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Core and Explore: Where's the Alpha?

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Index April 2003 QTD YTD Description
S&P 500 8.10% 8.10% 4.22% Large-cap stocks
DJIA 6.11% 6.11% 1.66% Large-cap stocks
Nasdaq Composite 9.18% 9.18% 9.64% Large-cap tech stocks
Russell 1000 Growth 7.39% 7.39% 6.25% Large-cap growth stocks
Russell 1000 Value 8.80% 8.80% 3.51% Large-cap value stocks
Russell 2000 Growth 9.46% 9.46% 5.22% Small-cap growth stocks
Russell 2000 Value 9.50% 9.50% 3.94% Small-cap value stocks
MSCI EAFE 9.62% 9.62% 0.83% Europe, Australasia & Far East Index
Lehman Aggregate 0.83% 0.83% 2.23% U.S. Government Bonds
Lehman High Yield 5.93% 5.93% 14.00% High-yield corporate bonds
Carr CTA Index 0.96% 0.96% 4.91% Managed futures
Through April 30, 2003.

“Core and explore” investing, a strategy that grew out of market participants’ desire to beat the market during the late 1990s, is in vogue once again.

Over the last few years, practitioner journals have published a number of well-regarded studies that trumpet the benefits of core and explore versus the more classic multi-asset-class approach.

Core and explore proponents put the bulk of their assets in a low-cost, broadly diversified index fund, and attempt to generate excess return by allocating the balance to a handful of actively managed funds.

The renewed interest in core and explore may be due to a parallel resurgence in sector-based investing. With the globalization of the world economy, there is considerable doubt whether regional factors adequately explain the return of a given stock. At the same time, global industry classification systems like the ones developed by Morgan Stanley Capital International (MSCI) will soon allow investors to research and choose every stock in a given industry without regard to geographical location

At present, 63% of European assets are now allocated on a sector basis rather than a country or cap basis, up from 22% in 1997, according to MSCI. Institutional investors in the U.S. also seem to be jumping on the bandwagon.

A private study recently performed by Ibbotson Associates adds credence to the sector investing approach. According to the report, including a handful of sector funds can add more portfolio diversification than a similar strategy of using international mutual funds.

I’m a big fan of diversification. If the “core” in the core and explore approach eliminates manager overlap and reduces fees, that part of the strategy should perform just fine. But what about the “explore” part of the equation? It seems hard to believe that investment advisors will be able to generate alpha for their clients by choosing a handful of market-beating sectors funds, a job that the most die-hard proponent of the efficient market theory would have to admit is nearly impossible. Picking a broadly diversified actively managed fund (or separate account) is almost as difficult. For starters, such funds tend to have high turnover, which increases their expenses and decreases their tax efficiency, a combination even the most talented manager will have trouble overcoming.

Searching for alpha can be a rewarding experience, but one must look for it in the right places. Specifically, those asset classes that exhibit sufficient pricing inefficiencies–small-cap stocks and high-yield bonds, for example–should be captured through active management. Asset classes that do not demonstrate such inefficiencies should be indexed.

So where does this leave core and explore? When parsed along industry lines, the only active strategy that has proven itself over time is sector long-short hedge funds. As a result, a portfolio designed along these lines would require a significant allocation to alternative investments.


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