2. Asset Classification Mis-fits David B. Loeper, CIMA, CIMC Chairman & CEO

3. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 2 #1 – Most advisors put a high value on asset allocation #2 – 90%+ of variance in returns explained by asset allocation to: » Stocks, bonds & cash (Brinson, Beebower, Hood Studies – R 2 ) » <10% of variance in returns explained by style, cap, selection, timing #3 – Overall target allocation optimized for client’s risk tolerance » If using Wealthcare, based on only risk that is necessary to confidently achieve client’s goals (normally < tolerance) #4 – Needed for rebalancing decisions » Target allocation is only representative if it is what you own AND HOW YOU EXPECT IT WILL PERFORM » Assets need to be classified so you know whether you are: 1) In balance – no action 2) Unintentionally over/under weighted – rebalance 3) Intentionally over/under weighted – tactical bet BUT- What if you don’t really know your current allocation? 1) What if you think you know, but it is wrong? » What if your trades to “correct” allocations (either tactical or strategic), end up doing the opposite of your intent? Why Classify?

4. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 3 Do you really know your current allocation? Is a label for a slice, the same as an asset class? What is the purpose of each allocation slice? a) To perform like a class we intentionally weighted considering its nature and how it combines with other assets? (either strategically or tactically) b) Give the appearance there is intent and reason behind the portfolio design, even though we have no reason to expect the slices will perform anything like the asset class we are calling it? c) Create more opportunities to generate rebalancing trades? d) Have something to talk about while we wait for a market cycle to pass as we defined in their investment policy? “In Pies We Trust”

5. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 4 Do you really know your current allocation? Is a label for a slice, the same as an asset class? What is the purpose of each allocation slice? a) To perform like a class we intentionally weighted considering its nature and how it combines with other assets? (either strategically or tactically) b) Give the appearance there is intent and reason behind the portfolio design, even though we have no reason to expect the slices will perform anything like the asset class we are calling it? c) Create more opportunities to generate rebalancing trades? d) Have something to talk about while we wait for a market cycle to pass as we defined in their investment policy? “In Pies We Trust”

6. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 5 Allocation Models Normally Designed By: » Optimization process & mean variance software » MOST IMPORTANT INPUT – Capital Market Assumptions (CMAs)Capital Market Assumptions » Return, risk and correlation matrix – Long term » Classification of securities should match RULES used to define asset classes in allocation models For Example…What is small cap? But, we have problems…

7. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 6 For Example…What is small cap? < $1 Billion market cap? (as of????) Stocks in the Russell 2000? Stocks in the S&P 600? (about 100 stocks > R2000 and 1400 fewer stocks) CRSP = deciles 6-8 of NYSE Market Cap? Generic= deciles 6-8 of all domestic stocks = 1,500 stocks A label from a data vendor? A description from a manager/fund? > Micro Cap < Large Cap? < Large Cap? But, we have problems…

8. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 7 What’s Large Cap? Large Domestic Stocks that: > $1 (or 2, 3, 4, 5) Billion market cap? (Like Berkshire Hathaway- $133B mkt cap) Stocks in the Russell 1000? (Not Berkshire Hathaway, Tyco, or Schlumberger) Stocks in S&P 500? (Schlumberger & Tyco, but not Berkshire Hathaway) CRSP = deciles 1-2 of NYSE Market Cap? Generic= deciles 1-2 of all domestic stocks = 500 stocks A label from a data vendor? A description from a manager/fund? > Mid Cap? > Small Cap? But, we have problems…

9. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 8 What’s a Domestic Stock? Headquartered in USA? Russell: Schlumberger, Tyco, Accenture is foreign S&P Committee: Schlumberger & Tyco is domestic, Accenture is foreign Primary exchange is USA (NYSE, AMEX, NASDAQ)? Not an investment trust? (Why Russell & S&P exclude Berkshire Hathaway?) Trammell Crow is a stock to Russell, but not S&P (REIT?) But, we have problems…

10. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 9 What’s Growth & Value? In Russell 3000 Growth or Value? About 30% of the stocks are in both P/B if known, adjusted for forecasts, maybe P/S Otherwise, assume average Above median (or below) price to book? 2/3 of the market cap is growth (Fama: the market over-weights growth?!) Above median (or below) price to book market cap adjusted? S&P 500 Growth has around 180 Stocks S&P 500 Value has around 320 What about Style?

11. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 10 Russell - Annually Enron, K-Mart, Worldcom = Large Cap Bankrupt for up to a year S&P – Semi- Annually Only for 6 months, unless the committee decides to keep the stock anyway… MCI - $4B+ Market Cap – Excluded from both at the moment How often do we evaluate?

12. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 11 For any one stock, depending on who you ask… » It could be large cap, mid cap, or small cap » Domestic, foreign or not even a stock at all! » Growth, Value, or a little of each AND, in all likelihood, whomever you ask the resulting classification is: » Unlikely to use the same rules for classification… That were used in the allocation model YOU ARE TARGETING FOR THE CLIENT! Think about the problems we have just in classifying a stock!

13. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 12 History of fund/manager classification » “Investment Objective” – Growth & Income, Aggressive Growth, etc. » Returns based style analysis » Either “best fit” » Or classified as nothing in particular, but instead a manufactured blend based on its performance » Holdings based analysis » At first, weighted average – one label based on market cap and price/book tilt » Then detailed holdings – like returns based style analysis, it isn’t anything in particular but instead a blend of what it owned at one point Now think about how we classify funds (managers)!

14. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 13 History of fund/manager classification » “Investment Objective” – Growth & Income, Aggressive Growth, etc. Problems: » Easily “Gamed” » Highly subjective » Many definitions inconsistent with asset classes PLUSES: » At least you might know what they are attempting to do going forward » Where past performance could represent a different objective » And holdings are too old, or tactically inconsistent with class in alpha attempt (i.e. an equity fund holding cash in anticipation of bear market) MORE PROBLEMS!

15. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 14 History of fund/manager classification » Returns based style analysis » Either “best fit” » Or classified as nothing in particular, but instead a manufactured blend based on its performance Problems: » Dependent completely on past performance being representative of future performance (isn’t there a rule about this somewhere?) » Wacky statistical results (equity fund with statistical bond allocation due to overweighting to interest sensitive stocks) Pluses: » Can label anything with performance if you don’t mind nearly every fund isn’t classified as anything in particular (is the label what’s important?) » If best fit based, can expose funds that are unreliable – didn’t perform like anything in particular so don’t assume they will start to now » Easier than digging up holdings MORE PROBLEMS!

16. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 15 History of fund/manager classification » Holdings based analysis » At first, weighted average – one label based on market cap and price/book tilt » Then detailed holdings – like returns based style analysis, it isn’t anything in particular but instead a blend of what it owned at one point PROBLEMS » Holdings out of date (rebalance because of fund weighting- even though manager of fund already did?! Result: overweight) » Vendor has different classification rules than allocation models (i.e. are the underlying stocks classified the same way?…i.e., all the problems we outlined in classifying stocks.) » Ignores performance – Which is worse? Returns based style that assumes performance will replicate, or holdings based that assume performance will match even though it never did! PLUSES: » Based on what the fund/manager really held » Many consider it “The Ultimate” MORE PROBLEMS!

17. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 16 What do you do with a portfolio that has stocks & funds? Let’s Assume: » Our stock rules apply to all holdings – even those within funds » Are based on the same rules we used to create our Capital Market Assumptions » And these result in our model portfolio allocations » These rules classify GE as large cap growth » The right target allocation for a sample client is weighted: Just to round things out… Simple Question: If this also was their current weight, are they on “Target”? YES or NO TARGET: CURRENT:

18. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 17 What do you do with a portfolio that has stocks & funds? Let’s Assume: » Our stock rules apply to all holdings – even those within funds » Are based on the same rules we used to create our Capital Market Assumptions » And these result in our model portfolio allocations » These rules classify GE as large cap growth » The right target allocation for a sample client is weighted: Just to round things out… If this also was their current weight, are they on “Target”? What if this was their current weight, but GE is 20% of the portfolio, are they still on target? Is owning GE the same as owning the large cap growth class? CURRENT:

19. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 18 Holdings analysis itself will not expose concentration risk 1) This portfolio could be 12 stocks 2) Or comprised of sector funds (regional banks for midcap value, technology fund for large cap growth, etc.) 3) Or 5000 stocks The TARGET allocation assumed each slice was diversified! Even with care, diligence and consistency… Imagine how different the performance would be if the portfolio were constructed like 1, 2, or 3 above! YET THEY ARE ALL “IN BALANCE” RELATIVE TO TARGET! CURRENT:

20. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 19 Holdings analysis itself will not expose concentration risk 1) This portfolio could be 12 stocks 2) Or comprised of sector funds 3) Or 5000 stocks The TARGET allocation assumed each slice was diversified! REMEMBER HOW YOU ANSWERED THE QUESTION… What is the purpose of each allocation slice? Imagine how different the performance would be if the portfolio were constructed like 1, 2, or 3 above! YET THEY ARE ALL “IN BALANCE” RELATIVE TO TARGET! a) To perform like a class we intentionally weighted considering its nature and how it combines with other assets? (either strategically or tactically) CONTRADICTIONS ?

21. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 20 Summary of problems for stock classifications: » It could be large cap, mid cap, or small cap » Domestic, foreign or not even a stock at all! » Growth, Value, or a little of each Summary of problems for fund/manager classifications: » Gamed Investment Objectives » Dependency on past performance replicating » Weird statistical allocations from returns based style analysis » Holdings out of date, and even if not, who knows whether the fund manager will correct tomorrow the weighting error you traded today » Ignores performance inconsistent with holdings And In General: » Classification rules used in designing Capital Market Assumptions for allocation modeling highly likely to be different than how current allocation is classified » Ignores concentration risk IS Consistency WITH THE TARGET ALLOCATION IMPORTANT? WASN’T IT TIED TO YOUR VALUE TO THE CLIENT? -Risk Tolerance (traditional) Goals (Wealthcare) CAN YOU REALLY TRUST YOUR “CURRENT” PIE? In Pies We Trust? - Are we REALLY measuring Current Vs. Target? LIES

22. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 21 Must our classification system… Choose between two evils? » Performance that ignores holdings? » Holdings that ignores performance? Be subject to whims of different vendors? » Stocks from one, funds from another? » All with different rules? » And disconnected from our Allocation modeling & CMAs? Ignore fundamental portfolio differences: » The risk of a stock, a sector and and index is worlds apart Can We Learn From Science? NO! YES I N T R O D U C I N G:

23. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 22 Our mission is to help advisors, to help their clients, make the most of the only life they have: The answer to this problem defines: A new advisory value proposition (Wealthcare), new profiling methods, new ways of designing (and analyzing) recommendations, implementation consistent with the analysis, and ongoing advising (and reporting) that continues the entire process For the last five years, we have been building everything that is necessary to make this value proposition a reality: » New profiling that truly identifies a client’s dreams, acceptable compromises and the price they would pay in one goal, to buy another they value more » Analytic tools that enable objective analysis of the trade-offs in these choices » Capital market assumptions to feed the tools to be consistent with represented confidence » Model allocations based on these consistent CMAs to cover a range of clients’ comfort with investment risk » Experts that can coach advisors in the process, or even do the hard part for them » Portfolios consistent with the model allocations that do not subject the client to unnecessary risk of materially under-performing their allocation model » Ongoing reports/reporting tools that not only measure the impact of what happened, but enable continuous advice about the future » Isn’t it proper that we enable advisors to be consistent in how they classify securities? Our Premises:

24. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 23 Good point…we chose some easy examples…maybe they were outliers? Let’s Examine the data: Out of 14,463 Mutual Funds with performance & holdings data: » 1,363 or 9.6% had an R 2 of LESS THAN.64 TO ANY INDEX » 1,959 or 13.5% had an R 2 of LESS THAN.74 TO ANY INDEX » 2,619 or 18.1% had an R 2 of LESS THAN.80 TO ANY INDEX Which indices? » 60% S&P/40% LB Aggregate, LB Aggregate Bond, LB Interm Gov’t, LB Munis, LB Munis 10-Yr, LB High Yield Composite Bond Index, EAFE, NAREIT, Russell 1000, Russell 1000 Growth, Russell 1000 Value, Russell 2000, Russell 2000 Growth, Russell 2000 Value, Russell Midcap Growth Index, Russell Midcap Index, Russell Midcap Value Index, SBr Non-US World Govt Bonds, Tax-Free Money Market, 3 Month T-Bill Yield Don’t think this is a big deal? An R 2 of.64 (correlation of.8) is less than the correlation of: » Mid Cap Growth to Large Cap Core! » Small Cap Growth to Large Cap Growth! » Micro Cap Core to MID CAP GROWTH! » 60%Large/40% Fixed to MID CAP GROWTH! THINK ABOUT IT!!! The fund you classify based on holdings as mid cap growth could perform less like mid cap growth than a balanced allocation or micro cap index!!! Is The Classification Problem Really That Big of a Deal?

25. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 24 What if we just examine funds we have performance & holdings data on that: » Had a correlation to an equity style index of >.80 (R 2 >.64) » Had 90% or more of holdings in large, mid, small, growth, value, core Total number of funds that met both criteria: » 4,336 » Total funds whose performance best fit WAS DIFFERENT than, their greatest holdings overweight (market relative)? Want to take a guess? 1,854 or 42.7% SO MUCH FOR HOLDINGS BEING THE “ULTIMATE”!!! Is The Classification Problem Really That Big of a Deal?

26. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 25 What label to stick on it? Or information? When You Are Examining Holdings, What Do You Want To Know? LINNAEUS STYLE BOXES % of PortfolioMarket Relative Weight

27. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 26 When You Are Examining Holdings, What Do You Want To Know? LINNAEUS STYLE BOXES % of PortfolioMarket Relative Weight Portfolio weighting to each style box Overall style weighting Overall market cap weighting Portfolio weighting relative to overall market: + = over-weighted - = under-weighted Overall style tilt relative to market Overall cap tilt relative to market Greatest weight And greatest over- weight relative to market The market relative weighting can expose some important information

28. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 27 Compare These Two Large Cap Core Funds: LINNAEUS STYLE BOXES Market Relative Weight About the same, but this one must buy bigger large cap stocks…Right? Or, maybe one is an S&P 500 Index Fund (Good for Large Cap Core allocation) Clearly they are both large cap core funds though…Right? Maybe one equal weights versus cap weights?…or…Maybe one avoids “super caps”? But both could be used for a large cap core allocation…right? Market Relative Weight And the other is a Total Market Index fund OH!!! THAT’S WHY THE AVERAGE MARKET CAP IS LOWER!!! That’s just the holdings though…What about that performance inconsistency we discovered on 43% of the funds?

29. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 28 Example: BRWIX Our holdings analysis: Morningstar Classification: Mid Cap Growth (source: Morningstar website) Correlation to Mid Cap Growth?.74 (R 2.55) » or less than its correlation to EAFE, Large Value, Small Core, Small Value (.84) or Mid Value (.83) But it is Four Stars Overall !!! Any of you use this for your mid cap growth allocation?….WHY? Is it really that bad? % of Portfolio Market Relative Weight

30. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 29 Example: BJSCX Our holdings analysis: Morningstar Category: Mid Growth (source: Morningstar website – style box small growth) Correlation to Mid Growth:.82 (R 2.67) Or less than its correlation to: » Small Value (.87), Mid Core (.88), Mid Value (.86), Small Core (.89) It may hold small & mid growth stocks, but it performs more like small/mid value & core Was that the intent of your midcap growth allocation? To perform like small and mid value & core? Is it really that bad? % of Portfolio Market Relative Weight

31. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 30 Define Your Asset Classes How you define each market: » Stocks (by region, i.e. domestic, foreign or far east, Europe, emerging markets) » Then by cap (micro, small, mid, large, super large) » Then by style (pure value, value bias, core, growth bias, pure growth) » Supports 1X1 Style box (Brinson Macro Level) to 5X5 (default is 3X4 – growth, value, core and micro, small, mid, large) » Can set style rules based on choices of price/book (% of cap segment ala Fama) or % of market ala Barra » Can set market cap breaks as percent of securities (ala CRSP or Russell) or as % of market (ala flexibility) Define fixed income styles » Quality, maturity, domestic/foreign, taxable/munis » Supports 1X1 Style box to 5X5 for domestic taxable alone (default is 4X3 – gov’t/insured, investment grade, high yield, in default and short, intermediate and long) Capital Market Assumptions Defined for each style level class (risk/return/correlation) » Either our defaults designed for Monte Carlo, or your over-rides How it works…getting rid of the evils:

32. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 31 Define Your Rules & Classification Philosophy: Performance Only (ignore holdings – everything with performance gets label unless you define minimum R 2 ) Performance Priority (Classify on performance if holdings over-weighted to best fit) Holdings Only Greatest Weight (Ignore performance and classify based on holdings that are largest port. %) Holdings Only Market Relative Weight (Ignore performance and classify on greatest market relative overweight) Holdings Priority Market Relative (Classify as most market relative overweight of holdings if performance of style benchmark is > minimum defined) Holdings Priority Greatest Weight (Classify as greatest weight of holdings if performance of style benchmark is > minimum defined) Our recommended default: Holdings Priority Market Relative (min r-squared.81) Exposes greatest number of inconsistent funds – those you cannot count on to fulfill a purpose in your allocation Of course, you can set it to slap a label on everything… (Performance Only with no minimum criteria or Holdings Only) It would probably be more valuable to know which funds you should not trust! How it works…getting rid of the evils:

33. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 32 Finally, run configuration: It will process all 5,800+ domestically traded stocks Plus 30,000 + Mutual Funds, Closed End Funds & Variable Annuities Plus 300,000+ Foreign Stocks & Bonds as well as domestic & municipal bonds In addition to classifying all of these securities based on the rules: » It will assign a risk & return assumption unique to each security for use in measuring portfolio risk (return= asset class & risk adjusted for relative standard deviation) » Allow you to drill into each security to examine it’s holdings, performance, and Monte Carlo based risk & return assumptions » Examine holdings based style by % of portfolio or relative to how you defined the markets around the world » Examine its performance relative to all of your asset classes » Assemble portfolios of stocks & mutual funds » Examine blended holdings down to the security level » Expose over-lap in holdings between funds » As well as portfolio concentration risk How it works…getting rid of the evils:

34. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 33 Portfolios designed to meet client goals: » Based on consistency of allocation models based on long-term CMAs » Consistent treatment of stocks whether they are individually held, or within a fund » Tied to how the CMAs were built » Accurate exposure of overlap and concentration risk » An objective measure of the risk of any one security » Or any one portfolio » And, if it matters to you, a means of accurately and consistently measuring whether or not: » There is reason to expect your holdings to perform like your allocation The Result:

35. ©Copyright Financeware, Inc. 2004 All rights reserved DELIVERING PAGE 34 If you are interested in being a Beta tester, contact your Wealthcare Specialist QUESTIONS? We are anticipating going to Beta late this summer/fall: