CHICAGO -- Consultant Ennis Knupp + Associates is urging clients to abandon narrowly defined specialized U.S. equity portfolios, adopting instead a combination of indexed strategies and broad-based "whole-stock portfolios" for domestic equities.
If widely adopted, the recommendation would reverse a 20-year-plus trend in institutional money management toward specialization, could involve reallocation of billions of dollars in domestic equity assets, and would eliminate such categories as small-cap value or large-cap growth stocks.
Ennis Knupp has 97 retainer tax-exempt institutional clients with a total of $190 billion in assets.
Chicago-based Ennis Knupp consultants propose a three-pronged approach:
* In general, clients would increase passive investments to 70% to 80% of domestic equities; currently, Ennis Knupp clients tend to have about 55% to 60% of assets passively tracking benchmarks.
* The firm intends to build a list of 10 to 15 active preferred managers capable of running "whole-stock" portfolios. An RFP has been posted on Ennis Knupp's website at www.ennisknupp.com/satellites/infoformgers_whole.html.
* A single fee will be negotiated with preferred managers for all Ennis Knupp clients, regardless of their individual sizes.
One upshot is that the managers for the active part of portfolio would take more aggressive bets, while the indexed core would provide risk control for the entire domestic equity portfolio.
"What plan sponsors have been doing is creating overdiversified structures with active managers," explained Suzanne Bernard, principal and director of manager research for Ennis Knupp. As a result, they've "been getting an index-type structure" while paying much higher active management fees, she said.The concept is not entirely new: many pension funds have pursued a similar approach with fixed-income investments in the form of core-plus portfolios. In addition, international equity mandates tend to be broadly based, as specialized regional and emerging market portfolios have been falling out of favor in recent years.
Still, reversing course could take time.
"I'm glad to see it, but I think the move is going to be glacial," said Peter Bernstein, president of Peter L. Bernstein Inc., New York, and consulting editor to the Journal of Portfolio Management, where the proposal is to be published.
Needs preferred managers
Ennis Knupp now needs a universe of preferred managers that can provide whole-stock portfolios. To do this, the firm has posted a request for proposals from money managers on its website and seeks responses by Dec. 31, Ms. Bernard said. In the process, the number of active domestic equity managers with which clients contract could be cut to 40 or 50 from 120, Ms. Bernard said. The firm will continue to monitor 400 domestic equity managers.
There's big money at stake in terms of returns.
The failure of the prevailing multiple specialist system to provide added value costs U.S. pension funds approximately $14 billion a year, wrote principal Richard M. Ennis in a paper that will be published in the Journal of Portfolio Management.
The strategy would give managers the opportunity to enhance returns by shifting in and out of sectors and styles. What's more, it would free pension executives from having to "manage the collective style of several active managers, eliminating in the process fairly arbitrary and rigid boundaries within the active equity portfolio," Mr. Ennis wrote.
He also said multispecialist strategies have failed to outperform their benchmarks. Using data from Cost Effectiveness Measurement Inc., Toronto, he found that active U.S. equity strategies came up short by an average 118 basis points annually in the eight-year period through 1999 - virtually identical to the 120 basis points Mr. Ennis has estimated as the cost of operating a multimanager portfolio.
Funds of funds, which combine multiple specialist managers, fared no better, providing underperformance of 134 basis points a year, he wrote.
Difficulty with changes
While style definitions have become narrower -- one leading manager database uses 76 categories to classify active U.S. stock managers, the article notes -- consultants and clients are ill-equipped to make tactical changes among market sectors or style.
Instead, "they are left to attempt to enforce a certain style purity among managers, keeping each in its designated style `box,' and plugging gaps between the boxes in an effort to maintain a style-neutral portfolio," Mr. Ennis wrote.
Rather than policing style, pension funds can add value by adopting an indexed core and whole-stock portfolio approach, he added. For example, a pension fund that indexes 50% of its domestic stocks and employs eight active managers could generate 100 basis points of active risk, with total operating costs of 65 basis points.
By boosting the passive component to 80% and reducing the number of active U.S. stock managers to two, the pension fund could produce the same level of active risk but would halve costs to 32 basis points, increasing the expected net return by 33 basis points, Mr. Ennis explained.
The upshot is that active managers would make a broader range of investment calls, pension executives would have fewer decisions to make, the number of managers hired would be fewer and expenses would fall, he concluded.
The next question, Mr. Ennis teased, is whether it makes sense to continue distinguishing between active domestic and foreign stock investments.
While no clients have yet embraced the whole-stock concept, the $7.5 billion Maine State Retirement System is studying it, said David Wakelin, chairman of the board of trustees.
Interest piqued
"We are intrigued by the possibilities of hiring a manager, giving them the Wilshire 5000 as a benchmark, and having the leeway to go between large- and small-cap, even going into convertible securities," said Mr. Wakelin.
He added the fund's active equity managers generally have underperformed their benchmarks, and the fund may not be taking full advantage of some managers' investment capabilities by confining them to a narrow mandate.
Currently, 79% of the fund's $3.7 billion in domestic equities are indexed. In its actively managed component, the fund has a $450 million large-cap growth portfolio with Alliance Capital Management LP, New York, and a $315 million small-cap portfolio with Peregrine Capital Management, Minneapolis. Another $20 million in a multimarket fund with J.P. Morgan Investment Management Inc., New York, is being liquidated.
Kathleen Palm, city treasurer for Hartford, Conn., said she does not expect the $1.08 billion Municipal Employees' Pension Fund to make any changes in its domestic equity structure. The board was scheduled to meet Nov. 27 to review Ennis Knupp's recommendations.
"Initially, I think it's an interesting concept, but frankly not one that we will pursue," she said. Ms. Palm said the pension fund's active managers have performed well.
Tim Barrett, retirement investment manager for the $3.7 billion San Bernardino County (Calif.) Employees' Retirement Association, said he thinks either a multiple specialist or a whole-stock approach "has the ability to work, assuming you can hire the right managers."
The fund, which hired Ennis Knupp last August, expects to deal with manager structure issues early next year, following review of an asset-liability study Jan. 4.
