The stock market is a long way from Lake Wobegon, Garrison Keillor's fictional Minnesota town where everyone is above average. In fact, when it comes to active equity management, most folks lag low-cost index funds. Considering the tenaciously efficient nature of the stock market, figuring out the best way to generate additional alpha is an important topic for investment advisors of every stripe.
The most relevant work in the area of increasing investment return was performed by Richard Grinold and Ronald Kahn in their seminal Active Portfolio Management (McGraw Hill, 1999). The authors argue that a manager's return-risk ratio can be improved by either increasing skill or broadening scope. Since improving skill is at best a tenuous pursuit (though pursued and promised by many), the two men state that the best way for a manager to improve returns is by combining a large number of uncorrelated strategies in a portfolio.
For the manager of a large pooled account, this idea would correspond to having as wide an investing mandate as possible. But even for an investment advisor that only uses index investments, this philosophy can be quite useful. Consider a traditional portfolio with a 60% stock, 40% bond mix, for example. Within the equity portion of the portfolio, he might tilt along the valuation axis, preferring to own a larger percentage of growth stocks than is present in the index. The Russell 3000 index, for example, is about evenly split between growth and value; a growth "tilt" would translate into owning more growth than value exchange-traded funds. Using the same methodology, he could also underweight small-cap stocks relative to large-cap stocks.
The bond allocation also offers a number of ways to add value. In a rising rate environment, a tilt to a lower duration fixed-income fund might be favored over an investment in the Lehman Aggregate Bond index. Or the advisor might adjust credit exposure in the form of a high-yield debt tilt if conditions warrant.
There are two important benefits to this approach. First off, this strategy allows RIAs to stay close to their benchmark. As a result, the tracking error, or difference in return between client accounts and the model portfolio, should be fairly small. Clients will likely participate in most market rallies, but a healthy allocation to fixed income should offset potential equity selloffs.
The second benefit, of course, is that client accounts have the potential to beat their benchmarks if the tactical tilts crafted by the advisor gain ground. But even if the tilts aren't profitable, they can still add value, if their returns are uncorrelated to the broader stock and bond markets.
The table below shows the correlation of a number of common tilts. In many cases, the correlations are negative, thus providing significant diversification benefits.
In my view, this is the type of intelligent risk that advisors should be taking. The uncorrelated nature of portfolio tilts creates a type of safety net that puts the advisor in the driver's seat. Combined with tax-loss selling and account rebalancing, portfolio tilts are a powerful addition to an arsenal and a nearly fool-proof way to generate alpha for clients.
The Puzzler, CIO of Memphis-based Sovereign Wealth Management, can be reached at email@example.com.