Consumers, businesses, and government all benefit from low borrowing costs. But on the other side, savers and investors earn almost nothing on their cash balances. This has been the case in most months since 2008, when the Fed cut short-term interest rates to near zero. Worse yet, investors are actually losing wealth in real terms. The inflation-adjusted yields on short-term Treasury securities have been negative in most months since October 2010. (Nominal yields reflect the stated interest rate, while real yields are adjusted for inflation.)

Earning negative real yields on short-term fixed income is not unprecedented, as shown in Figure 1. In fact, inflation has exceeded nominal interest rates in several post-war periods. This graph plots nominal and real yields of one-month Treasury bills, which are considered the equivalent of cash. The gap between the two lines is the inflation rate.

Figure 1: One-Month Treasury Bills
Nominal vs. Real Yield (April 1953–June 2011)

The real (inflation-adjusted) yield is computed using trailing 12-month changes in the Consumer Price Index. Source: Federal Reserve Economic Data

Negative real yields have occurred during periods of high interest rates (early 1980s) and during periods of low interest rates (2010–11). Regardless of the scenario, negative real yields cause investors to lose purchasing power. Keep in mind that the graph shows yields only and not total return, which also would reflect price changes resulting from interest rate movements.

You may note that some negative real yields have occurred during recessionary periods, when the Fed was cutting interest rates to spur a recovery. These times also may be when investors are most tempted to flee the capital markets for the perceived safety of cash. Investors may have a host of reasons for their flight—some might want to avoid economic uncertainty or stock market volatility, while others might fear that impending higher interest rates will cause bonds to lose value.

This is the case for many individual investors and professional money managers today. They are reportedly shifting their portfolios to money market funds and other cash instruments with the intent to return to stocks and bonds when the economy shows signs of improvement.1 The problem with this strategy is that no one can consistently time markets, and the signs are never clear. So while investors sit in cash, their purchasing power quietly erodes.

Investors may have good reasons to hold cash—for example, to keep a portion of their assets liquid. But they should understand that holding cash has a price in real terms. Investors ultimately may lose wealth even as they try to protect it.

1. Jonnelle Marte, “The New Cash Hoarders: Smart or Not-So-Smart?” SmartMoney, June 29, 2011.

Past performance is no guarantee of future results.

The graph below documents investor behavior during the stock market downturn in 2008 and subsequent market rebound. It offers a few key lessons about investing in turbulent markets.

Figure 1: Quarterly Equity Mutual Fund Flows
Industry vs. Dimensional Relative to S&P 500 Index Performance
January 2008–September 2011

For illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Dimensional’s figures are based on net new cash from financial advisors in US-domiciled funds. Industry and Dimensional data reflect investment in US and international equity markets and do not include funds of funds. S&P 500 Index performance is based on monthly returns data. The S&P data are provided by Standard & Poor’s Index Services Group. The S&P 500 includes 500 US stocks chosen for market size. Past performance is no guarantee of future results.
Reading the Graph

First, look at the shaded graph in the background, which plots the performance of the S&P 500 Index (measured by growth of a dollar) over this period. The market began falling in late 2008 and hit bottom in early March 2009. It then reversed sharply and began a long climb.

Now consider how mutual fund investors responded to the stock market’s downturn and recovery. The orange line plots quarterly net cash equity flows for the US mutual fund industry over the same period. (Net cash flow is the difference between redemptions and purchases of shares in a mutual fund. A net cash outflow occurs when redemptions exceed purchases.) Equity fund flows were cumulatively negative over the period. Investors were redeeming more shares than they were buying, and on a net basis, capital was leaving mutual funds.1

Note that these fund industry outflows followed the stock market downturn, and net flows stayed negative even after the market rebound. Investors were reacting to the falling stock market by either redeeming their fund shares or delaying the purchase of additional shares.2 When the stock market suddenly rebounded in March 2009, investors who had reduced their exposure to equities missed a good part of the recovery.

This apparent lack of discipline is well established over longer time periods too. Industry analyses and academic research suggest that investors tend to focus on recent performance and make decisions that compromise long-term returns in their portfolio.3

Recent history illustrates why the average fund investor may fail to earn returns comparable to those of the average fund or market index. Markets change quickly, and investors must be in their seats to capture returns. Unfortunately, many investors let their emotions get in the way of participating in long-term market performance.

Now consider the upward-sloping blue line, which plots quarterly net flows into equity strategies offered by Dimensional Fund Advisors. These flows were cumulatively positive throughout the entire period, suggesting that shareholders in Dimensional’s funds continued to purchase shares during the 2008–2009 market decline and after the March 2009 rebound.

As a group, these investors did not flee stocks en masse. In fact, they did the opposite by adding to their portfolios. Their discipline positioned them for the market rebound.

A mutual fund’s net cash flows also may reveal the collective discipline—or lack of discipline—among its shareholders. In fact, the direction of net flows can impact portfolio management and performance, especially for funds invested in less liquid markets. Large net redemptions typically increase the direct and indirect costs of a mutual fund, which compromise fund returns.4 The assorted costs are not borne by redeeming shareholders but by the shareholders who remain in the fund.5 Therefore, consistently positive net cash flows are helpful to a fund’s expenses, strategy, and performance.
Summary

The large net cash outflows from US-based mutual funds since 2008 document investor reaction to market volatility, while Dimensional’s stable and positive net fund flows suggest disciplined behavior. So why would shareholders in Dimensional’s funds behave differently? One reason might be the education, encouragement, and discipline offered by their financial advisor at that difficult time, underscoring the value of sound investment advice.

