Core and Explore: Where's the Alpha?

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.