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Modular Portfolio Construction®: Bringing an Institutional Framework to Individual Investors' Portfolios July 1, 2008

Modular Portfolio Construction is a Financial Engineering program brought to you by Janus Labs® In the world of asset management, it is widely acknowledged that among institutional investors university endowments in particular have historically enjoyed better performance results over time than individuals. The 10-year average annualized return of Yale University's endowment was 17.8% (through June 30, 2007), while Harvard and Stanford each produced similarly impressive returns of 15.0% and 15.1%, respectively. All of these endowments greatly outperformed the S&P 500® Index total return of 7.1% and, according to Dalbar, the average asset-weighted return earned by individual investors over the same period was lower still, at only 6.2%.1

Source: Yale University Office of Public Affairs, Stanford Management Company, Harvard Management Company and DALBAR1. According to DALBAR, the average equity fund investor earned 10-Year Average Annualized Returns of 4.5% as of December 31, 2007. Average stock investor performance was used from a DALBAR study, Quantitative Analysis of Investor Behavior (QAIB 12/2007). QAIB calculates investor returns as the change in assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. The 10-Year Average Annualized Returns for the S&P 500® Index was 3.50% as of 3/31/08. Past performance is no guarantee of future results.

© Copyright 2008, Advisor Perspectives, Inc. All rights reserved.


These results raise a critical question: why have these institutional investors produced returns so superior to those generated by individuals? Four elements of the investment approach used by institutions have been the key drivers of their returns over time. 1. Clearly Defined Goals: Most institutions know what they want to achieve (in terms of rate of return, or goals such as "growth" or "capital preservation") and the time frame in which they want to achieve it.

2. Ability to Leverage Different Sources of Return: Institutional investors have access to and have utilized many non-traditional investments such as real estate, private equity and hedge strategies. They also understand the risk and return dynamics of these asset classes, and how they can be used in a diversified portfolio. 3. Work with Experts: Institutional investors generally work with consultants and investment advisors who possess a clear understanding of how to build an investment portfolio to meet their clients' tolerance for risk and their need for returns. 4. Long-Term Investment Horizon: Endowments, more so than other institutions, also tend to invest with a longer time horizon, giving them the freedom to experiment with different asset classes, investment styles and unique sources of returns. Their long-term focus also means they can be patient with managers and asset classes, allowing them to stay the course through complete market cycles. On the other hand, they can at times be constrained by non-investment related issues, such as political or social investment criteria. An Evolutionary View of Asset Management The current practices of institutional investors reflect the evolution of the investment industry. While investors have always sought returns that are favorable in relation to the risks they bear, innovations have periodically redefined how investors view the trade-off between risk and reward, bringing the industry to the point at which it stands today. During the early days of investing, the primary way investors sought to create wealth was by trading individual securities. Eventually, investors realized that speculating in individual securities was not enough, and that there might be some benefit in diversifying their holdings across a broad range of the market. The concept of collective investing arrived in 1924 in what would become the forerunner to today's mutual fund. By pooling their assets, individuals could cheaply and easily diversify across a large number of holdings, while at the same time enjoying the benefits of professional management. In the late 1960s, the science of investing took another great leap forward with the work of Harry Markowitz, who essentially proved that a portfolio's risk-return profile could be improved by carefully combining non-correlated assets.2 Now, investors could add value by diversifying their assets more intelligently. The science of portfolio management was born and mutual funds began to proliferate. This development gave birth to yet another innovation during the 1990s—asset class and style diversification. Recognizing that the same laws of correlation and diversification that applied to individual securities and broad asset classes also applied to investment styles, investment managers concluded that non-correlated asset classes and investment styles could potentially increase returns without increasing risk. Services like Ibbotson, Zephyr, Lipper and Morningstar led this period of enlightenment by making style-based comparisons quick and easy.

Š Copyright 2008, Advisor Perspectives, Inc. All rights reserved.


