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

The Power of One

Asset allocation tends to be a do-it-yourself enterprise for wealth managers. But as multi-asset class funds become more sophisticated, some advisors are reconsidering off-the-shelf asset allocation funds, particularly those structured as a mutual fund of funds.

Love 'em or hate 'em, the product niche is clearly enjoying a renaissance. There were more than 2,300 mutual funds targeting two or more asset classes as of this past August, with a quarter of the population arriving since the end of 2004, according to Morningstar. They come with any number of monikers these days, including the trendy "life-cycle" label along with the old standby "asset allocation." But no matter what you call them, the overall field is growing at a healthy clip. One thing that hasn't changed: This corner of money management remains a mixed bag of strategies and results.

Nonetheless, a select group of the new offerings may find resonance with advisors. One reason is that a growing number of asset allocation funds employ strategies that just a few years ago could be found only in privately managed accounts for wealthy individuals and institutional investors.

Speaking of the past, it wasn't that long ago when asset allocation funds, particularly funds-of-funds, were given a cold shoulder by the independent investment counselors. A leading criticism was that the products were a thinly disguised excuse for layering fees on fees. Others complained that the controlling strategies were pedestrian. Asset allocation, as a result, was considered an essential service that advisors had to offer clients by way of customizing the process. Doing it right meant doing it yourself.

Many, if not most wealth managers continue to embrace that philosophy, and for good reason. Managing asset allocation directly offers more control and, in theory, the chance of producing superior results. Harvesting tax losses, for instance, is better served with a do-it-yourself approach. Meanwhile, farming out asset allocation--said to be the single-most important investment decision--transfers control of the management to someone else.

"I'm getting paid as an investment manager to help clients set up specific portfolios to meet their risk tolerance, goals, income needs, etc.," says Ram Kolluri, president and chief investment officer of Global Investment Management (GIM), a Princeton firm with $150 million under management that specializes in the "mass affluent" client. A typical GIM portfolio can hold 15 or more ETFs and index mutual funds. If a client is interested in a single-fund solution, Kolluri suggests, he should consider working directly with the fund company.

"The reason [clients] come to me is that they want someone to sit down with them and understand their financial needs," Kolluri explains. Individual investors have different investment goals, time horizons and risk tolerances, and their portfolios should reflect those differences, he says. By contrast, delivering highly specialized asset allocation plans isn't possible with off-the-shelf funds, which, he reminds, are built with a composite investor profile in mind.

Nonetheless, the view of asset allocation funds is changing for some professionals. The catalyst is a new breed of funds using concepts and techniques once available only with privately managed accounts. For instance, the Ovation Fund, a mutual fund that rolled out in February, offers a tactical-asset allocation overlay using an array of domestic and international equity ETFs. William Breen, emeritus professor at Northwestern, manages the fund, which is an offshoot of similar strategies he's been running for several years in separately managed accounts offered through AssetMark Investment Services.

Late last year, Oppenheimer Funds launched an ambitious series of asset allocation mutual funds for the advisor community. Holding a varied mix of other Oppenheimer mutual funds, the Portfolio Series comes in four varieties, each targeting a different level of risk and holding multiple asset classes including equities, bonds and commodities. A mean-variance optimization, ? la modern portfolio theory, is the controlling strategy, says Thomas Keffer, product director at New York-based Oppenheimer. The four funds offer an approximation of what an advisor would do with a wealthy client's portfolio, he claims.

Highmark Capital Management's two-year-old trio of asset allocation funds has reportedly found a market with professionals too, including reps at regional broker/dealers, independent advisors and registered investment advisors, says Greg Knopf, the firm's managing director. "The whole concept of asset allocation, diversification and reducing risk...has come into vogue over the last five years or so," he observes. "It's very popular."

Indeed, business is brisk for advising mutual funds on asset allocation-related strategies, says Scott Wentsel, a strategist at Ibbotson Associates, a unit of Morningstar. "It's the fastest-growing part of our consulting business," he notes. "Since 2000, everyone's come to appreciate asset allocation a lot more."

As a result, mutual fund companies are hiring third-party consultants like Ibbotson to set up asset allocation-oriented funds. Pioneer Investment Management, for instance, has used Ibbotson in recent years as the strategic advisor for its four asset allocation portfolios.

Three years ago, SEI Investments launched a series of mutual funds of funds for its advisors. Using an approach developed by SEI, its funds allocate assets across stocks, bonds and cash using a modified version of the standard mean-variance optimization process that's at the heart of modern portfolio theory (MPT).

"We're moving away from optimizing asset allocation in a mean variance format where you're simply optimizing return for every unit of standard deviation," says Ron Albahary, managing director of SEI's private client portfolio management. MPT's traditional risk measure is standard deviation, but that's not the risk that investors face, he asserts. For funding college tuition, for instance, falling short of the goal is the main risk. For retirees, the risk of outliving the assets is the primary threat, he says.

