THE ULTIMATE OBJECTIVE

The ultimate objective of investment management, of course, is to establish an investment structure that will, in the aggregate and over time, provide a return that compensates for the risk incurred, where the risk incurred is consistent with the investor's risk tolerance. The objective may be the equity market's return at the market's risk level or the market return plus incremental returns commensurate with incremental risks incurred.

This may be accomplished by focusing on the core universe and a passive representation or by mixing universes (core and static subsets, for example) and approaches (e.g., passive with traditional active or engineered). Whatever the selection universe and investment approach chosen, success is more likely when investors start off knowing their risk-tolerance levels and their potential managers' skill levels. The goal is to take no more risk than is compensated by expected return, but to take as much risk as risk-aversion level and manager skill allow.

Success is also more likely when equity architecture is taken into account. Without explicit ties between portfolios and the underlying market or market subsets (and thus between market subsets and the overall market), managers may be tempted to stray from their fold (core, value, or growth investing) in search of return. If value stocks are being punished, for example, an undisciplined value manager may be tempted to poach return from growth stock territory. An investor utilizing this manager cannot expect performance consistent with value stocks in general, nor can the investor combine this manager's “value” portfolio with a growth portfolio in the hopes of achieving an overall market return; the portfolio will instead be overweighted in growth stocks, and susceptible to the risk of growth stocks falling out of favor. The investor can mitigate the problem by balancing non-benchmark-constrained, traditional portfolios with engineered or passive portfolios that offer benchmark accountability.

When investors set goals in terms of return only, with no regard to equity architecture, similar problems can arise. Consider an investor who hires active managers and instructs them to make money, with no regard to market sector or investment approach. Manager holdings may overlap to an extent that the overall portfolio becomes overdiversified and individual manager efforts are diluted. The investor may end up paying active fees and active transaction costs for essentially passive results.

Equity architecture provides a basic blueprint for relating equity investment choices to their potential rewards and their risks. It can help investors construct portfolios that will meet their needs. First, however, the investor must determine what those needs are in terms of desire for return and tolerance for risk. Then the investor can choose managers whose investment approaches and market focuses offer, overall, the greatest assurance of fulfilling those needs.

We believe that engineered management can provide the best match between client risk-return goals and investment results. An engineered approach that combines range with depth of inquiry can increase both the number and goodness of investment insights. As a result, engineered management offers better control of risk exposure than traditional active management and incremental returns relative to passive management, whether the selection universe is core equity, static style subsets, or dynamic style subsets.