An advisor’s steady hand helps investors apply discipline in all types of markets, which can positively impact individual performance over time. Moreover, when advisors influence the collective decisions of shareholders in a fund, the greater cash flow stability can prove beneficial to the fund’s strategy, cost management, and returns.

1. Mutual fund investors redeem their shares by selling them back to the mutual fund and receiving cash proceeds based on the net asset value (NAV) of the shares at day’s end. Redemption is a normal activity in a mutual fund, and liquidity is one benefit of owning fund shares. A fund manager may use inflowing cash to cover the redemptions or keep cash in a “liquidity reserve” for this purpose. When cash balances do not suffice, the manager may execute trades to raise the cash.

2. According to the Investment Company Institute, mutual fund flows do not offer a good measure of total demand for equities since funds hold only about 20% of the total US equities outstanding, with the balance held directly by individuals, institutions, and governments. Academic research offers some evidence that mutual fund flows do not drive market returns but reflect investor reaction to markets. (Roger M. Edelen and Jerold B. Warner, “Aggregate Price Effects of Institutional Trading: A Study of Mutual Fund Flow and Market Returns,” Journal of Financial Economics 59, no. 2 (2001): 195–220.)

3. A Morningstar study compared the dollar-weighted returns of the average investor in a fund with the fund’s published total return for the ten-year period ending Dec. 31, 2009. In US equities, the average investor in all funds earned 0.22% annualized, compared with 1.59% for the average fund. (Russel Kinnel, “Bad Timing Eats Away at Investor Returns,” Morningstar.com, February 15, 2010.) Lack of investment discipline also is documented among individual investors who hold common stocks directly. Those who trade frequently pay a tremendous performance penalty for their actions. (Brad M. Barber and Terrance Odean, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, April 2000.)

4. Direct transaction costs include commissions, bid-ask spreads, and price impact incurred when a fund makes trades in response to shareholder redemptions. Net outflows also may generate indirect costs on a fund by forcing its manager to alter the target asset allocation or make disadvantageous, uninformed trades to raise cash. See Qi Chen, Itay Goldstein, and Wei Jiang, “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows” (white paper, February, 2007).

5. Mutual funds typically meet a redemption based on the NAV at day’s end but may execute a trade to raise cash on the following day. The redeeming shareholder cashes out at an NAV that does not reflect the trade, and the resulting costs are borne by remaining shareholders. See: “On the Run: Examining Patterns in Mutual Fund Redemptions,” Knowledge at Wharton, http://knowledge.wharton.upenn.edu/article.cfm?articleid=2133, accessed September 27, 2011.

After the downgrade, yields on US government securities fell across the term spectrum as investors around the world fled to the safe haven of US bonds. US stocks experienced negative returns in the following weeks but logged positive performance from the day of the downgrade to month end.2

These events raise questions about whether changes in sovereign debt ratings impact the financial markets. The short answer is that results are mixed, and that many other factors affect a country’s cost of capital and stock market returns.

Regarding bond markets, history offers examples of major developed countries that experienced a credit downgrade without a significant rise in interest rates.3 Examples include Australia, Canada, and Japan, which lost their top ratings in 1986, 1992, and 1998, respectively.

Other research suggests that countries with high credit ratings may withstand a downgrade better than countries with lower ratings. One study looked at sovereign credit rating downgrades since 1990 and found that bond yields changed little among countries downgraded from the highest triple-A rating. However, countries with lower credit ratings (single A or below) experienced significant interest rate increases following their downgrade.4
Stock market impact

Another question is whether the US downgrade has played a role in the US market downturn—and research does not provide convincing evidence.

Below is a chart that summarizes stock market performance of respective countries before and after a ratings change. It is based upon a study of ratings changes made by Moody’s from 1983 to 2009. During the twenty-seven-year period, the ratings agency made seventy-one upgrades and twenty-five downgrades to governments in the developed and emerging markets tracked by MSCI.

The study identified the date of each change and logged each country’s market performance in the twelve months before and twelve months after the event. Each country’s market returns were compared to the respective market index and the excess return averaged for all events. (Excess return refers to performance above or below the respective market index, either MSCI EAFE or MSCI Emerging Markets, as appropriate.)
Figure 1. Equity market performance before and after Moody’s ratings changes, 1983–2009

Analysis conducted by Dimensional Fund Advisors using sovereign bond rating data from Moody’s Investors Services, “Sovereign Default and Recovery Rates, 1983–2009.” Returns are in US dollars and represent performance in excess of MSCI EAFE Index for developed markets and MSCI Emerging Markets Index for emerging markets. A positive excess return indicates market outperformance; a negative excess return indicates underperformance. The table reports the return of an equal-weighted, event-time portfolio. Past performance is no guarantee of future results.

The aggregate results show that stock markets of upgraded countries outperformed their respective market index in the twelve months before the rating change (13.83%), while stocks in downgraded countries aggregately underperformed the market index before the event. However, cumulative returns in the twelve months following a ratings change were almost the same for the upgraded and downgraded countries (3.87% vs. 3.73%).5

These results suggest that market prices reflect all available information and expectations about a country’s economic prospects—including the possibility of a ratings change. By the time a country’s debt rating is upgraded or downgraded, the market has already integrated the news into prices. Stock markets reflected positive economic developments prior to a ratings upgrade and negative developments before a ratings downgrade. After the event, markets did not appear to perform much differently, in aggregate.
Conclusion

This research underscores the importance of looking to market prices for signals about the fiscal health and prospects of a country or a company. Based on the foregoing analysis, markets appear to work faster and more accurately than ratings firms to assess a country’s financial condition and evaluate the potential impact on its cost of capital and equity market.

1. A sovereign credit rating is an assessment of a government’s ability to pay its debts. The US had held S&P’s top rating since 1941. S&P made the announcement after business hours on Friday, August 5, but word of the downgrade leaked during the day. Although timing of the announcement was a surprise, the downgrade was mostly expected, as S&P had issued a negative long-term outlook for the US in April and July. The other top credit agencies, Moody’s Investors Service and Fitch Ratings, have maintained top ratings for the US.

2. Two weeks following the downgrade, the US market, as measured by the Russell 3000 Index, logged a negative 6.82% return (August 5–19). However, from the day of the announcement to month end, the market returned a positive 1.6%. Russell data copyright ©Russell Investment Group 1995–2011, all rights reserved.

3. Tom Lauricella, “Lessons of Lower Ratings,” Wall Street Journal, July 30, 2011.

4. Ivan Rudolph-Shabinsky and Dennis Shen, “When ‘Risk-Free’ Isn’t Risk Free: The Impact of a US Treasury Downgrade” white paper, Alliance Bernstein, June 2011.

5. The twelve-month aggregate excess performance prior to the ratings change was statistically significant, while the twelve-month returns after the ratings change were not.

So, is the municipal bond market at risk for widespread default? No one knows—and we are not in the prediction business. But your view probably depends on your economic expectations and familiarity with the municipal bond market. With this in mind, consider these principles:

• The municipal bond market is large and diverse. The media often report on municipal bond problems as though the market is a single, uniform sector. In reality, the market comprises an estimated $3 trillion in debt, with about 55,000 state and local issuers and approximately 2 million outstanding issues. These bonds are rated across a broad spectrum of credit categories and have different characteristics and structures for paying their obligations. Such complexity does not afford simple observations about the market.
• Historical default rates are low. Muni bonds have a strong track record of repayment. One reason is that state and local governments are motivated to avoid default since failure to pay affects their ability to raise capital in the future. Another reason is that most issues repay investors from either project revenues or from a general fund backed by the taxing power of the issuer. Chart 1 shows default rates for municipal and corporate bonds in the US from 1970 to 2008. There have been no defaults in the top-rated investment grade tier (Aaa/AAA). Most defaults are limited to the non-investment grade universe.

Chart 1: Bond Default Rates—Cumulative Percent (1970–2008)

Of course, these historical default rates may not be so low in the future, especially if fiscal conditions prove worse than in the past. Investors also should consider the potential for local government bankruptcy. Federal bankruptcy law enables local governments to file for Chapter 9, although some states do not permit these filings and provide alternative means for their distressed local governments to adjust debts. As sovereign entities, states cannot file for bankruptcy protection. But some lawmakers are considering ways to enable financially distressed states to seek bankruptcy protection versus requesting a federal bailout.4

• Most fiscal problems are reportedly concentrated in a few large states. An estimated 58% of the recent budget shortfalls have occurred in five states: Arizona, California, Illinois, New York, and Texas.5 Moreover, current levels of state and local government debt, as well as interest payments on that debt, remain well within the historical range.6 However, beyond the short-term budget gaps, many local and state governments face deep structural problems, including unfunded pension liabilities that could consume a growing share of their budgets. Research estimates that these pension obligations may be considerably higher than what states are reporting under Governmental Accounting Standard Board (GASB) rules.7
• Municipal bonds are assessed according to actual financials, not models or projections. Some reports have compared the municipal bond market to the subprime mortgage securities market prior to the financial crisis. The circumstances are different in some ways. Municipal bonds are not exotic instruments with complex structures that obscure the underlying credit rating and market value of the assets.8 As a result, munis are generally more transparent than the mortgage derivatives that helped spark the financial crisis. Also, state and local issuers are subject to financial disclosure rules, and the information they provide affects the market prices and credit ratings of their bonds. Unfortunately, municipal bond reporting is not as timely or thorough as financial reporting on corporate debt. According to the Securities and Exchange Commission (SEC), about 20,000 of the 55,000 borrowers in the municipal market do not adhere to GASB standards. Consequently, lawmakers are pushing for improved accounting standards and reporting rules to increase transparency for investors and market participants.9
• Current market conditions do not imply unusually high risk. The market incorporates information and expectations into prices, including perceived risk, as illustrated by rising bond yields during the financial crisis and in the recent municipal market selloff. However, since the start of the recession in November 2007, average yields for the AAA, AA, and BBB rated municipal securities have fallen.10 Also, total market volume as measured by total number of trades has been generally flat over the last three-year period.11 Chart 2 features the municipal bond indexes of several large states with reported budget problems, as well as US Treasury and corporate bond indexes (rated AAA through BB). Although slightly higher, the estimated tax-adjusted municipal bond yields are within range of corporate indexes with comparable average credit ratings. This may reflect higher perceived risk, but also differences between state tax rates and other factors influencing investor preferences.

Chart 2: US Bond Index Yields
State Municipals, Corporates, and Treasuries
As of April 26, 2011

Risk Management Issues

Investors should always consider ways to manage risk in their fixed income portfolios. Here are a few guiding principles:

• Hold shorter-term issues. This approach may help reduce volatility while enhancing liquidity. Also, fixed income investors who hold investment grade bonds must consider their exposure to changes in interest rates. Bond prices move in the opposite direction of interest rate changes—and the longer a bond’s maturity, the greater its price change.
• Stay broadly diversified. Holding many municipal bond issues and avoiding concentration in a particular state, sector, or issue type can help reduce the impact of a few non-performing bonds. If default rates rise, investors with a well-diversified municipal portfolio should be less exposed.
• Focus on quality and use market pricing to confirm credit ratings. The most creditworthy bonds are those rated AAA or AA, and most of the current problems involve lower-rated bonds. Although ratings are useful, recent history in the mortgage-backed securities market has shown that a bond may not be rated accurately. A bond that is rated AAA should trade in a similar price range to other bonds with similar characteristics and a comparable rating.

Portfolio Decisions

Investors can either hold a portfolio of individual municipal bonds or buy shares in a fund. Building a portfolio of individual bonds offers more direct control over maturity, face value, bond type, credit range, and other issue characteristics. This approach may be useful for matching future liabilities and pursuing other investment objectives. But achieving broad diversification with a custom portfolio may prove a challenge, and the portfolio may be less liquid and expensive to trade, and require more attention and oversight than is feasible for an individual.

Investors often favor professional fund management for many reasons, including enhanced diversification at a reasonable cost and those specific to the way the bond market operates. Since bonds are traded through a network of dealers and not a centralized exchange, price discovery may not be easy. Muni bonds also tend to be less liquid than equities since only about 0.7% of the market is traded daily (i.e., only 14,000 out of two million issues). These market realities result in high transaction costs. In fact, research shows municipal bond trades are significantly more expensive than equity trades of equal size.12

Municipal bond funds have better access to multiple dealers than most individual investors and have the capacity for large-volume trades, which renders a cost advantage over smaller investors, particularly when trying to achieve higher name counts to increase diversification. Funds offer better liquidity and broader diversification across issue type, maturity, credit quality, and geography, although shareholders do not control the selection of bonds in the portfolio. They also can access daily security prices and know the average credit rating within the portfolio. Equally important, managers should monitor average yields at different maturities, qualities, and regions to gauge the relative riskiness of different issues.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Municipal securities are subject to the risks of adverse economic and regulatory changes in their issuing states.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

End Notes:
1. Shawn Tully, “Meredith Whitney’s new target: The states,” CNNMoney.com, Sept. 28, 2010.
2. Dan Seymour, “Default Uneasiness Chases Investors from Muni Funds,” American Banker, Jan. 25, 2011.
3. Jane J. Kim, Eleanor Liaise, and Ben Levisohn, “Munis: What to Do Now,” Wall Street Journal, Jan. 15, 2011. Other factors that possibly contributed to the selling pressure are: (1) a major Treasury selloff in late 2010, (2) Standard & Poor’s downgrade of “tobacco bonds” to junk status, (3) expiration of the Build America Bonds program in 2010, and (4) extension of the Bush-era tax cuts.
4. Mary Williams Walsh, “A Path Is Sought for States to Escape Their Debt Burdens,” New York Times, Jan. 20, 2011. Bankruptcy would enable a state to alter its public pension liabilities and treat general obligation bond holders as unsecured creditors.
5. Randall Forsyth, “The Sky Isn’t Falling on the Muni Market,” Barrons.com, January 7, 2011.
6. Iris J. Lav and Elizabeth McNichol, “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm,” Center on Budget and Policy Priorities, Jan. 20, 2011.
7. Robert Novy-Marx and Joshua Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?” Journal of Finance (forthcoming).
8. Agnes T. Crane, “States’ Troubles Are Not the Real Risk for Muni Bonds,” New York Times, Jan. 30, 2011. Also see Randall W. Forsyth, “Man Bites Dog in the Muni Market,” Barrons.com, Feb. 1, 2011.
9. Andrew Ackerman. “SEC Could Gain Authority to Regulate Muni Disclosure,” Wall Street Journal, April 13, 2011. The SEC indirectly regulates municipal market disclosures through the banks and broker/dealers that underwrite municipal securities. Under current SEC rules, dealers cannot underwrite municipal bonds unless the issuer has agreed to provide annual audited financial reports and to notify the market of certain events, such as a change in credit rating.
10. Bank of America Merrill Lynch 1-10 Years AAA-BBB US Municipal Bond Index.
11. Municipal Securities Rulemaking Board (MRSB) 2010 Fact Book.
12. Lawrence E. Harris and Michael S. Piwowar, “Secondary Trading Costs in the Municipal Bond Market,” Journal of Finance, 61, no. 3 (June 2006): 1361–1397.

The chart below shows that the US monetary base has spiked since 2009. While inflation has fluctuated considerably, it has not tracked the changes in the monetary base. Although no one can reliably forecast inflation, we think markets do a pretty good job of sorting through all the macroeconomic data. At present (April 2011), the markets do not appear to reflect expectations of runaway inflation in the near future.2

US Monetary Policy since 2000

Source: Federal Reserve Board

Nevertheless, investors may be growing anxious in response to media coverage of the Fed’s continuing expansionary policy. For those who are certain QE2 will be inflationary, perhaps the recent example of Sweden’s monetary base run-up will offer some reassurance.

In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country’s monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. The graph below documents that even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit, and in fact, remained flat before falling in 1996.

