated Global Economy

Investment Insights and Policy Analysis

Victor A. Canto

Andy Wiese

Table of Contents

Cover

Title page

Copyright

Preface

Introduction: Asset Allocation: Indexing, Smart Beta, and ValueTiming

Section I: Arbitrage and Mobility

Chapter 1: Arbitrage, Mobility, and Equilibrium Prices

Abstract

A 2X2X2X2 World

Equilibrium Under Autarky

Global and National Equilibrium

Global Equilibrium and the Trade Accounts

The Terms of Trade or Real Exchange Rate

Interest Rate Parity

What Happens When the Terms of Trade Change in Predictable Directions?

Adding the Final X2

Mobility, Trade, and the Equalization of Price and Factor Returns Across Borders

Transportation Costs and Overall Equilibrium

Mobility and the Incidence of Taxes and Other Economic Shocks

The Speed of Adjustment to a New Equilibrium

Chapter 2: Practical Applications: The Investment and Policy Insights and Implications Derived From Arbitrage and Mobility

Abstract

Is the Law of One Price a Useful Concept?

Convergence: The Implementation of the Euro

The Convergence and Postconvergence Euro Environments

Divergence: The Dismantling of Bretton Woods

The Local Inflation Results

Does the Law of One Price Still Hold?

Are the Terms of Trade Constant?

Chapter 3: Are Commodity Price Increases Equivalent to Tax Increases?

Abstract

Are Commodity Price Increases a Harbinger of Future Inflation?

Solving the Signal Extraction Problem

Searching for the Equivalence between Price and Tax Increases

Does the Price/Tax Equivalence Always Hold?

Considering the Different Possibilities

Interpreting Relative Price Swings

Is a Commodity Relative Price Increase Bullish or Bearish?

Chapter 4: The Terms of Trade

Abstract

A Broader Estimate

Policy Links

The Adjustment Process: Investment Implications

Does Our Theory Hold Water?

Does the Relationship Hold for Other Countries?

Chapter 5: Yields, Risk Premium, and Terms of Trade

Abstract

The Different States of the World

Identifying the Different Environments

Summary

Chapter 6: The Competitive Economic Environment: Lessons From the States

Abstract

The States’ Competitive Environment

The States’ Income Tax Rates as a Proxy for Their Competitive Environment

The Evidence: The Changing Competitive Environment

The Interaction Among States’ Migration, State Income Tax Rates, and Right to Work

Brain Drain?

Summary

Chapter 7: Economic Policy and Performance: The Small-Cap and Country Effect

Abstract

A Framework for Regional Economic Performance

The Ranking of the States

Application: The States’ GDP Relative Performance

Application: The States’ Relative Stock Return Performance and the Size Effect

Investment Implications

Chapter 8: Migration: A Political Problem, an Economic Problem, or Both?

Abstract

Migration: Europe and the Middle East

Where Will the Migrants Go and What Will Be Their Economic Impact on These Economies?

Politics or Economics?

Is Europe Unique or Are These Effects Universal?

The Recent US Experience

Immigration as an Economic Problem

Who Should be Coming Into the Country?

How Would We Modify Immigration: What to Look for and How to Take Into Account the Policy Interactions?

The Economic Determinants of Migration

The Anchor Babies

The Politics of Immigration

The Burden of Adjustment

Section II: The Trade Balance

Chapter 9: Global Investing: The Macro Prospective Building Blocks

Abstract

The Framework

The Monetary System

The Exchange Rate and the Organization of the Monetary System

The Trade Balance and Capital Flows

What Happens When the Terms of Trade Change in Predictable Directions?

Chapter 10: Diversity and Harmonization

Abstract

Autarkic Equilibrium

Free Trade Equilibrium

Some Generalizations

The Link Between Consumption Harmonization and Production Divergence

The Politics of Job Protection Policies

Diversity and Harmonization

Chapter 11: The State Competitive Environment: Integration and Convergence

Abstract

A Framework for Regional Economic Performance

The Degree of Economic Integration

Some Evidence

States’ Fiscal Policies Could Potentially Impact the Degree of Integration

The Measurement of the Differences in Policies Across the States

The States’ Relative Marginal Tax Rates

Investment Strategy

Limitations of the State Competitive Environment as an Investment Strategy

Competitiveness, Integration, and Convergence

Chapter 12: The Degree of Global Integration and National Economies’ Policy Options and Limitations

Abstract

The Integrated Economy

The Price and Output Adjustment to a New Equilibrium

The Demand and Supply Response

Transportation Costs and the Degree of Integration

China and the Commodity Supercycle in the Context of an Integrated Global Economy

The Commodity Supercycle

Policy Differences and the Degree of Integration in an Economy Output Level

China’s Impact on the Global Economy’s Equilibrium Output

Implications and Insights

Chapter 13: A Unified Theory: Terms of Trade, Real GDP Growth Rate Differentials, the Trade Balance, Capital Flows, and the Relative Stock Market Performance

Abstract

The Two Possibilities

The Terms of Trade

The Global Economy’s Adjustments to Economic Disturbances and the Correlation Among the Key Economic Variables

What Does the Global Data Tell Us?

A Unified Theory

Appendix

Section III: Exchange Rate and the Terms of Trade

Chapter 14: Protectionism, Devaluation, and the Terms of Trade

Abstract

The Nominal Exchange Rate

Floating Exchange Rates, Purchasing Power Parity, and the Terms of Trade

Currency Manipulation

Terms of Trade Changes, the Wealth Effect, and the Transfer Problem

A Signal Extraction Problem

Chapter 15: Exchange Rates, Devaluations, and the Terms of Trade

Abstract

The Equivalence Between Currency Manipulation and Countervailing Duties

Why Tariffs May Fail

The Protectionist Case for Exchange Rate Management

The Case Against Devaluation or Revaluation

More on the Case Against the Nominal Exchange Rate

Expanding the View

The Big Mac Standard

The Real Exchange Rate or Terms of Trade as an Indicator

The Better and Broader Measure

Chapter 16: The Nominal Exchange Rate, the Terms of Trade, and the Economy

Abstract

Expanding the Framework to Include Transportation Costs

What Drives the Nominal Exchange Rate?

