From the March 2006 issue of Wealth Manager Web • Subscribe!

March 1, 2006

DO LARGE CAPS FIT?

LARGE CAPS ARE HERE TO STAY--THEY'RE JUST LIKELY TO HAVE A slightly smaller presence in the average investment portfolio over the next couple of years.

Though financial advisors and mutual-fund managers across the board remain committed to large caps as a keystone for any well-balanced investment portfolio, the way they are utilizing the asset class within their clients' portfolios is changing. In preparation for 2006, many are altering not only their weightings in large caps but the areas of the asset class where they commit money. And though it was only a few years back that most portfolio managers kept the majority of their clients' holdings in large caps, many have begun scaling back their exposure.

Tom Carstens, a partner with Lenox Advisors, says, "In 1998 the standard recommendation was, 'The S&P 500 is doing great. Just put 70 percent or 75 percent of your equity investments in large caps and have a much smaller weighting in international, small and mid-cap stocks.'" In fact, at the time, the marketplace was so impressed by the performance of large caps that advisors questioned the need for exposure to any other asset class.

"In 2000 the hot topic was whether there was any benefit at all to diversification, and a whole bunch of people were arguing that you didn't need to diversify--that all you needed was a large-cap fund and you'd be just fine," says Donna Skeels Cygan, president of Albuquerque, N.M.-based Essential Financial Planning Inc. Of course, she's quick to note that this thinking has since been disproved, and that the drastic fall in large caps' performance has essentially eliminated such thinking within the investment community.

Large caps were the indisputable winner from 1995 to 1998, and they significantly outperformed all other asset classes during that period, but small caps have outperformed them every year since. Financial advisors predict it will be much of the same in the year ahead. "If people had followed that advice, they really would have gone in the wrong direction," says Cygan, a longtime believer in the importance of diversified investments.

Not surprisingly, most financial advisors and fund managers focus on diversification these days. "Everybody has learned some hard lessons over the last two or three years, and a well-diversified approach--and maybe even more of a passive approach--is what you're going to see in the future," explains Carl F. von dem Bussche, a CFP and president of Palm Harbor, Fla.-based Financial Guidance Group Inc. Amid an uncertain economic climate, and with ambiguity surrounding the future performance of large caps, he thinks the importance of a truly diversified portfolio will only become more important. "We're very, very cautious about next year. With the deficit, inflation, interest rates and everything that's going on, we typically have 15 to 16 different asset classes in our models," notes von dem Bussche, who manages $80 million collectively, and whose average client has roughly $750,000 in assets.

Varied Approaches

Of course, while large caps may have lost some of their luster, financial managers remain committed to the asset class and believe that it should comprise a substantial portion of any well-balanced investment strategy. Where advisors differ is in the allocations and weightings they use to try to create diversified portfolios--approaches nearly as varied as their clients' holdings.

Take, for instance, Curt Fey, a CFA, CFP and Ph.D. who works as an independent financial advisor and whose average client has roughly $1 million in assets under management. Fey believes that at least half of an individual's holdings should be kept in large caps. In 2005 he had 56 percent of his core portfolios in them--10 percent in U.S. large caps, 10 percent in U.S. large-cap value, 10 percent in foreign-developed large-cap value, 20 percent in emerging markets large caps and 6 percent in natural-resources large caps. "Since large caps don't fluctuate a lot, they're relatively stable," says Fey. Despite concerns such as the bankruptcies plaguing the airline industry and the huge pension obligations major car manufacturers face, he believes that any impact on the asset class as a whole will be minimal, and that large caps remain a fairly sound investment. And he's not alone.

Jeff Broadhurst, a CFA and financial advisor who is president of the Lansdale, Pa.-based investment-advisory firm Broadhurst Financial Advisors Inc. says, "The role large caps have in a portfolio is stability and noteworthiness. And I say that thinking there's going to be a lot more defaults from the large-cap companies, such as the airlines and the auto industry." However, he explains that "on a percentage basis, small companies still tend to go under a lot more than large-cap companies, and small caps are inherently more risky."

Many financial advisors have begun shifting the portions of the large-class assets in which they invest. "The biggest trend in large-cap stocks is a shift from value-type stocks outperforming growth to growth outperforming value," says Lenox Advisors' Carstens.

Michael Rosen, a principal with Angeles Investment Advisors, agrees. "We're seeing a fairly large spread now in relative historic valuations that suggests that growth looks more attractive, relative to value, today than it has at any time in the last 10 years or so," he says. In fact, many financial advisors have already started selling off their large-cap value investments in order to overweight themselves in large-cap growth--a shift Carstens says has begun within many pensions and endowments as well. And as funds begin re-weighting their allocations for 2006, it is likely there will be only more movement in this direction.

Many financial advisors have also begun shifting their approach toward active investments rather than passive ones. While many advisors have long relied on the idea of "core and explore"--the belief that large-cap index funds are efficient with minimal swings--they are now questioning that thinking since index funds have fallen off their pedestal.

Only five years ago, index funds were viewed as one of the easiest ways to gain exposure to large caps. At the time, the Vanguard Index outperformed 80 percent of all managed accounts. But the tables have turned. During the last few years, managed accounts have consistently been outperforming passive accounts, and wealth managers say they have responded by similarly altering their investments.

