Portfolio Review: Seeking Beta Instead of Nebulous Alpha

February 07, 2008

New York-based pro studying ETFs as low-cost way to access alternative asset classes and side-step high-priced hedge funds.


Some investors tell Mark Armbruster his strategy's boring.

"But I think of it as powerful in its simplicity," said the Rochester, N.Y.-based advisor. "We don't focus on what's proven not to work, like timing markets. We think using decades' worth of academic research stacks the odds in our favor over time."

Armbruster serves as chief investment officer at Alesco Advisors, which manages around $1 billion in stock and bond assets. Most of that business is working with institutions such as corporate pension funds, private foundations and endowments.

But a good deal also involves high net worth individuals. "We've been pleased that people aren't freaking out in the current market conditions," he said. "They're continuing to focus on medium- to long-term objectives and making sure their asset allocations are appropriate to meet those goals."

His firm likes to use exchange-traded funds (ETFs) to help build portfolios. "On the equity side, the majority of our assets are in ETFs," said Armbruster. "All things being equal, we prefer using bond index mutual funds rather than ETFs."

Alesco has tried various bond ETFs in the past. "We do use them, but they're not our first choice because tracking error tends to be quite high in the ETF format," Armbruster noted. "A lot of the bonds that need to be delivered for creation units are less liquid. So the Authorized Participants, who can step in and arbitrage the spread between market price and NAV, aren't willing to do that in bonds a lot of the time."

Only a handful of securities are often available in bond ETF portfolios as well. "Some of the New York state muni bond funds only have 15-20 individual issues in their portfolios," Armbruster said. "The benchmarks for bond ETFs hold hundreds of different issues. So there's going to be tracking error issues just from the fact that bond ETFs have to use sampling techniques to replicate their benchmarks."

As the firm's chief investment officer, he rarely suggests tactical allocation changes. On average, he'll tweak portfolios every two years or so if necessary. But at the end of last year, Armbruster became concerned about valuation levels in real estate investment trusts. "REITs had run up for a number of years and valuations were way above their historical averages," he said. "So we lowered our allocations to REITs. But we didn't get out of the asset class totally."

He prefers Dow Jones Wilshire REIT ETF (AMEX: RWR) and Vanguard REIT Index ETF (AMEX: VNQ). "On average, we went from a 5% weighting down to around 3% of total assets in December of 2007," said Armbruster. "But now that they've corrected, we think REITs are more attractive."

As a result, he's been shifting recently back into REITs. But instead of adding to RWR and VNQ, Armbruster's been advising his clients to diversify overseas. The firm's been adding to its REIT holdings by buying the SPDR Dow Jones Wilshire International Real Estate ETF (AMEX: RWX).

"It's nothing about the timing or a call on valuations," he noted. "The reason why we like it is that international REITs have very low correlations to stocks, bonds and domestic REITs."

Foreign REITs is an asset class his analysts have been watching for awhile. "But it's an area that we couldn't access easily or efficiently at relatively low costs until recently when international REIT ETFs started showing up in the market," said Armbruster. "We've been waiting to see how this ETF performed in terms of tracking error. Our research showed it has done a pretty good job at replicating its index."

The next allocation innovations he sees coming is using ETFs to gain exposure to alternative asset classes. The firm has been studying PowerShares DB G10 Currency Harvest (AMEX: DBV). "They look at the G-10 currencies. They'll short the currencies in the countries with the lowest interest rates. They'll then buy the currencies of the nations with the highest interest rates," Armbruster said.

If interest rates are significantly different among major economies around the world, "the theory is that the currencies will adjust so that your return from this sort of strategy will be zero," he noted.

But historically, that hasn't been the case, Armbruster added. "There actually has been in the order of a 10% return over time from this type of strategy," he said. "And the correlations are very low to traditional asset classes."

If they decide to add the ETF, it'll go as a separate asset class. "It's our answer to hedge funds," said Armbruster. "Everyone wants to be in hedge funds. But there's still a lot of debate over whether you can really add alpha through hedge funds, especially with their fee structure."

So, his firm likes to go with low-cost alternatives focusing on alternative beta "rather than chasing alpha, which may or may not be there," Armbruster added.

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