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."

"Using index strategies is useful to garner returns from asset classes like large-cap growth stocks, where alpha generation is extremely difficult," says Frank G. DeMaio, CFA and CFP of Sterling Financial, a financial planning group in Concord, N.H. "The actively managed SMAs are probably better used in less efficient areas of the market such as small-cap and value strategies where alpha can be gleaned more readily."

  
Indexing, Hedge Fund Replication, And The World Of ETFs

Despite the application of the firm's models to high-net-worth individuals and families, one of the firm's goals is to provide institutional-caliber investment strategies to a broader set of investors.

"Rules-Based Alpha is where we really bridge the gap between traditional active and passive management and pull institutional investment strategies into a construct suitable for a broad set of investors," says Patti. "We applied our knowledge initially to equity products based on what we learned with the Fortune 500, using fundamental factors to create more value. Whether it's diversification, lower volatility, or better performance, again, it's all about taking investing to the next level."

ETFs are the perfect investment vehicle to accommodate this broader appeal. They are structures that both advisors and their clients easily understand, Patti explains. Since they are a universal tool for which customization is not as important, ETFs create turnkey methods of employing sophisticated strategies in complex investment vehicles such as commodities, emerging markets, and foreign countries. The ETF structure makes these strategies accessible to investors with smaller assets who normally would not have sufficient asset levels to attract managers who employ such strategies.

Another focus of product development at Index IQ was in hedge fund replication. "We wanted to replicate the performance characteristics of hedge funds and what they're providing today-what the broader universe of hedge funds is providing-and offer it under 100 basis points with full liquidity," says Patti. "We felt there might be a lot of value there." The firm developed six underlying strategies including long/short, market neutral and global macro and rolled them into a composite. This was then placed into an ETF so that investors at any level could access an investment that provided alternative beta, low correlation and low volatility.

The three strategies-Rules-based alpha, rotation and hedge fund replication-have all been made available through SMA, ETF and mutual fund investment structures.

The Jury is Still Out

Surz has doubts that the strategies are anything new. "I see a lot of form, but not  substance," he notes.

Todd Battaglia, president of Meg Green & Associates in Miami, says, "I understand a lot of what they're trying to do with the indexes, and it looks like there's a Stern School relationship, so it seems very cerebral at some level-very heavily researched. To me, it feels more like a unit investment trust (UIT), and I don't find that much that's unique about it. I see a lot of these academics' ideas on paper and back tested. And it sounds pretty good! There have been a couple of instances where academics have been able to run portfolios and build wealth. But I think the jury's still out-I'm just not sure how successful they've been."

"Often, academia fails to take into consideration the different needs of individual investors," says Lisa Gray. "Their institutional models don't deal with the different types of tax exposures, the different types of ownership structures, asset locations, and the liquidity and life-event-driven needs with which even multi-million-dollar investors contend." DeMaio offers, "I think these strategies are useful for folks of varying net worth. There are merits to combining qualitative and quantitative strategies in a portfolio-primarily greater diversification and greater risk management."

Jeffrey S. Cohen and Randy P. Siller, partners at Siller & Cohen in Rye Brook, N.Y. (one of the top advisor teams at Lincoln Financial Advisors), both agree that any strategy recommended for a client would have to be based on their situation and goals. "But in general, this may potentially favor a situation where a $1 million to $10 million client is disillusioned with active management and might be looking for a low-fee approach. For clients over $10 million, you can buy the actual positions of the fund and therefore save the costs of the index and the overlaying management fee, so it might not be a good fit for those high-net-worth clients willing to employ that strategy."

However, Battaglia notes that, "The hedge fund arena is the widest area of opportunity for someone with some brains who can replicate some of these strategies and do it for less cost. If someone could come in and offer similar types of volatility and cut the costs way, way down, they'd look like a genius."