Devaluation and Terms of Trade Effects

A Signal Extraction or a Conceptual Problem?

What Moves the Exchange Rates and Terms of Trade?

The Economic Performance During the Cycles

The Events

Mexico and the Tequila Effect

The Thai Blood Baht and the Asian Flu

The Russian Crisis

The Commodity Super Cycle

China

Chapter 17: The US Experience: An Interpretation

Abstract

Trade Balance: Value or Growth Signal?

The Trade Balance and the Economy’s Price Earnings Ratio

Trade, Employment, and Growth

Do Exports Create Jobs? What About Imports?

Economic Growth, the Trade Balance, and the Stock Market Performance

The Exchange Rate and Terms of Trade

Chapter 18: Relative Price Changes, Income Redistribution, and the Politics of Envy

Abstract

Necessary Conditions

Agricultural Commodities, the New Oil?

Impact of Agricultural Price Support Programs

Unintended Consequences: Economic Dependency

Economic Growth and Price Support Programs

Unintended Consequences: Oil and Agricultural Products

A Warning

More Unintended Consequences: Starvation

More Unintended Consequences: Trade Restrictions

A Generalization

Mercantilism Does Not Make For Good Economics

Protectionists Versus Free Trade Arguments

The Facts

Chapter 19: Self-Sufficiency, Nationalism, and Protectionism: The Common Elements

Abstract

Self-Sufficiency Policies: Potential Pitfalls

The Narrow View

Budget Constraints and Self-Sufficiency Policies

Self-Sufficiency or Trade Restriction Policy Equivalences

Winners and Losers and the Politics of Special Interest Groups

Intertemporal Considerations

Is Self-Sufficiency and Protectionism the Answer?

Chapter 20: Immigration and Protectionism

Abstract

Illegal Immigration

Security

Crime

Legal Immigration: Economic Issues

The Case for a Skills-Based Immigration System

The Unintended Consequences of an Immigration System

The Effect of Alternative Immigration Schemes

Chapter 21: Trade Policy, Protectionism, and Currency Manipulation

Abstract

Global Implications of an Anticurrency Manipulation Policy

Will Currency Manipulation Deliver the Goods?

China

Chapter 22: Protectionism and Trade Policy

Abstract

The Trade Balance and Real GDP Growth

The Trade Balance and the Capital Account

The Conquest by Purchase

Section IV: The Balance of Payments

Chapter 23: Global Investing: The Balance of Payments

Abstract

The Monetary System

Extending the Framework to Account for Multiple Economies and Currencies

The Global and Individual Countries’ Monetary Equilibrium Under a Floating Exchange Rate

Variations on a Theme: Alternative Assumption Regarding the Money Demand Functions

Scenario 1: The Textbook Scenario Where Each Country Exclusively Uses Its Own Currency in All Domestic Transactions

Scenario 2: Each Country Uses Both Currencies in Domestic Transactions

Implications and Insights

Scenario 3: One Country’s Currency Circulates Both at Home and Abroad, but the Second Country’s Currency Only Circulates at Home

Extending the Framework: Accounting for Alternative Operating Procedures by the Monetary Authorities

Scenario 1: Each Country’s Central bank Is Committed to not Allowing Its Currency to Appreciate and Thereby Lose What They Perceive to Be a Comparative Advantage Due to an Exchange Rate Appreciation

Scenario 2: Each Country Central Bank Is Committed to Not Allowing the Other Country’s Currency to Depreciate and Thereby Prevent the Other Country From Gaining What They Perceive to Be a Comparative Advantage Due to an Exchange Rate Depreciation

Scenario 3: One of the Country’s Central Bank Decides to Fix Its Exchange Rate to the Currency of Another Country

The Mechanics of Operation of a Strict Fixed Exchange Rate Mechanism and Its Impact on the Domestic Monetary Base

The Nonreserve Currency Country Equilibrium Relationships

Reining in the Reserve Currency Country

That Relative Price Thing

What if the Central Bank Chooses to Hold a 100% Inventory of the Commodity Used as Reserve? How Safe Is It Against a Speculative Attack?

Chapter 24: Monetary Views: Part I

Abstract

Is There an Inflation/Output Trade-off?

The Phillips Curve and the Dual Mandate

Rules Versus Discretion

Chapter 25: Monetary Views: Part II

Abstract

The Monetarist Views

Can the Fed Control the Quantity of Money?

Exploring the Left Side of the Equation

The Case for a Quantity Rule

The Case for a Price Rule

The Financial Crisis

Chapter 26: The Greenspan Monetary Rule

Abstract

Chapter 27: Transparency and Rule-Based Monetary Policy

Abstract

Deconstructing Monetary Policy

Anticipating Monetary Responses

A Concern: Can the Fed Replicate Its Precrisis Success?

Chapter 28: A Single or Dual Mandate

Abstract

The Interaction between the Mandates and the Organization of the Monetary System

Evaluating the Post-Crisis Monetary Policy

Chapter 29: The Demise of the Global Price Rule

Abstract

The Elements of the Global Price Rule

What Could Go Wrong?

Nonreserve Currency Issues

Chapter 30: The US Inflation Rate

Abstract

The Different Specifications

The Results

A Final Thought

Chapter 31: The Exchange Rate and the Rest of the World Inflation

Abstract

The Perfect Substitutability or Fixed Exchange Rate

The Textbook Flexible Exchange Rate

The Partial Substitutability Case

Empirical Relationships: The Exchange Rate Changes

Empirical Relationships: The Inflation Rate

Section V: The Financial Crisis—A Case Study

Chapter 32: The Financial Crisis: Inflection Point or Black Swan?

Abstract

Did We Find a Black Swan?

An Inflection Point?

Hindsight or Foresight?

The Parallels

Chapter 33: The Financial Crisis: Could We Have Avoided It or At Least Minimize Its Impact?

Abstract

The Credit and Leverage Economy (October 21, 2004)

The Anatomy of a Crisis

Japan Is a Perfect Example

A Generalization of the Crisis Preconditions

How to Deal with a Potential Crisis

How Resilient Is the US Financial System?