Swedish Monetary Policy in the 1990s

Source: Sveriges Riksbank

Sweden’s monetary base expansion is one of several international examples of quantitative easing over the past two decades. These case studies, which include past expansionary periods in the UK, Switzerland, Japan, Australia, New Zealand, and Iceland, are discussed in a recent Federal Reserve Bank of St. Louis review.3 The researchers concluded that doubling or tripling a country’s monetary base does not lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.

Of course, many factors may come into play, and we cannot know whether the US will share the same fortune. But at least we know that quantitative easing has occurred without triggering high inflation.

1. Monetary base is the total amount of the liquid currencies circulating in the hands of the public, deposits in financial institutions, and the deposits of the commercial banks in the central bank of the respective country.

2. One indicator of expected future inflation is the difference in rates between US Treasury bonds and Treasury Inflation Protected Securities (TIPS), also known as the TIPS spread. In the 4th Quarter 2010, the 10-year zero-coupon TIPS spread was 2.35% (http://www.federalreserve.gov/econresdata/researchdata.htm). Consider, however, that the spread also includes an inflation risk premium, so the spread is not an exact measure of the market’s inflation expectations.

3. Richard G. Anderson, Charles S. Cascon, and Yang Liu, “Doubling Your Monetary Base and Surviving: Some International Experience,” Federal Reserve Bank of St. Louis Review 92, no. 6 (November/December 2010): 481-505.

The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.

Let’s look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:

1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.

US Stock Market Performance after 1932^*

5 Years            10 Years               20 Years

Annualized Return                        15.35%                10.07%                  13.19%

Growth of $1                                   $ 2.04                  $ 2.61                  $ 11.92

*All stock market returns based on CRSP 1-10 Index.²

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.

US Stock Market Performance after 1941*

5 Years                10 Years             20 Years

Annualized Return                      18.63%                    16.67%                16.29%

Growth of $1                                $  2.35                     $  4.67                $ 20.47

1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.

US Stock Market Performance after 1974*

5 years                10 years             20 years

Annualized Return                      17.29%                    15.92%                14.89%

Growth of $1                                $  2.22                     $  4.38                $ 16.07

1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled “The Death of Equities” claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.

US Stock Market Performance after 1981*

5 Years                10 years             20 Years

Annualized Return                      18.82%                    16.58%                14.54%

Growth of $1                                 $ 2.37                      $ 4.64                $ 15.11

1987: On “Black Monday” (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.

US Stock Market Performance after 1987*

5 Years                10 Years             20 Years

Annualized Return                      16.16%                    17.75%                11.89%

Growth of $1                                 $ 2.11                      $ 5.12                  $ 9.46

2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market’s low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the “new economy.”

US Stock Market Performance after 2002*

5 Years                10 Years             20 Years

Annualized Return                      13.84%                    —                         —

Growth of $1                                 $ 1.91                       —                         —

2008−Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the “lost decade” have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today’s headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.

Of course, no one knows what the future holds, which brings the concept of “normal” into question. What exactly is the status quo in the markets?

The chart below shows the annual performance of the US market, as defined by CRSP deciles 1-10. Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market’s 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.

What’s new about that?

End Notes:

1. Adam Shell, “’New Normal’ Argues for Investor Caution,” USA Today, August, 16, 2010. The term “new normal” originally referred to a post-global financial crisis environment characterized by several years of sluggish economic growth, below-average equity returns in developed markets, high market volatility and risk, high unemployment, and a world in which the range of possible financial outcomes is wider than normal and wealth dynamics are moving from developed to emerging economies.

2. Returns for all periods of the CRSP 1-10 Index are annualized. Data provided by the Center for Research in Securities Prices, University of Chicago.  Data includes indices of securities in each decile as well as other segments of NYSE securities (plus AMEX equivalents since July 1962 and NASDAQ equivalents since 1973). Additionally, includes US Treasury constant maturity indices.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.  This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.

Stocks performed well in the US and most developed countries, and across size and value risk factors, despite ongoing concerns over a possible double-dip recession, rising government indebtedness, and inflation. Thirty-seven out of forty-five countries tracked by MSCI achieved positive returns in both local currency and US dollar terms.

Fixed income returns were positive, thwarting assertions that bond prices were in dangerous “bubble” territory. Despite continued weakness in residential housing and commercial property, real estate securities around the world outperformed the broad equity market. Diversification across the size and value risk dimensions proved rewarding in both US and non-US markets, particularly among small company stocks.

As shown in the US Stock Market Performance chart, the broad US stock market logged strong performance, returning 16.93% for the calendar year. The chart features some of the year’s most highly publicized events. These events are not offered as an explanation of market performance, but simply to illustrate that long-term investors faced a major challenge to stay disciplined in a volatile news environment. Although investors must deal with uncertainty in all markets, 2010 may have presented a more intense challenge as markets watched for signs of economic recovery from the global financial crisis.

The World Stock Market Performance chart offers a snapshot of global stock market performance, as measured by the MSCI All Country World Index. Actual headlines from publications around the world are featured. Again, these headlines are just a sample of many events during the year.

Throughout the year, investors could find a host of reasons to avoid stocks and wait for more positive news before returning to the market. As these select headlines suggest, determining the right time to invest is a difficult task since the market anticipates news and quickly factors in new information.

The Year in Review

Themes in 2010

In retrospect, it was a good year for globally diversified investors. But if investors had shaped their market expectations and decisions according to economic news, they likely would not have expected positive returns. The following are a few dominant themes during the year.

Mixed Economic Signals

Although investors in the US and Europe awaited signs of a rebound, economic news was mixed, with some measures showing gradual improvement and others offering evidence that the economy remains vulnerable. Favorable news included moderate economic expansion in the US, Euro zone, and Australia, as well as rising factory orders and manufacturing activity, rebounding auto sales and automaker profits, slowing growth in US bankruptcies, declining home foreclosures, and an improving financial services sector. In late Q3, US corporate cash levels reached $1.9 trillion, which, as a percentage of total corporate assets, is the highest since 1959. In late Q4, initial claims for unemployment fell to the lowest level in two years.

Negative news included continuing high jobless rates in the US and other developed markets. US unemployment began the year at 9.7%, dipped to 9.5% in July, but climbed to 9.8% in November. Personal bankruptcies in the US increased 9%, reaching their highest level since 2005. Also, bank failures in 2010 were the worst since 1992, during the savings and loan crisis.

Housing and Real Estate

The global property decline that helped trigger the 2008 financial crisis began to ease in 2010. Home prices improved in the UK but remained weak in the US, with monthly sales of new homes falling at one point to the lowest level since tracking was initiated in 1963. Foreclosures increased dramatically in the first half of 2010 before improving in Q4. However, 2010 proved to be another successful year for REITs, despite recurring predictions of a brewing commercial real estate collapse that would trigger a financial crisis.

Quantitative Easing and Fiscal Stimulus

Governments and central banks took additional actions to stimulate economies and shore up financial markets. The most direct support came as central banks supported government bond markets in the US and Europe. The Federal Reserve’s November announcement of a second round of quantitative easing (known as “QE2”) sparked concern that additional monetary stimulus would stoke inflation and debase the dollar. According to some, the actions helped lift stocks and corporate bond markets. In December, the extension of the Bush-era tax cuts and a 2% reduction in Social Security payroll taxes in 2011 improved economic expectations.

Sovereign Debt Worries

During the year, the weakening finances of some European states, including Portugal, Ireland, Italy, Greece, Spain, and Belgium, raised concern that the financial crisis had moved from private-sector banks to public-sector balance sheets. These concerns led to the downgrading of certain government debt and widening of bond yield spreads. The Euro zone countries and International Monetary Fund responded with loans that were conditional on some sovereign borrowers taking drastic austerity measures.

Inflation vs. Deflation

Despite moderate inflation in most economies during 2010, economists warned that continued government budget deficits and monetary expansion would drive up prices. Conversely, the US central bank was concerned that inflation was so low that the economy might slip into a deflationary cycle. In fact, potential deflation was one of the main reasons the Fed implemented QE2 and pumped $600 billion into the banking system. By year end, the Fed indicated that the deflation threat was easing.

Higher Commodity Prices

Commodities climbed during 2010, with many sectors reaching price levels not seen in decades. Copper prices, which are considered a bellwether of economic activity, rose 33%, and oil gained 15% to finish 2010 over $91 a barrel. Agricultural commodities, a traditionally volatile sector, saw even more extreme price swings. Concern about a weakening dollar drove up precious metals, with gold exceeding $1,400 per ounce and silver up 81% for the year.

Investor Confidence

In the wake of the financial crisis, investors who have become more risk averse or accepted the tenets of a “new normal” in the economy and markets chose to remain in fixed income assets. Bond funds in the US received a massive net inflow of money in the past two years, suggesting that many investors who fled stocks may have missed out on much of the rebound in equities. Throughout most of 2010, investment flows were leaving the US stock market and moving to emerging markets. In December, flows turned sharply positive in the US, with an estimated $22 billion directed to US stock funds.

2010 Investment Overview

After a slow start and a tough second quarter, most markets in the world ended the year with positive results. The US market indices accounted for most of the top performance, with the Russell 2000 Growth Index delivering a 29.09% return for the year. US small cap and small value also were among the top performers. (All returns are in US dollars.)

Most developed markets around the world logged positive returns, with thirty-seven of the forty-five countries that MSCI tracks gaining ground in both local currency and US dollar terms. Scandinavia and Asia had particularly high returns. Overall, the MSCI World ex USA index gained 9%, and the MSCI Emerging Markets Index gained 19% for the year.

In the last few months of the year, the highest returns were generally experienced by countries whose economies are dominated by oil and commodity exports—for example, Canada, Norway, Russia, and South Africa. Other emerging markets, such as Thailand, Philippines, Chile, and Peru had strong returns. China, despite its continued high profile and news of economic growth, was one of the lowest-performing emerging markets.

The US dollar lost ground against the Canadian dollar and most Pacific Rim currencies, which helped dollar-denominated equity returns from those countries. The US dollar gained against the euro and British pound.

Along the market capitalization dimension, small caps outperformed large caps by substantial margins in the US, developed, and emerging markets. Value stocks underperformed growth stocks across all market capitalization segments in the US and had more mixed results in international developed and emerging markets.

Fixed income performed generally well, especially for investors who took term and credit risk, with long-term, high-yield bonds returning more than 20%. Real estate securities had excellent returns, performing comparably to the equity asset classes.

Quarterly Highlights

First Quarter

Following a slow start in the year, equity markets around the world began to climb in mid-February and ended the first quarter in the black. The broad US market gained about 6% in the quarter, with all asset classes delivering solid gains. (All returns are in US dollars.) The developed markets benchmark MSCI World ex US Index was up 6.4% in March and finished the quarter with a return of 1.3%.  Emerging markets outperformed the developed markets, up 8.1% in March and 2.4% for the quarter. Some of the larger markets, such as Brazil, China, and Taiwan, had negative returns. As in the case of developed markets, there was much dispersion in the performance of different emerging markets and asset classes. However, both developed and emerging underperformed the US, partially due to the stronger US dollar, which was up 6% against the pound and the euro, hurting the dollar-denominated returns of developed market equities. Fixed income securities had positive returns. Longer-term securities tended to have better performance than short-term ones.

Major news in the developed markets was related to the fiscal crisis in Greece and the resulting worry about the mechanics of a bailout and its impact on the euro. As a result, the worst equity market returns were in Europe, where stocks slipped in Greece, Portugal, and Spain—the countries most at risk of sovereign default.

Second Quarter

After four consecutive quarters of strong performance, the US equity market saw a sharp reversal in May and June, ending the second quarter with large negative returns. The broad US market lost over 11%, with most asset classes delivering double-digit negative returns. Both developed and emerging markets performed poorly. The MSCI World ex US Index was down 13.6% for the quarter, with most of the damage coming in May, when the index fell 11%. Emerging markets outperformed developed markets for the second quarter in a row, down 8.4%. The US dollar gained ground against most major currencies, especially the euro and the Australian dollar, and against major emerging market currencies. This strong performance hurt dollar-denominated returns of developed and emerging market equities. Fixed income securities had good returns due to a flight to safety triggered by the sovereign debt problems in Europe and weak economic data around the globe. Intermediate government securities and inflation-protected securities did particularly well.

The sovereign debt crisis in Greece, Spain, Portugal, and Ireland continued to affect European banks. Officials in Hungary hinted at a default, and Spain’s credit was downgraded. Widespread announcements of austerity measures and budget cuts across Europe caused some observers to lower growth expectations. Other major events were the April explosion of the Deepwater Horizon rig in the Gulf of Mexico, which cast a negative spotlight on BP and raised concerns of a major environmental calamity, and the bewildering “flash crash” in May, which saw the Dow plummet over 1,000 points in the course of a few frantic minutes.

Third Quarter

The US equity market rallied strongly in the third quarter, with the broad US market gaining over 11% and most asset classes delivering double-digit returns. With the exception of Q2 and Q3 of 2009, non-US markets had their best quarter since 2003. Although both developed and emerging markets did well, emerging markets once again had the strongest performance. Looking at benchmark returns, strong performance in July and September led the MSCI Emerging Markets benchmark to a quarterly return of 18%. By comparison, the benchmark MSCI World ex US Index was up 16%.

The US dollar lost ground against most major currencies in developed and emerging market countries, which greatly helped the dollar-denominated equity returns. Fixed income securities had good returns. Declining long-term rates rewarded investors who were exposed to term risk. Intermediate government securities and inflation-protected securities did particularly well.

International news focused on central banks around the world intervening to curtail rising currencies, with the focus on Japan and China.

Fourth Quarter

The equity markets had a strong finish for the year, with the broad US market gaining over 11%. US asset classes again delivered double-digit returns. Most of the world’s stock markets continued with the gains experienced in the third quarter, albeit at more moderate pace. The MSCI World ex US Index and the MSCI Emerging Markets Index both had returns of over 7%. Returns were especially good in Canada and Japan, which returned over 12%.  Emerging markets had slightly higher performance than developed markets. The US dollar lost ground against the Canadian dollar and most Pacific Rim currencies, which greatly helped the dollar-denominated equity returns from those countries. However, the US dollar gained against the euro and British pound.

Value stocks underperformed growth stocks across all market capitalization segments in the US and in other developed markets. In emerging markets, value stocks outperformed growth stocks for the quarter. Small cap value stocks outperformed small cap growth stocks, while large cap value stocks underperformed large cap growth stocks. Along the market capitalization dimension, small caps outperformed large caps in the US and developed markets by substantial margins. In emerging markets, small caps narrowly beat large caps.

Fixed income securities had generally poor returns in the fourth quarter. Rising long-term rates hurt investors who were exposed to term risk. However, high-yield bonds did particularly well, rewarding investors who took extensive credit risk. Notwithstanding the continued weakness in the commercial and residential real estate markets, real estate securities had excellent returns, performing comparably to the equity asset classes.

Notable events included the mid-term election results in the US, which resulted in an anticipated shift in the political landscape. There was additional anxiety over sovereign debt, with the Irish system accepting an €85 billion bailout from the Euro zone. Finally, the implementation of quantitative easing (QE2) by the US central bank contributed to a weakening dollar across most major world currencies, with the exception of the euro, which continued to struggle.

Russell data copyright © Russell Investment Group 1995-2011, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2011, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2011 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Citigroup bond indices copyright 2011 by Citigroup. Barclays Capital data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is no guarantee of future results.  This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

The graph below shows the projected state of indebtedness around the world.1 Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have debt-to-GDP levels above 70%—and the US, Canada, and the UK project debt levels exceeding 80% of their economic output.

Government efforts to stimulate these economies out of recession may partly explain this level of borrowing, which is high compared to historical levels. But longer-term trends such as aging populations, expanding public pensions, and rising health care obligations are compounding the fiscal challenges of these countries.

Global investors may be particularly concerned about the economics of government spending in countries around the world. So how does public debt affect economic growth and market returns? The evidence might surprise you. Although rising levels of government debt create headwinds for economic growth, a country’s deficit and debt levels do not seem to adversely impact capital market returns.

Let’s explore these issues by addressing a few popular questions about sovereign debt:

Do rising deficits drive up interest rates?