But yet another innovation was to come. The rapid development of deep and robust markets for investments in real estate, currencies, commodities and private equity—as well as an explosion of interest in hedge strategies3 such as long/short, global macro and arbitrage—allowed institutions to seek the outsized returns and risk-reducing benefits of the non-correlated returns from these investments. Wealthy individuals and institutions flocked to these new alternative investment vehicles and an entirely new segment of the industry was hatched. The Next Stage Today, the investment industry is characterized by increased attention to diversification, a greater focus on risk management and broader choices. Still, many types of investments are not fully utilized by either advisors or individual investors. A full 58% of mutual funds reside outside of the traditional domestic equity nine-box style grid,4 yet many investors have not explored these alternatives in their portfolio. Conversely, many have invested in securities that don’t fall neatly into the style boxes, REITs for example, and are now looking for a way to better rationalize these into their total portfolio. Individuals continue to display a limited understanding of how the different elements of a portfolio can work together to achieve a particular risk/reward profile—ultimately investing in too many funds with similar holdings, investment strategies and risk/return profiles. The result: mutual fund "collectors" and not enough mutual fund investors. Individuals and their advisors might consider adopting an approach in-line with the investment strategies practiced by institutions. A modular approach to portfolio construction, the use of a broader opportunity set and a more clearly defined set of investment goals—including time horizons and return requirements—are all elements of an approach used primarily by institutions. Today, individual investors can adopt these institutional-style strategies with Modular Portfolio Construction.®

© Copyright 2008, Advisor Perspectives, Inc. All rights reserved.


What is Modular Portfolio Construction®? Modular Portfolio Construction® (MPC) is a robust and flexible framework designed to allow advisors to build institutional-style portfolios for their clients by utilizing different sources of return and combining disparate elements into a diversified portfolio while managing risk and return expectations for their clients. MPC accommodates a broad array of investment options—including high-beta sector funds, historical alpha generators, hedge strategies and individual stocks—and allows an advisor to add his or her insight through dynamic portfolio construction and rebalancing. Benefits of adopting MPC may include: 1. A potential improvement in the risk/reward profile of clients' portfolios by fully (and intelligently) utilizing all of the tools available to today's investor 2. A way to clearly articulate how the advisor seeks to add value in building and maintaining client portfolios 3. The flexibility to design portfolios using mutual funds, ETFs, alternative investment vehicles and individual securities 4. The ability to accommodate an advisor's proprietary insights as well as the client's own biases Modular Portfolio Construction® provides an adaptable framework for building customized client portfolios with the potential for greater returns and lower risk. It also provides an open platform for evaluating the role of differentiated products within a diversified portfolio. In other words, it provides the opportunity to move "beyond the style box." MPC consists of these components: 1) STRATEGY is the starting point for the portfolio; investment consulting is utilized to determine client objectives and asset allocation mix. 2) CORE is the workhorse; market-oriented investments are utilized to provide broad market exposure. 3) ALPHA seeks consistent above-market returns. 4) ALTERNATIVE attempts to add stability and diversification through investments with a lower correlation to the broader market. Janus examines each of the four components in a white paper titled, Modular Portfolio Construction®: Bringing an Institutional Framework to Individual Investors' Portfolios. View full white paper. Janus Labs® brings advisors practice management ideas, personal development programs, and investment insights that leverage research from Janus thought leaders and industry experts— helping deliver outstanding results for your clients. Modular Portfolio Construction® (MPC) is a tool intended for use by professional financial advisors. Zephyr's software has been used by Janus to create the performance related exhibits. A fee was paid to the firm for the use of the software. The results are presented gross of fees and are annualized for periods of one year or longer. For periods less than one year, performance is not annualized.

© Copyright 2008, Advisor Perspectives, Inc. All rights reserved.


FOR INSTITUTIONAL INVESTOR USE ONLY / NOT FOR PUBLIC VIEWING OR DISTRIBUTION Average stock investor performance was used from a DALBAR study, Quantitative Analysis of Investor Behavior (QAIB), 12/2006. QAIB calculates investor returns as the change in assets after excluding sales, redemptions, and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses, and any other costs. 2 "Portfolio Selection: Efficient Diversification in Investments," Harry M. Markowitz, Wiley, 1959, 1991 3 "The Dynamics of the Hedge Fund Industry," Andrew W. Lo, CFA Institute Research Foundation, 2005 4 Source: Lipper, 9/30/2007 1

The preceding article is for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. There is no guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regards to the results obtained from its use. It is not our intention to indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are inherent risks that individuals would need to address. Past performance is no guarantee of future results. C-0608-182 10-15-08

www.advisorperspectives.com For a free subscription to the Advisor Perspectives newsletter, visit: http://www.advisorperspectives.com/subscribers/subscribe.php

Š Copyright 2008, Advisor Perspectives, Inc. All rights reserved.

Modular Portfolio Construction  

Modular Portfolio Construction

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