With the turbulent markets of late, investors have been seeking higher returns with less volatility. Is that a match found only in a fictional land like Utopia? Or could a hybrid product offering index-like features with hedge-fund-like returns be a working reality? With index investing used as a foundation, numerous strategies are being employed to help generate returns that may beat the market while keeping costs low and allowing investors to sleep at night.
But how effective are these strategies? The world of academia theorizes that they could be quite successful, but how do they work in the real world? By taking a look at three commonly used investment vehicles and the innovative strategies being employed through them, advisors may get a glimpse of what's possible-and what's not-in the world of investment Utopia.
Index Investing 101
As we know, indexes were originally developed to be used as benchmarks. Academics Eugene Fama and Kenneth French created research indexes to form the basis for William Sharpe's capital asset pricing model, the "Three Factor Model." Other indexes were created by Robert Arnott and Jeremy Siegel based on fundamental factors such as dividends, earnings and book value. Other famous names have made history using indexes-people like John Bogle and Charles Ellis, for instance.
Siegel and his team have employed a method that uses dividends to weight the stocks included in their indexes. They believe dividends are tied to the fundamental values of stocks and that as investors automatically reinvest their dividends during times of downside market volatility, they accumulate more stock at lower prices in a way that is similar to dollar cost averaging. Dividends are also subject to lower taxes, are a cash measurement of a company's value and signify the health of a company's cash flow and profitability.
Siegel's firm Wisdom Tree (www.wisdomtree.com) offers both dividend and earnings-weighted ETFs. Arnott's firm, Research Affiliates, also uses fundamental weighting, but bases its weightings on the size of the company as opposed to its market capitalization (which is what the S&P 500 index uses). The firm offers three other strategies-an asset/liability hedging strategy for pension funds; a global tactical asset allocation strategy that employs commodities, real estate investment trusts (REITs) and emerging markets plays, among other investments; and a tax-minimization strategy.
Index IQ, a firm in Rye Brook, N.Y., has been developing its own new offering over the past 18 months-forging products that try to integrate basic indexing qualities such as low costs, low volatility and daily liquidity with alpha-producing strategies such as alternative investments might offer. "We've been hard at work developing investment strategies that we believe are unique and which, more importantly, offer value to the investor," says Adam Patti, CEO of Index IQ. "If you look at the indexes that make up most of the assets of the world, indexing really hasn't evolved over the past 30 years. Most index products were not developed originally to be investment products. They were benchmarks, which is why they haven't changed in so many years."
The firm offers three product categories-SMAs, ETFs and mutual funds-all of which feature what it calls "Rules-Based Alpha," a combination of quantitative and qualitative strategies designed to offer superior risk-adjusted returns. According to Ron Surz, president and CEO of PPCA Inc. in San Clemente, Calif., mixing quantitative and qualitative strategies is nothing new. "The key is how they track the index while they're adding value," says Surz, noting that many firms are "hugging a benchmark" while making small bets around it using some form of factor analysis.
Indexing And SMAs
Index IQ has a good marketing approach. But what benefit does indexing have in a separately managed account, when the point of an SMA is to have active management-having someone manage your funds for you? If investors wanted an index fund, they could buy it on their own. Meanwhile, if an index incorporates alpha into the mix, is it still an index fund? Patti says his firm is trying to take investing to a higher level. SMAs accommodate the higher customization sought by family offices and ultrahigh-net-worth investors. Placing a group of ETFs to be managed within an SMA format combines the advantages of indexing with an active management overlay provided by an SMA.
For example, the firm generally will use nine different ETFs or exchange-traded vehicles and rebalance them monthly using a proprietary model measuring the vehicles' momentum factors. They are overweighted or underweighted based on the model's dictates, and their turnover is 60%. This rotation is charged with the same fees you would use for an SMA. And ETFs within an SMA is nothing new.
There are two global rotation models the firm has created that rotate in and out of various countries. "One of our country products has a higher degree of emerging markets exposure, and then we have more of an EAFE-type product where we rotate among approximately 20 country ETFs. And we'll soon have a global sector rotation product as well," explains Patti.
"The beauty of an SMA," he continues, "is that it is highly customizable, and the fact that we've built our own strategies and then commercialized those strategies gives us the ability to actually implement that customization. So with SMAs, customization and satisfying the needs of higher-net-worth clients is easy."
According to Lisa Gray, a managing member of Graymatter Strategies LLC in Richmond, Va., customization and the variety of investment choices such strategies provide are important for advisors serving families with assets in the hundreds of millions of dollars. "Costs are also important," she says, "and if these are strategies which truly fulfill their claims, families of wealth may embrace the opportunity to garner better returns with the traditional advantages of indexed investments."