Yes. As borrowing increases, a government must offer higher interest rates on its debt to compete for capital. The public sector consumes savings and investment that may have otherwise fueled private sector growth—a displacement of resources known as the “crowding out effect” in economic theory. Additionally, as debt levels rise, market concerns about higher default and inflation risks put additional upward pressure on interest rates.

Consistent with this theory, our analysis shows that current interest rates reflect expectations of future deficits² but that current government deficits and debt do not predict future interest rates or bond returns.³ So, long-term interest rates rise when the market expects future deficits to increase. However, today’s interest rates and bond prices already reflect information about current government spending, and markets quickly incorporate new information.

Do higher deficits hamper economic growth?

It depends on a country’s debt level. Using World Bank data from 1991 to 2008, we compared current deficits to future GDP growth in sixty-seven countries and found an increasing interactive effect between deficits, debt, and economic growth. High-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth. The combination of high debt and deficits can create headwinds for economic expansion, but slower growth is not guaranteed.

So investors are justified in having some economic concern about higher government spending and borrowing. But the impact on investment returns is less clear. Let’s now consider the potential effect on equity markets.

Does low economic growth result in diminished equity returns?

No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. We conducted this analysis using all the developed countries in the MSCI universe, divided each year into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.

The graph below illustrates this relationship in terms of a dollar invested in high- versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio’s higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.

Applying the same methodology to the MSCI emerging market countries shows an even greater return difference, although the data period is much shorter (2001 to 2008). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth).

Other research has confirmed a weak relationship between a country’s economic growth and its stock market returns.⁴ Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company’s stock price in its home market may not reflect economic conditions in other countries. Also, the fruits of economic growth do not accrue exclusively to public companies, but also to income earners, non-public businesses, and private investments.

Finally, consider that risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market.⁵ Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a “growth market” may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth.

Do fiscal deficits lead to currency depreciation?

No. It is commonly believed that large fiscal deficits and high debt cause a currency to depreciate as the government borrows more from foreign sources, and investors who are concerned about inflation and default risk flee the currency. Although recent developments in the US would seem to support this relationship, there is less convincing long-term evidence that deficits affect currency rates. During the 1970s and 1980s, the dollar strengthened while the government increased deficit spending.⁶ This observation is consistent with academic studies concluding that exchange rates appear to move randomly, and there are no models to date that can reliably forecast currency returns.⁷

Conclusions

Some economists claim that developed market countries are moving into an era of high government deficits and lower market returns. While higher deficits and debt may impact a nation’s interest rates and economic growth to some extent, the investment implications are not easily discerned. History does not offer strong evidence that current deficits predict future bond or equity returns in a country’s financial markets, or anticipate short-term currency movements.

Investors should assume that stock and bond prices reflect all that is currently known and expected about government spending and debt, economic growth, risk, and other issues affecting performance.

Endnotes:

1.  The Organization of Economic Co-operation and Development (OECD) is an international economic organization of thirty-three countries founded in 1961 to stimulate economic progress and world trade. It defines itself as a forum of countries committed to democracy and the market economy.

2. Today’s interest rates reflect expectations of future deficit levels. The analysis compared five-year US deficit projections (as a percent of GDP) to yield spreads (five-year US Treasuries minus three-month US Treasuries) from 1992 to 2010. The yield spread increased 29 basis points for every one percentage-point increase in projected deficits. Data sources: Baseline projected deficits from the Congressional Budget Office; yields from Federal Reserve Bank of St. Louis.

3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year US Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.

4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.

5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.

6. Another common assumption is that current account deficits and currency appreciation are related. (The current account balance is the difference between a country’s receipts and payments to the world. This account is composed mostly of the balance of trade, with net income and foreign aid playing a smaller role.) Academic research yields equivocal results on whether this relationship holds.

7. Richard A. Meese and Kenneth Rogoff, “Empirical exchange rate models of the seventies: Do they fit out of sample?” Journal of International Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania Stavrakeva, “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting” (National Bureau of Economic Research working paper No. 14071, June 2008).

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

© 2010 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.¹ With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

Basic design

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes.² The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain. Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.³

The following summarizes a few common characteristics of structured products:

• Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.
• Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.
• Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.
• Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.
• Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.
• Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

Who might benefit?

A structured product might help an investor who needs a specific payout at a designated point in the future and who is willing to pay another party to shoulder much of the uncertainty. But this benefit generally comes at the expense of lower yield or limited upside potential.

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock (even though this might mean giving up the upside potential of the stock), and at the same time, provide better-diversified exposure to an equity index, such as the S&P 500.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent. And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.

Endnotes

¹ Larry Light, “Twice Shy on Structured Products?” Wall Street Journal, May 28, 2009.

² A reverse convertible bond is one example of a yield enhancement tool. It pays investors a higher coupon rate than other comparable bonds due to its higher risk. This risk comes in the form of the issuer having the option to pay off the debt with either cash or a predetermined number of common stock shares. The method of payment at time of maturity will depend on the stock price, and the issuer will pay with common stock when it is advantageous to do so. The reverse convertible bond was popular until the last market crisis, when many investors experienced heavy losses when they were paid off with lower-value stock shares.

³ A call option provides the holder the right to buy the underlying security at a given price at a certain time in the future. A put option provides the holder with rights to sell the underlying security at a pre-specified price on maturity date. (American-style options can be exercised before the maturity date, whereas European-style options can be exercised only on the maturity date.) An option holder will exercise the put or call option only if the payoff is positive.

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

© 2010 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.