Appendix A: Credit Creation Constraints

Chapter 34: The Roadmap to a Backcast

Abstract

A Primer on the S&L Crisis

The Impact of the Regulatory Changes on the S&Ls

Spillover Effects

The Fannie and Freddie Crisis

A Primer on the Financial Crisis

Spillover Effects

Were the RTC Lessons Useful?

Chapter 35: Credit, the Carry Trade, Tax Rates, and the Residential Real Estate Market: A Retrospective

Abstract

The Democratization of Credit and Income Smoothing

The Role of Real Estate in the Credit Equation

The Advantages of Owner-occupied Residential Real Estate

Financial Innovations and the Loss of Transparency

The Credit Explosion

Excessive Credit Creation and the Economy

The Fed’s Role and the Carry Trade

Did the Carry Trade Fuel the Market?

The Making of a Storm

The Anatomy of a Crisis

Chapter 36: The Fed’s Crisis Response

Abstract

The Greenspan Fed’s Preemptive Strike

Two Wrongs Do Not Make a Right

Some Money and Banking Mechanics

Helicopter Ben’s Crisis Response

Chapter 37: Monetary Policy and the Interaction Between the Money and Credit Markets

Abstract

Money Market Disturbances, Uncertainty, and the Demand for Cash

The Interaction Between Price Stability and the Credit Markets

Money Demand and Supply Shocks

Chapter 38: Is Central Banking an Art?

Abstract

Low-Interest Rates and Keynesian Monetarism

Yield: Documenting the Effects Induced by Low-Interest Rates

What Does the Data Tell Us?

Keynesian Monetarism’s Track Record

Monetary Policy’s Burden

Chapter 39: After the Deluge?

Abstract

A Brief Description of the Problem and Economic Conditions as We Saw It

The Monetary Base, Bank Credit, Money of Zero Maturity, and the Financial Crisis

The Fed’s Crisis Response

The Monetary Aggregates After the Crisis

Inflation Rate, Interest Rates, the Slope of the Yield Curve, and the Credit Spread

How Distorted Is the Fixed Income Market?

Chapter 40: The Panic of 2008: Cause and Consequences

Abstract

Bad Luck or Bad Policies

Lack of Regulation

Searching for Causes and Cures: The Carry Trade

Searching for Causes and Cures: The Government-Sponsored Enterprises

Searching for Causes and Cures: The Homeowners

Searching for Causes and Cures: The Financing Mechanisms

Searching for Causes and Cures: Wealth Versus Income

Searching for Causes and Cures: Capital Adequacy Ratios

Searching for Causes and Cures: The Fed and Other Government Agencies

Some Conclusions

Chapter 41: Realignment?

Abstract

A Government That Works?

Failure or Success, What Does the Data Say?

Policy-Induced Moral Hazard and Substitution Effects

Multiplier Effects?

The Politics of Special Interest Groups

Class Warfare, the Politics of Redistribution, and the Slow Growth Trap

A Lasting Legacy?

Summary and Implications

Chapter 42: Obamanomics: An Evaluation

Abstract

Was President Obama Dealt a Bad Hand?

The Misery Index

The Ranking of the Economic Performance

Improvement Over the Initial Economic Conditions

Transformational Change or Trickle up Economics

Section VI: China—A Case Study

Chapter 43: China in a Global Economy: An Interpretation

Abstract

Weeding Out the Wrong Theories

The Possibilities Under a Floating Exchange Rate System

The Fixed Exchange Rate Scenarios

Where Is China Today?

Chapter 44: China’s Wealth, Income, and the Savings Rate: The Complete Markets Case

Abstract

Wealth, Income, and the Savings Rate: The Incomplete Markets Case

Implications

Appendix to Chapter 2: Consumption, Savings, and Net Wealth

Chapter 45: Examining China: Purchasing Power Parity, Terms of Trade, and Real Exchange Rates

Abstract

A Purchasing Power Parity World

Nontraded Goods: A Violation of PPP?

Rates of Returns and Relative Price Differentials Across National Economies

Purchasing Power Parity Versus the Terms of Trade

Was China’s Currency Overvalued?

Chapter 46: Examining China: Economic Growth, Exchange Rates, and Relative Stock Performance

Abstract

A Tale of Two Countries

Are There More Than Two Tales?

Which Tale is the Relevant One?

Can Currency Manipulation Affect the Trade Balance?

What Do We Know

Chapter 47: Examining China: Monetary Policy, Inflation Potential, and the Organization of the Monetary System Under a Floating Exchange Rate System

Abstract

China’s Monetary Policy and the Floating Exchange Rate Experience

The Central Bank Reaction to the Floating Exchange Rate Experience

Chapter 48: Examining China: Monetary Policy, Inflation Potential, and the Organization of the Monetary System Under a Fixed Exchange Rate System

Abstract

The RCC and NRCC Countries

China’s Monetary Policy and the Fixed-Rate Experience

Chapter 49: Examining China: China as a Nonreserve Currency Country

Abstract

The Fixed Exchange Rate Mechanism Link to the Domestic Money Supply

The Limits to the Central Bank’s Money Creation Ability

Domestic Credit Creation: Too Loose or Too Tight

The Balance of Payments

Domestic Credit Creation and Hot Capital Flows

Grading China’s Performance as a NRCC

Index

Copyright

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Preface

The writing of this book is the culmination of a long journey that began in the south side of Chicago several decades ago. In retrospect, attending the University of Chicago was a great professional decision. There was no better place to be if you were an economist than Hyde Park during the early 1970’s. The stars were properly aligned. The economics department and business school were full of luminaries, not only with future Nobel Prize winners but also many professors who, even though they did not win a Nobel Prize, were or would later become giants in their field. The economics and finance workshops were amazing. Anybody who was somebody in the profession either presented at the workshops or at least tried to do so. I feel fortunate to have been there. It was an amazing time.

The University of Chicago Economics department played a major role in shaping the way I view the world and interpret unfolding and past events. Although many people deserve credit, a few had a disproportionate influence in my economic education. Early on, one of the professors teaching the introductory price theory sequence made an incredible impression on me. It was none other than Gary Becker. From time to time I re-read his textbook, Becker (1971). It still amazes me how brilliant and insightful he was.

