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


TO EACH HIS OWN, CICERO WROTE MORE THAN TWO MILLENNIA AGO. A ripe old bit of advice, but no less relevant for wear in the business of money management. Indeed, there's a growing affinity for separating beta and alpha, otherwise known as the passive returns dispensed by the market and active management results, respectively. Cicero would be proud.

Exhibit A is the embrace of the so-called core-and-satellite portfolio, which holds the promise of simultaneously exploiting passive and active management under one strategic roof. For many, the rationale runs like this: an equity core is best served through the pursuit of beta in its pure, unadulterated form, dutifully represented by index funds. Meanwhile, the satellite portion satisfies the alpha itch with relatively cautious allocations in aggressive active strategies.

A core-and-satellite equity portfolio might wed, say, an 80 percent weighting in a Russell 3000 index fund to a 20 percent allocation of three or four sharply focused alpha-hunting strategies, such as hedge funds or mutual funds favoring concentrated stock portfolios. The appeal is one of anchoring the bulk of a portfolio to beta's low-cost durability while seeking market-beating results with a modest allocation in managers making no apologies for chasing alpha.

Core and satellite is "the best thing since sliced bread," says Harold Evensky, a financial advisor with Evensky & Katz in Coral Gables, Fla.

A growing number of his colleagues agree, many having come around to such thinking after watching active managers stumble next to the soaring indices in the late-1990s. The across-the-board collapse of equities in the crash of 2000-2002 only added to the appeal of core and satellite.

If there's any controversy over core and satellite, it tends to loom over the latter, which is something of an open-ended category. An equity core, by contrast, is relatively settled and well-defined turf or so one might think in 2006.

Five years ago, a widely read 2001 study by EnnisKnupp, a Chicago investment consultancy, ruffled feathers by opining that theory and empirical evidence raise questions about diversifying with active managers for institutional accounts. A far better choice, the paper concludes, is a passively run equity fund that's broadly diversified for the core. The reason: The relatively steep costs of active management and the failure of sufficient alpha to overcome those costs. In the years since, there's been momentum in the embrace of broadly diversified indices as a core.

But if you thought the subject was effectively closed, think again. Several recent product offerings suggest that even the seemingly staid world of equity core is still open to debate and innovation. Two representative examples of how ambitious minds are rethinking core offer a glimpse into an intriguing and ultimately controversial trend of late. The first is a mutual fund--the recently launched SEI Large Cap Diversified Alpha Fund; the other, an exchange traded fund: PowerShares FTSE RAFI U.S. 1000, which started trading on the NYSE in December. Each boasts a starkly divergent operating philosophy from the other, yet both share a common goal of reinventing assumptions about an equity core, or that portion of a portfolio consigned with generating the lion's share of the expected results for a given allocation to stocks.

Reinvention is no stranger to equity core strategies. In the 1990s, the leading lights of financial advice championed active funds for filling the various style and capitalization buckets for stocks. Evensky was among the practitioners using a so-called multi-asset-class/multi-style strategy by way of a painstaking method for choosing active managers. "We used to have a dozen, 15 different managers. We had lots of stories. We were hiring this one, firing that one," he recalls of the old days.

The wheels started coming off that train in the late 1990s, when the bull market elevated the broad stock indices to extraordinary performance heights, which in turn left a growing share of active managers in the relative-return dust. Indexing's shining moment came in 1999, a year when the Nasdaq Composite led broad equity benchmarks with an astounding total return of nearly 86 percent. It was short lived, of course, and soon led to the great stock market crash. A few years later, after the dust settled, the appeal of actively managed core took another hit as expectations of mediocre equity returns promoted low-cost index funds.

All of which has elevated a Russell 3000 index fund as central for building a core equity position at Evensky's shop. The "overriding issue," he explains of his philosophical migration to core-and-satellite thinking, is a cautious outlook for stock performance in the years ahead. The old way of mixing active managers for building a core position inflicts a toll that's unacceptable, given the relatively modest performance expectations for equities. If his forecast proves accurate, an actively managed core threatens "too much tax and expense drag, and it overwhelms the opportunity," he reasons.

Evensky is hardly alone in singing the praises of an indexed based core. Even for those who don't use index funds, equity core these days is likely to emphasize something comparable: Efficiency, by way of emphasizing fewer managers with broader mandates and lower fees.

Against that backdrop comes a new breed of funds that bucks the trend with fresh thinking on the subject of an equity core. If these innovations have any influence on the business of wealth management, a new core might be dawning yet again. Deciding if new is also better is the operative question. The jury's necessarily out when it comes to definitive answers, if only because the funds are recent arrivals. But to the extent that the new products attract assets, the strategies embrace a mindset that until recently was thought to be in decline, namely, active management for core equity.

The SEI offering, a mutual fund of funds, turns the core and satellite paradigm on its head by using alpha in the design of core. Diversified Alpha fund's premise is that holding a select group of active large-cap managers intent on generating alpha, some by fairly unconventional means, fares well next to conventional long-only money management. Active managers masquerading as closet indexers need not apply here.

SEI's goal for the fund: Consistently generating alpha in the long run over the broad equity market, defined by the Russell 1000, a popular large-cap equity benchmark. The strategic edge for delivering that result, SEI advises, is combining various strategies that are uncorrelated with each other or the stock market generally.

"We created a core product with a beta of one, but it delivers on the premise of putting together managers who look at the large-cap market through a different lens," says Ron Albahary, managing director for SEI's client portfolio management group, which manages money for the firm's high-net-worth clients. "Each manager [in Diversified Alpha] has a distinctly different way of finding inefficiencies in the large-cap space and exploiting those inefficiencies to generate excess returns."

