Wealth Manager

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, á 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.