After the Becker price theory sequence, I began to focus on preparing for the core exams. As I had not majored in economics, I decided I needed to shore up my international economics. I figured that an MBA course on the subject would be what I needed to be reasonably prepared for the core. It was a decision that led me to meet Arthur Laffer, with whom I would develop a friendship that lasted many years. Laffer’s lectures introduced me to the general equilibrium framework used in international economics. It piqued my interest on the subject and I followed up with Harry G. Johnson’s lectures. Harry G’s lectures helped me become an expert on the two-sector model.

The international economics sequence turned out to be a good and important decision for my professional career. I was introduced to the teachings of Robert Mundell, which helped me to further expand my economics portfolio in a systematic and coherent way. But that was not enough. My interest in policy led me to Al Harberger’s lectures on public finance, project evaluation, and economic development. Alito, as we affectionately called him, embodied all of the characteristics that I value in an economist: great intellect combined with an ability to apply his insights and knowledge to real life problems faced by different economies. Two of his published papers had a great deal of influence in my career path. One was The Incidence of the Corporation Income Tax (1962). That opened my eyes to the fact that a tax on one factor of production could have a devastating impact on a completely different factor. The other paper had to do with Alito’s famous welfare triangles (1964). The article illustrated what H. Gregg Lewis called a practical general equilibrium analysis. Alito’s so-called reaction coefficients were nothing more than reduced form coefficients of the general equilibrium’s response to the changes in distortions. One insightful point made in this paper was that all the properties of the traditional demand and supply curves applied to this general equilibrium-derived demand and supply curves. The Harberger approach opened my eyes to the possibility of a practical general equilibrium analysis, going well beyond the ability of analyzing the impact of tax rates and other policy shocks to an economy’s equilibrium conditions. Alito had the biggest impact on my economic profession. I am really proud to be one of his boys, as his wife Anita fondly called us.

During my time in Hyde Park, the Efficient Market Hypothesis (EMH) was all the rage, so I decided to take Gene Fama’s course to find out what it was all about. While exciting and interesting, the finance literature created a bit of a problem for me. Most of the presentations assumed that the individual investor was a price taker and that meant to me a partial equilibrium analysis, not a general equilibrium one. The second problem was that the finance literature did not provide a simple way in which one could link the effects of policy changes to some of the coefficients, as traditional economic analysis does. In part, that was due to the fact that EMH in its strong form assumed that all the relevant information is included in the asset prices. Therefore EMH was not amenable to establishing a relationship or link between the policy variables and the reduced form coefficients. Robert Barro’s teachings and the Rational Expectations Hypothesis (REH) literature solved that problem. It showed me that one could develop a structural model, decompose the policy variables into their expected and unexpected components, and solve for the reduced form coefficients measuring the impact of anticipated and unanticipated policy shocks [1]. The introduction of adjustment costs generated some interesting dynamics that were quite different than those produced by an instantaneous adjustments to a new equilibrium. The efficient market and rational expectations hypothesis added a new dimension to my views of the world. This was a promising approach, but it created another problem. The average investor may not have the sufficient math and statistics skills to deal with such an approach. All of this brought me full circle. To borrow an H. Gregg Lewis phrase, the issue at hand was how to develop a practical general equilibrium analysis that the average investor could use, that would also be consistent with the profit maximization efficient markets/rational expectations hypothesis, while also allowing the investor to incorporate policy changes into the prospective analysis. For me, the starting point was the Harberger triangle combined with the Mundell-Johnson-Laffer monetary approach to the balance of payments was the way to go and that gave rise to our current undertaking.

The idea behind the new project was to outline a framework that combined elements of finance and international economics in a general equilibrium setting. One benefit of the practical general equilibrium analysis approach is that it allows one to weed out inconsistencies in an economic analysis, as well as identifying the inconsistencies in the policy recommendation derived from the different points of views. This insight was seared in my mind when I was a graduate student and took a summer job with the finance minister of the Dominican Republic. At the time, the finance minister assembled a group of ten economists and each one was charged with leading a different project or policy initiative. The list of projects included a group studying export promotion policies, while another group focused on import substitution policies. At a meeting with the minister, I pointed out that these two projects were inconsistent with each other. If the export promotion was successful, a general equilibrium budget constraint would suggest that imports would also rise. Think of the extreme case where everything the country produced was exported, then everything the country consumed would have to be imported. The import substitution would have the opposite effect. If in the extreme the country could produce domestically everything it previously imported, all the resources that were previously devoted to the export sector would now be employed there, and hence exports would fall. The lessons learned during my real world experience were quite powerful. I understood the importance of a general equilibrium framework. At least it helped identify inconsistencies in policy recommendations. Generalizing this insight takes us to the interesting proposition that, at the very least, general equilibrium modeling forces one to develop a consistent view. While this does not assure that one has the correct view of the world, the process weeds out models where the explanations for the different components contradict each other or do not add up to a consistent framework. The general equilibrium approach only includes logically consistent explanations. As such, it reduces the number of possible solutions and increases the odds that one is on the correct path. It may also allow for a quick approximation of the new equilibriums that a policy shock may cause.

We hope to outline a parsimonious, yet realistic, representation of the global equilibrium conditions that could be used to derive practical insights. We begin the journey by attempting to show that many of the terms and insights developed using the modern finance literature, such as the efficient market hypothesis, are easily derived using the simple concept of demand and supply elasticities. We contend that the economic approach offers the opportunity to anticipate changes in the parameters or reaction coefficients, this in the context of the finance literature means that the macroeconomic analysis may allow us to anticipate the changes in the betas and other parameters used in the modern portfolio theory. That, in turn, may allow us to make better investment decisions. The remainder of the book contains six parts, each focusing on a different topic. The approach is a simple one; we begin with the broadest concepts such as mobility and arbitrage and as the sections progress we add additional considerations such as changes in terms of trade, the trade balance, and the balance of payments.

