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Portfolio > Portfolio Construction

Diversify Clients Through Indexing

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As we all know, and have known for years, it is important for clients to have adequate diversification in their investment portfolios.

But if ever there was a time to be sure that investors portfolios remain in line with their risk tolerance, its now, when the stock market is volatile and uncertainty about its future direction continues.

A good financial advisor can be an investors most valuable asset in all market conditions, but especially in markets with wide swings, such as exist today. It is critically important for clients to have their risk profiles reassessed to ensure they have adequate diversification among mutual funds, insurance products, and other savings vehicles.

As a financial advisor, your advice and knowledge will be greatly sought during this choppy economic period. Expect to field questions such as, “Should I move money out of the markets and into an annuity?” or, “If I do that, and the market roars back, am I going to miss out?”

To help you address such issues with clients, it may be useful to keep in mind the following ideas related to “passive investing,” or investing in products that replicate an equity market index. The benefits of such products include lower management fees, lower risk, and greater tax efficiencies than can be found in actively managed portfolios.

As you know, properly diversified investment choices can help smooth out the bad times and protect for the future. Over the years, more and more consumers have apparently come to agree with that. As a result, there has been a great proliferation of assets tied to financial indices, such as those at my own company, Standard & Poors.

Why? Investing in an index-linked product, such as an index fund or an exchange-traded fund, is one way of getting diversified exposure to a market with a relatively low cost, tax efficient investment. This is passive investing. Today, more than $1 trillion is passively managed this way to S&P indices.

Insurance products linked to an index are also thriving. In fact, 94% of equity indexed products are tied to the S&P 500, our U.S. large cap equity index.

Thats not all there is to it, however. Within the passive component of equity allocations, there are ways to further diversify and manage risk to the client portfolio. As you evaluate and re-evaluate client risk profiles, asset allocation models will change, so this further diversification might become a valued option for your client.

For instance, in reviewing investment choices with a client, you might want to consider allocating assets to a product that offers exposure to large-, mid- and small-capitalization segments of the market, rather than just large cap. Research has shown that historically this “cap-allocation” could actually have offered a lower risk and a better return to a portfolio than one tied primarily to large-caps.

In the example used in the chart, the assumption is that a portion of the sample portfolio is appropriately allocated to an index-linked insurance product such as a variable index-linked annuity.

As illustrated in the graph, a portfolio that introduces a 5% allocation to the S&P MidCap 400 and a 20% allocation to the S&P SmallCap 600 would historically have lowered risk to the client.

Different mixes would obviously change the risk/reward points, but you can see that the strategy may make sense for your clients. It can also make sense for you, the advisor, because it enables you to provide more options to clients.

With mutual funds, this type of cap-allocation is easily achieved. With an index-linked annuity, product development teams will need to offer their producers a way to implement this strategy. Over time, though, such options should become more readily available.

In sum, the growth in assets linked to various indices demonstrates that individual investors have overwhelmingly embraced indexing as an integral part of their portfolios.

As interest in small- and mid-cap exposure increases, producers have an opportunity to bring additional value to the table. They can explain to clients how exposure to index cap-allocation may make sense for them within an appropriate product, and they can show how some of the new strategies will offer them more choice in the way they execute their diversification plan.

is director of market development at Standard & Poors Index Services, New York. His e-mail address is [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, September 16, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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