A recent allocation for SEI Diversified Alpha included a Smith Breeden fund using an alpha-transport/fixed-income strategy and a factor-rotation system run by Analytic Investors, a strategy that emphasizes the quantitatively driven metrics currently in favor, such as low price-to-book stocks or equities exhibiting strong price momentum. Another fund in SEI Diversified Alpha pursues what's called a volatility capture strategy, which essentially rebalances an index's components for generating alpha relative to simply holding the benchmark. No one will confuse such strategies as conventional long-only equity templates, and that's the point.

Sounds good in theory, but does it add up in practice? SEI claims it does, pointing to a similar strategy run by the firm in its SIIT Large Cap Disciplined Equity strategy, which has been used for institutional clients since 2003 as an alternative to traditional large-cap equity core products, which the firm also offers. Disciplined Equity posts a gross-of-fees 13 percent annualized total return through the end of 2005 from its August 28, 2003 inception vs. 11.6 percent for the S&P 500, according to SEI.

While the search for a superior core convinces SEI to leave the familiar terrain of indices proper, PowerShares FTSE RAFI U.S. 1000 ETF prefers a quasi-active management fix for what critics say is a major flaw in conventional benchmarks: a capitalization-weighting design. A common complaint is that cap weighting tends to overweight the overvalued stocks and underweight the undervalued.

The height of this form of excess in cap weighting came in the late 1990s, when the bull market roared on and hot big-cap names like Microsoft and General Electric were assigned ever larger slices of the S&P 500. Complaints largely fell on deaf ears at the time, thanks to the robust performance of the indices. Yet in the long run, the effect is more likely to work in reverse by giving fairly light weightings to companies that some investors consider undervalued, thereby keeping indices from posting higher returns if cap weighting was minimized or ignored.

In a bid to capitalize on the opportunity of re-weighting comes the new PowerShares ETF, which holds the 1000 largest U.S. equities. The ETF claims a superior means of capturing the large-cap market's return by weighting those 1000 stocks by four criteria: sales, cash flow, book value and dividends--that is to say, weighting by something other than market cap. The preference is said to minimize the excess born of a cap weighting system that defines the S&P 500, Russell 1000 and most other popular benchmarks.

One way to think of the alternative index design is that cap weighting measures the performance of the average stock, while so-called fundamentals weighting measures the performance of the stock of the average company, says Research Affiliates Chairman Robert Arnott, the architect of the underlying index for the new PowerShares ETF. "It's a subtle difference, but an important difference," he asserts.

And so it appears, based on Arnott's back testing of the data. For the 23 years through 2004's close, the benchmark for the new FTSE RAFI U.S. 1000 earned an annualized total of 12.5 percent, or nearly 200 basis points over the S&P 500. A comparable premium is expected for the long haul going forward, Arnott predicts.

The new funds from SEI and PowerShares are clearly innovative, and in one sense reflect the ongoing evolution of investing that arises from financial engineering. Yet the question remains: Are such innovations truly superior to using a broad equity index fund for a core as a long-term proposition? Only time will dispense an answer. Meanwhile, there's only opinion, which promises to be fast and furious for these and the avalanche of savvy new products coming down the pike. But for all the push to leverage the intellectual and technological capital that infuses finance, innovators face no small challenge in toppling cap-weighted indexing from its considerable sway over strategic thinking.

Consider, for instance, EnnisKnupp President Richard Ennis, who says market cap indices are still the way to go, warts and all. That immediately removes SEI's alpha-focused approach for core as a contender at this institutional investor consultancy. The new PowerShares ETF seems to have a better chance at embrace. After all, Arnott's strategy for creating a new large-cap core index takes a page from the respected three-factor model of Fama and French, which holds that a small cap value tilt for equity allocations will deliver a superior performance bang for the buck in the long run. But Ennis says that the Fama-French model is merely an empirical observation of history. As a result, the Fama-French worldview doesn't rise to the level of theory, as per the Capital Asset Pricing Model (CAPM), the intellectual foundation that powers capweighted indices, he concludes.

William Bernstein, a principal at Efficient Frontier Advisors in Eastford, Conn., disagrees, countering that market beta--CAPM's lone factor--is "empirically flat." Adding in the additional factors outlined by Fama and French--small caps and value--makes beta work," he says. Even so, he prefers to use the passive small-cap value funds from Dimensional Fund Advisors, which pioneered the application of the French-Fama three-factor model in mutual funds. "I don't want to pay 60 basis points for something I can get from DFA for 30 basis points," Bernstein says.

Of course, if the new PowerShares ETF can live up to its theoretical history of besting the S&P 500 by 200 basis points, an expense ratio of 60 basis points may look like a bargain.

In fact, more than a few advisors keep an open, albeit skeptical mind when it comes to claims of new and improved investment strategies in the 21st century. "We're always looking," says Evensky of equity strategies. "I'd love to come up with something more interesting."

SEI, PowerShares and others are certainly delivering on that front. Rest assured, the new age of reinventing the status quo, from CAPM to cap-weighting indexing and beyond, has only just begun. Nonetheless, the financial advisory world has become increasingly wary of claims for innovating and rethinking, and not without reason. "I'm always cautious on being sold the latest gizmo," says Kathy Boyle, president of Chapin Hill Advisors in New York.

Indeed, building a better mousetrap has a mixed, at best, history of delivering on its promises in money management. That said, true progress arrives every now and again. Indexing, for instance, was once a new and radical notion, initially dismissed as a nutty idea.

Alas, separating the strategic chaff from the wheat is getting tougher in an age of product profligacy. Dismissing everything would make life easier, but it risks overlooking that rare diamond in the rough. Finding the middle ground, as a result, promises to be the great challenge in the years ahead for advisors who want to keep portfolio results above average.

James Picerno ( is senior writer at Wealth Manager.

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