The organization of the different sections posed a major challenge for us. We had to choose between placing the building block chapters at the beginning or the end of the different sections. The reason for placing the building block chapters at the end of the sections is that the building block chapters describe in algebraic form many of the relationships developed in earlier chapters. The algebra and formal derivation of the different concepts may intimidate some of the readers. While the building block chapters are not necessary to illustrate the concepts formalized in the chapters of each of the sections, ignoring the building block chapters could deprive the reader from some of the additional insights generated from a formal derivation of framework building blocks. In the end, we concluded that the formal derivation of the different propositions merits placing the building blocks up front and thereby risk alienating the readers intimidated by the algebraic formulation. In each section, we label a chapter as a building block that formally develops the theoretical foundation for the component of the general equilibrium approach that we hoped to outline in the book. Collectively, the different building blocks add up to the general framework that we develop in the book. The remaining chapters in each of the sections apply the basic concept developed in the first chapter of that section to actual policy or investment issues. The hope is that these examples illustrate the applicability of the concepts in the context of the framework being developed. The last two sections of the book apply the different concepts developed in the building blocks to two different case studies: the financial crisis and Chinese economic miracle. The hope is that these two case studies show the flexibility and robustness of the basic framework outlined in the different building blocks.

Simplicity in the outline of our framework would be a virtue; the simpler the framework, the easier it is for the average investor to incorporate the basic framework into their decision-making process. We also look for a robustness and flexibility that allows the individual investor to modify the basic framework to suit their needs, as well as to allow the investor or analyst incorporating additional features that further expand the framework’s capabilities. Simplicity and elegance do not matter if the model does not produce sensible outcomes. Hence, we should also add the explanatory power of the framework as a criterion of paramount importance. Next, we need to discuss the difference between the explanatory power and causality. We do not claim, nor do we represent, that the statistics and data presented in this book provide proof of a causal relationship. In many cases the relationship is assumed and all we show is that the evidence is consistent with our framework. Recall that our objective is to develop a framework that helps us make consistent choices. A framework that helps us weed out bad ideas and theories. It was our objective that the approach outlined in this book makes it easier for an investor or policymaker to analyze the impact of policy changes and other economic shocks on the overall equilibrium conditions for global and different national economies.

We foresee several possible applications of the framework. The policymakers could focus on the impact of the different policy combinations on the equilibrium values for the variables of interests such as real GDP growth, inflation, the trade balance, the balance of payments, and capital flows, among others. In turn, the investors would also add the impact on the rates of returns of the different factors across different localities. If adjustment costs are positive, the long run equilibrium will not be reached instantaneously. Knowledge of the long run and the adjustment process could be very useful to investors and the information gained from this analysis could easily be incorporated in the development of a successful investment or portfolio strategy. In short, this book summarizes much of the progress we have made over the last several decades. We do not claim to have reached the end of the road. Hopefully the user may feel, to the extent that we succeed or get closer to our goals and objectives, that we have made progress toward our final goal.

During the last decade, I have been fortunate to run into Andy Wiese. We have worked side-by-side conducting research and gathering data. We have coauthored many articles. For others that he did not coauthor, Andy was quite instrumental in their publication, preparation, and data gathering. Without him many of the publications under my authorship—including this project—would not have been possible. For that reason I consider him a coauthor.

Jaime Olmos selflessly devoted a great deal of time proofreading many of the chapters and for that we are indebted to him. We have benefited from discussion and conversations with many colleagues and friends, who in one way or another have had a major impact on how we see the world. To all of them, our sincere gratitude for allowing us to benefit from their wisdom.

Victor A. Canto

La Jolla, CA

Reference

[1] I tried this approach early on in my career, see Canto, Joines and Webb (1984). But even in a very simple model, the math gets difficult in a hurry, creating a major obstacle for most of the general population.

Introduction: Asset Allocation: Indexing, Smart Beta, and ValueTiming

According to a common saying originated with a Chinese proverb, the journey of a thousand miles begins with a single step. We have taken many steps in our quest to develop a framework broad enough to analyze the effects of global shocks to the global economy, as well as on the equilibrium relationships among the different nations of the world. With every additional step we get a bit closer to our goal. This is one more step on that quest. Our goal is to combine the best of the developments in finance literature with a general equilibrium macroeconomic framework into what we have called a ValueTiming strategy.

It has been our experience that, in general, many people trained in finance and/or economics have a compartmentalized view of the two. They behave as if the two are totally independent and there is no direct linkage between the two. Yet we know that economics is much more general and that it encompasses finance as one of its specialties. But there is more to this. In fact, we can show that many of the key concepts of modern finance as embodied in the Capital Asset Pricing Model (CAPM) [1] have a counterpart in the traditional textbook economic framework. In most cases, there is a one-to-one correspondence between the CAPM terms and some textbook economics concepts. At the risk of mixing metaphors, we are going to argue that finance and economics are two sides of the same coin. This is very important to us. What some may view as very esoteric and abstract concepts in finance literature, they may have a simple explanation in the context of traditional economic analysis. More importantly, one can develop a link between the economic shocks caused by policy changes, natural events, or innovations and the parameters used in finance literature. This allows us to relate every day issues and concepts used in the finance literature. In effect, we view this exercise as a translation of many ideas of modern finance literature into traditional, everyday economic concepts. In what follows, we use the CAPM as our version of the finance literature to illustrate the mapping or correspondence between the CAPM components and the simple textbook economic concepts.

Finance: One Side of the Coin

It is striking how little most people understood about risk as recently as three decades ago. Fortunately, developments in modern portfolio theory provide a framework for addressing the way risk can affect expected returns. We now have the CAPM, which looks at the relationship between an investment’s risk and its expected market return [2]. One major insight of the CAPM is that not all risks should affect asset prices. For example, if two assets are negatively correlated and move in opposite directions, the volatility of a portfolio consisting of these two assets would be much lower than that of a portfolio consisting of only one of the assets. The latter represents an example of a risk that can be diversified away by combining it with other assets in the portfolio. If the asset does not add to the volatility of the portfolio, it should not be priced for risk, or more plainly, investors would not demand additional return or a premium over and above the current expected return.

In the context of the CAPM, the valuation of a risky asset has two components. One is the time value of money represented by the risk-free rate, Rf. It compensates the investors for placing money in any investment over a period of time. The second component calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure, beta (β), of the nondiversifiable risk as related to the covariance of the asset with the market, and scaling the returns of the market, Rm, by the beta measure. That is:

(I.1)

Hence, investors are compensated in two ways: the time value of money and their risk taking. The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free instrument plus a risk premium. Using the previous equation, one can calculate the security market line, which describes the possible combinations of risky investments that maximize the expected returns for a given level of risk, or betas, relative to the market returns. Once the security market line is calculated, investors are free to choose the risk return combinations that maximize their preferences.

