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Challenging Traditional Active Management

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Index Nov-04 QTD YTD Description
S&P 500 Index* 3.86% 5.31% 5.57% Large-cap stocks
size=”-1″>DJIA* 3.99% 3.45% -0.25% Large-cap stocks
Nasdaq Comp.* 6.17% 10.54% 4.66% Large-cap tech stocks
Russell 1000 Growth 3.44% 5.05% 2.29% Large-cap growth stocks
Russell 1000 Value 5.06% 6.80% 12.72% Large-cap value stocks
Russell 2000 Growth 10.34% 13.02% 8.45% Small-cap growth stocks
Russell 2000 Value 19.40% 21.25% 8.87% Small-cap value stocks
size=”-1″>EAFE 6.86% 10.51% 15.62% Europe, Australasia & Far East Index
Lehman Aggregate -0.80% 0.03% 3.39% U.S. Government Bonds
Lehman High Yield 1.21% 3.04% 9.50% High Yield Corporate Bonds
Calyon Financial Barclay Index** 4.10% 5.90% 1.31% Managed Futures
size=”-1″>3-month Treasury Bill 1.03%
All returns are estimates as of November 30, 2004. *Return numbers do not include dividends. **Returns as of November 29, 2004.< /td>

Over the past few months, a handful of studies are reporting that the age-old method of selecting active asset managers has resulted in little more than disappointment.

According to Why Do Institutional Plan Sponsors Fire Their Investment Managers?, by Jeffrey Heisler at the Boston University School of Management, plan sponsors tend to favor managers that have historically outpaced their benchmarks, and are quick to sell funds that go through tough patches. Institutional investors typically use advanced quantitative techniques in choosing managers, although the authors believe (based on preliminary findings) that plan sponsors do not add value through this selection process.

The alternative investment crowd echoes this sentiment. According to Institutional Demand for Hedge Funds, by Casey, Quirk, and Acito and the Bank of New York, hedge funds of funds are gaining assets to the detriment of traditional, active-only allocations because the latter approach has failed to consistently generate market-beating returns.

Morgan Stanley’s latest European asset management missive is equally forthright. In Morgan Stanley’s view, the growing polarization of the industry favors dirt-cheap indexers and specialist managers who offer steady returns.

These trends filter down to wealth management in a number of discrete ways. First off, advisors will need to become increasingly nimble in order to generate the types of returns their investors want. The old game of choosing an actively managed large-cap mutual fund and hoping for the best are likely over. Innovative products such as ETFs and hedge funds should be considered, especially for those interested in marketing to the wealthiest segments of the market.

Matching client needs with returns is also a crucial piece of the puzzle. As Peter Bernstein once said, “survival is the only road to riches.” In his view, one should try to maximize returns only if losses don’t threaten survival and there is a compelling need for extra gains. As wealth managers, it’s time we realize that our clients don’t fit into this risky category, and our actions as prudent asset allocators should reflect that realization. Ben Warwick is chief investment officer of Sovereign Wealth Management in Denver and the author of Searching for Alpha: The Quest for Exceptional Investment Performance (Wiley, 2000) and The WorldlyInvestor Guide to Beating the Market (Wiley, 2001). You can purchase these books at the IA Bookstore at