A look at an important and elegant enhancement to model portfolio programs. Ronald Surz is president of PPCA, a San Clemente, Calif.-based software firm that provides advanced performance-evaluation and attribution analytics, and a principal of RCG Capital Partners, a Denver, Colo.-based fund-of-hedge-funds manager.

Model portfolios are being touted as the investment industry's newest and best solution. Investment managers submit their models to broker sponsors who then package these style and asset classes into various diversified programs, tailored to investors with varying risk appetites.

Despite all the hoopla, these programs could stand improvement, and certainly will evolve. For example "core" -- the stuff in the middle between "value" and "growth" -- has gone largely unnoticed.

Strategic bets

Most model portfolio programs acknowledge a middle range in company size by employing large-, middle- and small-capitalization managers. But none realize that there is a similar middle in styles: a core in between value and growth. Ignoring this core leads to poor diversification and the consequent exposure to poor performance.

Mid-cap companies do not perform like large and small companies, so there are good reasons to treat them as a separate category. Similarly, "homogenized core" stocks -- the stuff in the middle as opposed to a blend of value and growth -- perform differently than value and growth.

Using the Surz style index definitions, core surprises about a third of the time on a quarterly basis by either outperforming or underperforming both value and growth. In other words, core doesn't fall in between these two styles about a third of the time. Accordingly, ignoring homogenized core is like throwing away the filling in an Oreo cookie - it's the sweet spot of diversification, around which value and growth revolve.

Here's what's happening in model portfolio programs. Value and growth models receive allocations that are roughly the market weights in these styles, plus the sponsor usually applies strategic bets above or below market weights to enhance performance.

But these bets unknowingly underweight homogenized core all the time. Research conducted by Frank Sortino of the Pension Research Institute indicates that allocations to skillful value and growth managers systematically underweight the middle of the market.

This is understandable in light of the scrutiny that most managers are under to maintain style consistency. Managers have incentive to sell companies that drift toward the middle, away from their declared style. The result is an unintended bet in model portfolios away from homogenized core -- and of course that's at odds with effective diversification.

This is an easy problem to fix. Broker sponsors can refer to the composition of homogenized core as another, albeit passive, model. The constituents of the current large cap core are provided in the following table.

Homogenized large-cap core model portfolio: Q1 '07

Ticker
Size($B)
Company Name

ABX
26.52

BARRICK GLD

AET
22.54
AETNA INC

AFL
22.66
AFLAC INC

AIG
186.26
AM INTL GRP

AL
18.33
ALCAN INC

AMA
25.68
APPLD MATLS

APD
15.21
AIR PRDS&CH

AXP
72.74
AM EXPRESS

BK
29.76
BANK OF NY

BRK
169.6
BERKSHIRE A

BUD
37.83
ANHEUSR-BSH

CCU
17.55
CLEAR CHANL

EMR
35.48
EMERSON EL

EXC
41.53
EXELON

FDX
33.36
FEDEX CORP

FRE
47.03
FREDDIE MAC

GD
30.17
GEN DYNAMCS

GPS
16.03
GAP INC

HOG
18.26
HARLEY

IBM
146.34
INTL BUS MA

INTC
116.6
INTEL CORP

JCI
16.84
JOHNSN CNTL

JCP
17.38
PENNEY (JC)

JNJ
191.74
JOHNSN&JHNS

K
19.91
KELLOGG CO

KO
113
COCA-CL CO

KR
16.31
KROGER CO

LMT
38.79
LOCKHD MART

LOW
47.35
LOWE'S COS

LTR
23.07
LOEWS CORP

MCD
54.82
MCDONALDS

MET
44.85
METLIFE INC

MMC
16.88
MARSH&MCLEN

MOT
49.7
MOTOROLA

NKE
24.96
NIKE INC-B

PEP
102.96
PEPSICO INC

PFG
15.83
PRINCPL FNL

PG
203.66
PROCTR & GM

PRU
40.98
PRUDNTL FIN

PX
19.16
PRAXAIR INC

RTN
23.46
RAYTHEON CO

STT
22.42
STATE ST CP

SU
36.27
SUNCOR ENGY

TGT
49
TARGET CORP

TOC
26.62
THOMSON

There's a good chance that many of the stocks in this model core portfolio will appear among the current holdings of value and growth managers, so the diversification fix is as much on the weights as on the membership. Our definition of homogenized core is the 20% in the middle -- it's 20% of the market. It's a simple matter to merge the current models' holdings in core with a model core to constitute 20% of the U.S. equity holdings.

Sometimes the simplest solutions are the most elegant. -FWR

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