The CAPM says nothing about what determines the risk-free rate (Rf), the market volatility (σm), or market returns (Rm). And to us, knowledge of the risk-free rate, market returns, and volatility are of vital importance to an investment strategy. Hence, to determine what drives the risk-free rate and market volatility, we need an additional theory to supplement the CAPM framework. We believe that a top-down macroeconomic approach fills the void identified in this paragraph.

In the process, as the macroeconomic views are incorporated, one may be able to find a simple explanation as to why the alpha and beta of the different asset classes may change in response to policy changes, as well as to the changing economic conditions that result from these policy changes or other economic shocks. Viewed from this vantage point, finance turns out to be a branch of the much broader economic framework. Hence, borrowing a line from a famous movie, finance should say to economics, you complete me.

The Economic Side of the Coin: Elasticities

In the next few paragraphs, we provide a simple explanation for the links between the concepts of a beta in finance literature and an industry or firm’s supply elasticities, or flexibilities to respond to different demand shocks.

In the traditional textbook presentation, inelastic industries that are unable to alter production plans easily (i.e., industries with inelastic supply) change their prices to accommodate fluctuations in demand. A classic example of an inelastic industry was the airline industry before it was deregulated in 1978. Largely because of government restrictions, airlines were unable to easily expand their supply in times of increased demand. As a consequence, when more people wanted to travel, ticket prices rose. In contrast, during tough times when people did not travel as much, ticket prices fell. For inelastic industries, profitability and share prices primarily reflect changes in demand.

Industries whose elasticities are of a smaller magnitude than the economy as a whole will not be able to adjust their supply as fast as the rest of the economy. Therefore during periods of aggregate demand increases, in relation to the overall economy, they will have to ration the increased demand through above average price increases. During periods of declining aggregate demand, the inelastic industries will experience a larger than average decline in prices. The inelastic industries will experience above average profit increases during periods of rising aggregate demand and above average declines in profitability during periods of declining aggregate demand. That is the inelastic industries will experience an above average beta.

In contrast, elastic industries will adjust their production levels to accommodate the shifts in demand with little or no impact on their relative profitability. Hence, elastic industries will have a beta similar to that of the overall market.

The economic analysis also explains negative beta stocks. All one has to think is in terms of the so-called inferior goods. These goods have a negative income elasticity of demand. That is, when the economy-wide income rises, the demand for inferior goods decline, producing a negative beta. The magnitude of the beta is directly related to the price inelasticity of supply. When all is said and done, the combination of income elasticities and price elasticities can be used to explain positive and negative betas of different magnitudes. This relationship between profits and the economy closely matches the high beta concept, a beta in excess of 1, of the CAPM that dominates much of modern finance.

These insights lead to a possible investment strategy: forecasting changes in the level of economic activity, in general economic conditions; and in aggregate demand is of critical importance for the cyclical investor. For inelastic industries, profitability oscillates with the vibrancy of the economy. Profits will rise and fall faster than the economic activity for the inelastic industries.

The knowledge of the elasticities offers the possibility of two types of investment strategies for investors. Combining the investments in industries with different elasticities will reduce the volatility of the cash flows generated by the investment. In the context of the CAPM, it reduces the riskiness of cash flows. A second strategy would be for those who can anticipate the shifts in aggregate demand. They can pursue an active investment strategy that focuses on buying the high beta during upswings and selling them during downswings, and perhaps buying the lower beta or none at all. The counterpart within the context of the CAPM is an active beta strategy. It requires knowledge or a forecast of the changes in returns of the overall market.

So far we have established a one-to-one correspondence between the CAPM and the elasticity concept. That is why we believe that they are two sides of the same coin.

Are Betas or Elasticities Exogenous?

The empirical data shows that industry responsiveness to economic shocks is not invariant to economic regulations. Our analysis also suggests that the beta does not have to be constant over time. It can change.

The Oil and Airline Deregulation Experience: The oil price controls in the 1970s reduced the ability of the domestic industries to respond to increases in demand and we inadvertently shifted demand to the Organization of Petroleum Exporting Countries (OPEC) cartel. The increased demand for foreign oil and reduced supply elasticity at home increased OPEC’s monopoly power. President Reagan decontrolled the price of oil and the beta of the oil industry declined dramatically [3].

A close look at the airline industry demonstrates this. Deregulation, by way of the US Airline Deregulation Act of 1978, changed the shape of the airline industry’s supply curve. The entry of new carriers almost instantly increased competition and industry prices became more elastic. Demand, in short, was largely met with the arrival of new airlines. Once the scheduled flight was operational, independent of which airline was flying it, empty seats drove the market. With an occupancy rate below 100%, the marginal cost of filling the extra seat was very low. So competition for the marginal, elastic passenger pushed the marginal price of coach tickets down. The industry lost most—if not all—of its pricing power in the mass market. Fluctuations in demand following deregulation were satisfied primarily by altering production levels without the industry experiencing significant changes in profitability. In other words, there is very little correlation between the rates of returns and the level of economic activity. Though profit per unit (profitability) will remain similar, profits will rise and fall in proportion to the level of economic activity. In the context of the CAPM model, the elastic industries will have a beta close to 1. Their profits will move in line with the pace of economic activity.

The Technology Story: The absence of substitutes (i.e., inelasticity of supply or high beta and alpha) can be used to explain some of the effects of the technological revolution of the last three decades. The changes are nothing short of a miracle comparable to the industrial revolution. It is hard to imagine a world without a personal computer, the internet, or a cell phone. These technological innovations have transformed the world in which we live. They have made our lives better and for that we should be grateful to the pioneers of industry.