Some money managers are also questioning whether the passive nature of index funds could pose risks for their clients. "When you buy an index fund, the top 10 holdings are a very large percentage of that fund ... and if they include General Motors, Ford, Delta, United and those types of companies, that's a big concern," says Essential Financial Planning's Cygan. Instead, she prefers actively managed funds where each portfolio manager actively decides the types of companies they will hold and alters weightings when they choose.

While mutual-fund managers say they are aware of issues such as the pension burdens of the U.S. auto industry, few are concerned about remaining committed to large caps. Instead of approaching large caps as a collective asset class, most say they focus on the individual companies in which they invest and avoid troubled stocks.

"When we look at companies, we try to look at them regardless of their size," says Bruce Bartlett, a mutual-fund manager and director of growth equity investments for Lord Abbett & Co. Though he says he's focused on companies worth $5 billion and above, his primary concern with potential large-cap investments is the business model and overall performance of each company. "We're not really trying to manage the market-cap exposure with any idea that a certain market-cap exposure is any better or worse than any other," he says. And when it comes to the financial trouble dominating news headlines these days, Bartlett says he merely uses the issues raised as a barometer for any potential problems with companies in which he might invest.

Louis P. Stanasolovich, CEO and president of Pittsburgh-based Legend Financial Advisors Inc., also uses the headlines as a barometer. "We've avoided the companies with problems such as underfunded pensions, unrealistic earnings assumptions about their pensions, high PE ratios and mega amounts of debt relative to their equity," says Stanasolovich, who invests in individual stocks on behalf of his clients. In fact, he says he won't even invest in companies whose sales are increasing, in case they are unable to handle such rapid growth. "That's an area of danger, because we want a company that's growing its top line, as well as the bottom line," he explains, adding that companies can only cut costs to a certain degree. "Yes, there will be turnaround situations, but we feel they carry too much risk for our clients."

And, of course, some financial advisors also find themselves thrown into headline-grabbing concerns on a more personal level. When a client of Cygan's recently retired from Delta Air Lines, she had a small pension with the company and was in a hurry to grab her investment before it might disappear.

"We've had people contact us from Delta because they're so frightened they're going to lose all their years and the pensions they've built up, and which they feel they've earned," says Cygan. "We're spending a lot of time looking at lump sums vs. annuities, and the whole pension issue is just going to get bigger and bigger in terms of being a problem." Broadhurst has also seen an increasing number of clients with concerns about company sponsored retirement plans. "People are worried about their pensions, and they keep hearing more and more about the large companies that aren't going to be able to fund their pensions," he says. "They want to know, 'Hey, how's my pension doing? And what can I be doing to protect myself?'"

Opportunities Remain

But as others ease their exposure to portions of the large-cap sector, Larry Puglia, a vice president and manager of T. Rowe Price's Blue Chip Growth Fund, is prepared to dive right in. Puglia, who manages a collective $16 billion in assets, is optimistic about the near-term prospects for large caps and believes that the large-cap segment's floundering performance during the last couple of years has created a positive effect in some respects.

"It's created a situation where there are good, solid investment opportunities among companies such as General Electric, Wal-Mart and even certain technology companies like Microsoft," says Puglia. "If you look at those companies specifically, in many cases you will find they've doubled earnings in the last five years and have grown at double-digit rates, but that their stocks have not moved up that much." Though he predicts it will be more challenging for companies to deliver growth moving forward, he believes that companies with diversified products and geographic exposure will be among the best-positioned to deliver strong, consistent returns.

Another shift that has occurred within large caps is the growing popularity of foreign stocks. "There is now a trend into foreign stocks, particularly among emerging-market stocks," says independent advisor Fey. In particular, he says companies within Latin America, Eastern Europe and China have been garnering a significant amount of attention since large-cap stocks within those countries have outpaced the growth of U.S. stocks and are benefiting from the rapid growth of their emerging markets. Financial advisors also expect to see more investment activity within large caps in India, particularly amid some of the reform occurring in the country and the fact that its consumer market remains largely untapped.

When it comes to the heightened investing in foreign companies, Lord Abbett's Bartlett says the trend has been most active within a few specific industries, such as large-cap pharmaceuticals. "Many of the European companies have better fundamentals than our domestic large-cap pharmaceuticals," notes Bartlett. "As a result, I've noticed other large-cap growth managers populating their portfolios with companies such as Roche and Novartis, instead of Pfizer and Merck."

Of course, not everyone is jumping into foreign large caps. "With overseas companies you have an expanded opportunity set, but many of those companies are overpriced as well," says Stanasolovich. "That doesn't mean you can't find diamonds in the rough, but there's not a lot of them." Instead, he says he prefers to seek out foreign diversification through U.S. companies with an international presence, and through ADRs of some foreign listings.

Whether the funds contain homegrown or overseas companies, advisors will find opportunities for their clients. Of course, the professionals do have to explain to investors that large caps are not panaceas for all their investing problems. But then again, nothing ever is.

Britt Erica Tunick is a writer who specializes in financial topics.

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