This article will appear as a chapter in the forthcoming book, “A New Framework for Portfolio Construction,” to be published in 2009 by the Academic Press.

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He who stops being better
stops being good.
Oliver Cromwell

A solid investment program evolves from the integration of various interrelated disciplines, or puzzle pieces. Asset allocation is paramount and involves not only the assignment to asset classes but also the make-up of asset classes, specifically the types of stocks, bonds, etc. The active-passive decision – allocating between active managers and passive indexes – is an important part of the investment program, and constitutes a second level of the portfolio construction puzzle that needs to be solved.

In this chapter we focus on solving the equity investment part of the puzzle which entails (1) the composition of the equity market so we can determine how we want to allocate within it, and (2) the metric we’ll use to identify talent so we can make an informed active-passive decision. The first puzzle involves choosing the best family of market indexes. The second involves investment manager evaluation, and requires the construction of the best benchmarks.

As you will see, indexes are not the same as benchmarks, although they are connected. We’ll begin our discussion with the distinction between the two.

Equity Market Composition

An index is a barometer of how a particular market segment has performed. For example, the Dow Industrial Index tracks the performance of 30 industrial stocks. By contrast, a benchmark establishes a goal for the investment manager. A reasonable objective is to earn a return that exceeds a low-cost, passive implementation of the manager’s investment approach. This may be an index, especially if the investment manager is an index hugger. But it is best to consider customized benchmarks, which is the subject of the next section.

Solving the equity allocation puzzle requires decomposing the market into segments that behave differently, so we can be sure that we have diversified among these components. The benefits of diversification arise from allocations to assets that are uncorrelated, or move differently. The relatively recent introduction of style indexes (based on market capitalization and value/growth) work well for this purpose, although you could choose another differentiator like economic sector. Style indexes have the desirable property of being easily applicable to many money manager disciplines, so they set up well for the second piece of the puzzle. A variety of style index families are available for consideration, including the popular Russell and S&P indexes, and the less well known Surz Style Indexes.

So how do we choose from among these candidates? We want to divide up the market in small enough pieces that behave differently but not so many pieces that integration is unwieldy.

The Russell and S&P families come in six pieces: large, middle and small sizes of both value and growth. There’s an inconsistency here that matters a great deal. On the size scale, defining a middle in between large and small has proven worthwhile since there have been periods when mid-cap stocks have outperformed both large and small, and periods when they have underperformed. Mid-caps behave differently than small and large so it’s important to have a separate and distinct barometer for this segment of the market.

What is missing is a similar differentiator on the style front, namely something between value and growth. There are degrees of value and growth, so some growth stocks are more aggressive than others, and some value stocks are deeper value than others.  And some stocks have characteristics that are not clearly value or growth – they’re the stuff in the middle. Russell deals with this issue by allocating a percentage of each fuzzy stock into value and growth – they are classified as a specific unique mixture of value and growth. S&P ignores the problem altogether by drawing a hard line that divides half of the market’s value between value and growth.

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