Most news stories about the death of Steve Jobs described him as a visionary who created products we did not know that we needed. In economic terms, this means that initially he was the sole supplier, that is, the supply was inelastic, and if we realized we needed the product, then the demand for these gadgets would explode. The innovations made Steve Jobs right; they were creating products that the market did not know they really needed them, like iPads. The innovations and lack of alternatives also generated an alpha effect. Demand did explode and the gadgets made Steve Jobs iconic, as well as a very wealthy man. Looking through other segments of the industry, we have Larry Ellison at Oracle, Irwin Jacobs at Qualcomm, and Bill Gates at Microsoft. They all led companies that produced attractive and unique products, that is, inelastically supplied with positive alpha. As the demand for and use of these inelastically supplied products surged, these companies’ market capitalization rose and made some of their original investors billionaires.

Once again, the supply elasticity combined with a surge in aggregate demand easily explains the success of these companies, as well as the vast amount of wealth created for their investors. While to some these increases in wealth may be excessive, people fail to take into account the improvement these products make in our lives. If one were to add the increased well-being to all the users, we would venture to say that the sum of the benefits would far exceed the net worth or increase in wealth of the creators of these products. The world is better off with these products than without them.

Linking the Elasticity Concept to CAPM and the Beta Concept

The airline and oil industries examples show how government regulation may significantly alter the response functions of an industry to changing demand conditions. But in the same way, technological innovations and other variables can affect the supply and/or aggregate demand functions of an industry. Technological innovations can also be used to explain the measured alpha of the different industries, countries, or sectors. An increase in aggregate demand will result in an above average performance of the inelastic factors and during economic downdrafts, it would produce a below average returns for the same factors. That is, the behavior is qualitatively the same as the one generated by an above average beta.

Positive alpha industries can be characterized as both inelastic and experiencing an increase secular aggregate demand, which may come as the result of technological innovation, government regulation, or a number of other factors. Additionally, due to supply constraints, the industry will not be able to accommodate all of the increase in demand. Hence, prices will ration the available output. All of this suggests that the beta in the CAPM can be replicated by the elasticity of supply of different factors.

Global Equilibrium: The Overall Market

In the context of the CAPM, once one knows the risk-free rate, alpha, and the beta, one has all the information needed regarding the assets and the construction of an investment portfolio. Yet the approach has some potential weaknesses.

One obvious concern with regards to the CAPM is that it provides a valuation relative to the market and risk-free rate. In fact, we know that a weighted average of all assets will add up to the market, which means that a weighted average of all the alphas is zero and a weighted average of all betas is 1. Hence, we can infer from this that any asset with a positive alpha has to have a counterpart with a negative alpha. Furthermore, a positive or negative alpha has to be temporary; otherwise investors could flock to these stocks to generate persistent returns in excess of the ones prescribed by the CAPM. The increase in aggregate demand would result in a change in the pricing of the asset class and the capitalized value of the alpha will be incorporated in the valuation of the asset class. Simply put, the argument suggests that any alpha effects will be temporary.

There is a parallel in the context of the supply and demand analysis presented here. Beta is the measure of a portfolio systematic risk in relation to the overall market, and the alpha, the measure of excess returns. Inelastic industries generate above average returns during periods of aggregate demand increases and below average return during periods of declining demand. However, we contend that competition, new entrants, capacity expansions intended to capture high and/or rising profits will have the effect of eroding or reducing the alpha, as well as the inelasticity or high betas. Put another way, competition will tend to erode the excess rates of return. Therefore, over time we expect the alphas to dissipate and the long run elasticities converge to the economy’s. That is as new entrants compete in the market place, the alphas and betas will converge to the economy’s long run value of a zero alpha. Any excess return will decay over time. Understanding the rate of decay may improve a portfolio’s long run performance.

Another void within the CAPM is that it says nothing about what determines the risk-free rate and the overall market volatility and rates of return. We believe that this is a void that economic analysis can fill. And this belief leads us to the next point: anticipating the changes in the market rates of return and volatility, as well as the changes in the risk-free rate will impact the choices suggested by the CAPM. As such, it would impact the portfolio strategies based on the CAPM. If that is the case, then economic analysis could add a great deal of value to a CAPM-based investment strategy.

Financial Economics: The Marriage of Finance and Economics

We have shown that there is a clear correspondence between finance and economic literature and that the CAPM alpha and beta concepts can be easily explained in simple economic terms. The elasticity concept is directly related to the beta concept. Inelastic factors tend to outperform during periods of rising demand and to underperform during periods of falling demand. The alpha effect can be explained in terms of unique characteristics, that individuals can do the job of other factors of lesser skills and ability. We also argued that government regulations and taxes may also affect the elasticity of supply/the beta, and quite possibly the alpha of the different factors.

The examples previously mentioned suggest that a beta or elasticity is dependent on the economic environment. Government regulations can significantly impact the rates of returns of businesses located within their tax and regulatory jurisdiction. We have shown elsewhere that the burden of these regulations fall disproportionately on the immobile factors of production within the jurisdiction. Similarly, the decline in regulatory burden results in a disproportionate benefit on the immobile factors of production. In short, there is a location beta/elasticity that is the result of the regulatory/tax jurisdiction. There is a link between the changing environments to the policy shocks. Supply and demand elasticities, whether it is for a country, industry, or a factor of production, are determined by government regulations and economic policy.

In a world economy, the demand for a country or an asset class is determined in part by the sum of the monetary and fiscal policies of the world’s countries. Trade policy also determines the mobility of goods and services along with factors of production across national borders. In short, regulatory, trade, and tax policies all have a part in determining the elasticity of responses to changing economic conditions.

These insights provide us with a clue as to the reaction function or how different variables respond to economic shocks, whether they are caused by government policies, innovations, or other economic shocks. The changes in the ability to respond to these shocks alter the alpha and beta of the different asset classes. This approach also suggests that explicit policy changes may alter the reaction coefficient and, as a result, the government may be able to achieve certain policy objectives. An investor who pays attention to government regulations and technological innovations may be able to anticipate industry responses to aggregate demand shocks. In doing so, he may be able to anticipate changes in the alpha and beta coefficients of the different countries, industries and from there implement a successful industry-selection strategy. By anticipating and understanding the impact of these policy changes an astute investor will be able to position their portfolio to take advantage of the impact of the policy changes in the economy.