Perhaps the most ambitious asset allocation mutual fund to date is Rydex's latest offering: a trio called Essential Portfolios. Pushing the boundaries of the standard stocks/bonds/cash paradigm, Essential Portfolios embrace the world of so-called alternative investments to a degree that's unprecedented for mutual funds with a multi-asset class perspective. Constructed as a fund of funds, Essential Portfolios own other Rydex funds, which encompass a variety of traditional and non-traditional assets, including funds that use leverage, shorting, arbitrage, currency-related trading, commodities, and a number of hedge fund-related strategies.

David Reilly, director of portfolio strategies at Rydex, says Essential Portfolios deliver a form of asset allocation that's increasingly popular with institutional investors. "We're structuring [Essential Portfolios] much more closely to what you'd see in an institutional portfolio than what you tend to see in the retail marketplace right now."

Reilly is referring to institutions' growing use of non-traditional asset classes (such as commodities and hedge funds) and unconventional trading tactics. For example, consider a traditional asset allocation plan that calls for a 60 percent weighting in stocks. A comparable allocation in Essential Portfolios might reduce that to 30 percent in a Rydex equity mutual fund that's levered two to one. The result arguably delivers a similar exposure to the asset class while freeing up dollars for use elsewhere, where prospects look brighter--a strategy otherwise known as alpha transport.

Rydex isn't shy about suggesting a link between the impressive returns generated by the endowment funds of Harvard and Yale, for instance, which have reported recent annualized total returns in the range of 16 percent to 17 percent for the past 10 years. That's an extraordinary result when you consider that the S&P 500 delivered substantially less--an annualized 11.4 percent for the decade through the end of 2005. How did Harvard, Yale and other savvy institutions beat the odds? By moving beyond the conventional stocks/bonds/cash allocation, Rydex asserts.

No one disagrees. The question is whether the results enjoyed by Harvard, Yale and other large institutional investors is replicable in retail mutual funds. Rydex, for one, aims to find out. Nonetheless, even Rydex admits that endowments and pension funds have advantages that aren't necessarily available to mutual funds, particularly small ones venturing into bold asset allocation strategies for the first time. Yale's endowment, for instance, had a hefty allocation to private equity (15 percent in June 2005)--an asset class that's beyond the reach of mutual funds.

There's also the issue of management skill. Unlike single-asset funds, there's no passive equivalent for asset allocation. Allocating investments based on market capitalization comes the closest to that ideal, but almost no one invests this way. Skill and timing, in sum, count for much when it comes to asset allocation. David Swensen, Yale's chief investment officer, has been hailed as one of the great investment strategists of his generation. Alas, not every manager overseeing asset allocation is a Swensen.

In fact, mediocrity seems to be fairly common, even for ambitious institutional investors. Consider the performance history of the endowment funds for members of the National Association of College and University Business Officers (NACUBO), which includes the likes of Harvard, Yale and other schools. The equal-weighted average of returns for this group from 1990 through last year was 9.9 percent--well behind the S&P 500's 11.5 percent annualized total return over that span.

Maybe that's why even institutional investors are starting to reconsider off-the-shelf asset allocation funds. Fran Kinniry, a Vanguard Group principal in the firm's investment counseling and research division, says "some very large mandates" have been investing in the firm's multi-asset class funds. They're also using the portfolios as benchmarks for judging managers.

It's not hard to see why. The Vanguard Asset Allocation Fund, for the 15 years through this past August, posted a 10.5 percent annualized total return. That's comparable to the S&P 500's record over those years, but with a significantly smoother ride; the fund's standard deviation was about half that of the S&P 500's. What's more, the cost is an expense ratio of only 38 basis points for retail investors.

Still, it's unlikely that the top wealth managers are about to start moving clients into single-fund solutions any time soon. Then again, one needn't view the new breed of asset allocation funds as an all-or-nothing proposition. One example: using one of the asset allocation funds as a core holding for smaller accounts that may not justify the expense and time required for a full-blown customization.

Another perspective is using some of the more innovative asset allocation funds as a low-cost global macro-hedge fund equivalent. Robert Arnott, manager of PIMCO All Asset Strategy Fund, says that institutional investors account for about 70 percent of the portfolio's $13 billion in assets. One of the attractions is the multi-asset class fund's low correlation with the stock market. For the three years through this past August, the All Asset fund's performance posted a correlation of 0.40 with the S&P 500 (1.0 is perfect positive correlation, 0.0 is no correlation), while delivering about 88 percent of the benchmark's return over those 36 months.

Despite the opportunities, wealth managers serving high-net-worth clients aren't likely to suddenly embrace asset allocation funds to any great degree. At least not yet. In the meantime, ignoring the niche won't stop the comparisons that these increasingly popular and innovative products invite. The financial industry grows evermore competitive--a fact that doesn't stop at the gates of asset allocation. If nothing else, advisors should be prepared to explain the benefits of customized strategies and how they compare to the generic competition.

James Picerno ( is senior writer at Wealth Manager.

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