The CAPM: Portfolio Construction

The attraction of the CAPM is that it offers a powerful and intuitive prediction about how to measure risk and the relation between expected returns and risk. No wonder that the CAPM has become the dominant paradigm in the asset allocation business. However, many of the implications of the CAPM are dependent on the simplifying assumptions made in the derivation. Despite its mixed empirical performance, some of which we will discuss later on, we now think differently about the relationship between expected returns and risks and how investors should allocate their investment portfolios.

According to the CAPM, the only risk that should be priced is the risk that cannot be diversified away, the residual risk or systematic risk. The CAPM is firm on this point. What should matter to the investor, therefore, is the incremental volatility on the overall portfolio volatility—not the individual investment volatility. When considering adding an asset to a portfolio, focus on two different variables is needed. The asset may impact both the portfolio return as well as the overall volatility. Hence the investor has to determine whether the incremental investment adds to the risk or volatility as well as the return of the overall portfolio. In turn, the investor then has to decide whether the incremental return is sufficient to compensate the investor for any added risk to the overall portfolio. Another way of putting the investor choices is that they must decide whether they are more concerned about their portfolio relative risk, measured as the tracking error relative to a benchmark or whether they are more concerned about their portfolio total risk, measured as the standard deviation of returns.

Nobel Prize winner Bill Sharpe has come to the rescue of investors who must perform this task. Because of him, we now have the Sharpe Ratio at our disposal [4]. This well-known formula is useful for evaluating potential investments and determining when to add additional assets to a portfolio. If a potential addition to a portfolio improves the Sharpe Ratio, the asset in question adds to the return of the portfolio over and above the return required to compensate for the increased volatility of the new portfolio. Thus, adding the asset should improve the overall portfolio performance. Needless to say, from an economic perspective, investors and market participants would prefer policies that produce an improving economy with little or no volatility; most often that is not the case. Investors must decide whether a macroeconomic policy shock’s impact on total returns is sufficiently large to compensate the economy for the uncertainty and/or volatility the economy must experience as it approaches the new equilibrium. The Sharpe Ratio is tailor made to address this issue.

The CAPM: Active Versus Passive Investing

An efficient portfolio is defined as a portfolio that contains returns that have been maximized in relation to the risk levels that individual investor’s desire. In a market that is in equilibrium, where the number of winners and losers must balance out, adding one additional asset class or stock does not increase the portfolio’s risk return ratio. This means the portfolio containing risky assets with the highest Sharpe Ratio must be the market portfolio. In other words the market portfolio is an efficient portfolio and as such denotes a great starting point in any portfolio strategy.

The Case for Passive Investing: For those who believe that markets are in continuous equilibrium, the insight that holding the market portfolio at all times yields the highest Sharpe Ratio is an important one. Investing suddenly seems very simple; the market portfolio is an efficient portfolio. If we add to this, the assumptions of market efficiency as well as the common argument that there is not much one can do about economic shocks as one cannot anticipate most shocks and we end up with the conclusion that one cannot beat the market. We can see the argument that we are much better off as a result of the insights on risk developed by modern finance. For example, we have a very clear risk return trade-off mechanism. It is summarized in the efficient frontier. In this context the CAPM may very well be an appropriate technique to optimize investment strategy.

In the context of a traditional economic approach, the problem faced by investors is to find a mix of investments for which the weighted average elasticity maximizes the returns while at the same time minimizes the volatility of the returns for each level of returns. The various combinations describe the efficient frontier. And the investors based on their risk return preferences choose a point in the efficient frontier.

A low cost index portfolio will over the long term minimize management costs without significantly impacting long run performance. As one can see from the previous lines, the case for passive indexing is very compelling. Once one buys into the passive strategy, it follows that the market portfolio may be the way to go. It is an efficient way to achieve the broadest diversification possible. As we will show next, this insight is very important even for those of us who believe in implementing active strategies from time to time.

Asset Allocation as a Beta Strategy

When one assumes an unrestricted risk-free borrowing and lending, the expected return on assets that are uncorrelated with the market (which is the asset’s expected return less the beta, times the expected market returns less the risk-free rate) must equal the risk-free rate. For those who keep score this is the Sharpe-Lintner version of the CAPM. With unlimited risk-free borrowing and lending, there is no alpha or risk adjusted excess return. In other words, managers do not have superior information.

All an investor can choose is the appropriate beta mix that is the appropriate elasticity mix. Hence, the asset allocation process becomes one of estimating the betas and or elasticities of the different asset classes to finding the combination of funds that produces the ratio of volatility to expected returns consistent with the investors’ preferences or risk tolerance. Once this is done, buying the cheapest funds with a given beta exposure will maximize the investors returns, hence the case for Exchange Traded Funds (ETFs).

Smart Beta

The marketing of the Smart Beta strategies is very interesting. The proponents of these strategies argue that in the past, investors had two choices. Those who believed markets were largely efficient or doubted their ability to select skillful managers would choose low-cost, capitalization-weighted index funds. On the other hand, those who believed markets were inefficient and had confidence in their manager selection process would choose active management approach. In contrast, the Smart Beta proponents argue that both types of strategies have their drawbacks. They point that cap-weighted equity index funds automatically increase their exposure to stocks whose prices appreciate and reduce their exposure to stocks whose prices fall. As a result, the proponents of the Smart Beta argue that cap-weighting tends to overweigh overvalued securities and underweight undervalued ones.

Instead of accessing this market exposure via traditional cap-weighting, Smart Beta strategies advocate the use of alternative-weighting schemes to increase the portfolio exposure toward certain factors. In theory, Smart Beta strategies preserve the typical benefits of traditional capitalization-based strategies, such as broad market exposure, diversification, and liquidity. It also offers the benefits of passive approaches such as transparency, consistency, predictability, and low cost, while providing the presumptive benefits of active investing styles. As such, the Smart Beta strategy offers investors either a third choice or a better and improved second generation of index investing. Smart Beta offers the promise of delivering the best of both active and passive investment strategies [5].

The Objective: Smart Beta strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio holdings on the basis of characteristics other than market capitalization. The Smart Beta approach aims to develop a transparent, consistent investment process to explicitly capture a desired factor (or multi-factor) exposure relative to the cap-weighted market portfolio; the strategy offers the possibility for customization. It provides a